OPERATIONAL LEVEL

Subject Financial Reporting (F1)

Pasindu Dewalegama
Lecturer CIMA Passed Finalist, MBA (West London-UK), ACSI-UK, AIB (SL), Member at Association of Professional Bankers (SL),
Advanced Diploma in Credit Management - Institute of Bankers (SL)

Module Study Session 4-4 - Inventory Control

Code F1/PD/21

[Link]
 INVENTORY CONTROL

Cost of high inventory

1. The foregone interest that is lost from tying up capital in inventory/ cost of borrowing.
2. Cost of holding
• Storage
• Administration
• Risk of damage / theft/ obsolescence.

Cost of low inventory levels.

1. Stock outs
• Lost contribution
• Production stoppage.
• Emergency orders.
2. High reorder / setup cost.
3. Lost quantity discounts

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 Any organisation should determine
1. Optimum reorder level – At what level of Inventory should the order be placed to
receive the new inventory?
2. Optimum reorder quantity – the quantity to be ordered.

Other key terms associated with inventory management include:

• Lead Time- the time taken from the time the order is placed until the inventory is
received.

• Buffer Inventory – This is the minimum level of inventory expected under normal
conditions. This will be reached just before the inventory is received.

EOQ

Economic Order Quantity

• This will be used by organisations that do not use Just in Time (JIT).
• This is the number of units to be ordered at a time.
• The aim of the EOQ model is to minimise the total cost of holding and ordering inventory.
• The cost of ordering will be equal to cost of holding

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Cost of holding (Ch)
• This is the average cost of holding one unit per annum. It is calculated based on the
average inventory held by the organisation.
• The total cost of holding is considered as a fixed cost.
• It is calculated as = Cost of holding a unit per annum x average quantity held

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Cost of ordering (Co)
• This is the cost of ordering inventory.
• Total cost of ordering will be based on number of times the orders are placed.
• It is calculated as = Cost of ordering per order x number of orders.
• Number of orders will be = Demand per annum / EOQ

Where:
CO = Cost per order
D = Annual demand
CH = Cost of holding one
unit for one year.

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EOQ is calculated based on the following assumptions.

1. Demand and lead time are known and constant.

2. Purchase price is constant.
3. No buffer inventory is held since demand and lead times are known.

Question no 01

An entity requires 1,000 units of material X per month. The cost per order is $30 regardless of
the size of the order. The annual holding costs are$2.88 per unit.

Required: The total cost of buying the material in quantities of 400, 500,or 600 units at one time.
Identify the cheapest option. [Apply the EOQ formula to prove your answer is correct.]

Dealing with quantity discounts

The supplier may offer a price discount for purchases above a certain quantity. In such a situation
the decision will be to determine whether to order the EOQ or the quantity based on discount. It
should be determined based on the following.

1. Calculate the EOQ ignoring the discount.

2. If the EOQ is below the quantity qualifying for a discount then calculate the annual cost
using EOQ.
3. Recalculate the annual cost using order size required to obtain the discount.
4. Compare the cost of Step 2 with step 3 and select the cheapest option.
5. Repeat for all discounts levels

Question no 02
Wolvo is a retailer of barrels. The entity has an annual demand of 30,000barrels. The barrels cost
$12 each. Supplies can be obtained immediately, with ordering and transport costs amounting
to $200 per order. The annual cost of holding one barrel in stock is estimated to be
$1.20 per barrel.
A 2% discount is available on orders of at least 5,000 barrels and a 2.5%discount is available if the
order quantity is 7,500 barrels or above.

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Calculate the EOQ ignoring the discount and calculate if it would change once the discount is
taken into account.

Criticism of EOQ
1. It is based on simplified assumptions. (Demand, usage, lead-time).
2. Does not consider discounts.
3. Does not consider the managing the inventory.
4. Not compatible with JIT and Total Quality Management (TQM)

Inventory management systems

A number of systems have been developed to simplify the inventory management process:

1. Periodic review
2. JIT

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1. Periodic review system (constant order cycle system)
Inventory levels are reviewed at fixed intervals, e.g. every four weeks. The inventory in hand is
then made up to a predetermined level, which takes account of:

• likely demand before the next review

• likely demand during the lead time.

Thus a four-weekly review in a system where the lead time was two weeks would demand that
inventory be made up to the likely maximum demand for the next six weeks.

Question no 03

A company has estimated that, for the coming season, weekly demand for components will be
80 units. At the most recent stock count, 250 units of inventory where counted. Suppliers take
three weeks on average to deliver goods once they have been ordered and a buffer inventory of
35 units is held.

If the inventory levels are reviewed every six weeks, how many units will need to be ordered to
ensure the buffer is maintained?

2. Just in Time (JIT) systems

JIT is a series of manufacturing and supply chain techniques that aim to minimise inventory levels
and improve customer service by manufacturing not only at the exact time customers require,
but also in the exact quantities they need and at competitive prices.

In JIT systems, the balancing act is dispensed with. Inventory is reduced to an absolute
minimum or eliminated altogether.

Aims of JIT are:

• a smooth flow of work through the manufacturing plant

• a flexible production process which is responsive to the customer’s requirements
• reduction in capital tied up in inventory.

This involves the elimination of all activities performed that do not add value =waste.

JIT extends much further than a concentration on inventory levels. It centres around the
elimination of waste. Waste is defined as any activity performed within a manufacturing
company which does not add value to the product. Examples of waste are:

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 • Raw material inventory
• WIP inventory
• Finished goods inventory
• Materials handling
• Quality problems (rejects and reworks, etc.)
• Queues and delays on the shop floor
• Long raw material lead times
• Long customer lead times
• Unnecessary clerical and accounting procedures.

JIT attempts to eliminate waste at every stage of the manufacturing process, notably by the
elimination of:

• WIP, by reducing batch sizes (often to one)

• raw materials inventory, by the suppliers delivering direct to the shop floor JIT for use
• scrap and rework, by an emphasis on total quality control of the design, of the process,
and of the materials
• finished goods inventory, by reducing lead times so that all products are made to order
• material handling costs, by re-design of the shop floor so that goods move directly
between adjacent work centres.

The combination of these concepts in JIT results in:

• a smooth flow of work through the manufacturing plant

• a flexible production process which is responsive to the customer’s requirements
• reduction in capital tied up in inventory.

A JIT manufacturer looks for a single supplier who can provide high quality, frequent and reliable
deliveries, rather than the lowest price. In return, the supplier can expect more business under
long-term purchase orders, thus providing greater certainty in forecasting activity levels. Very
often the suppliers will be located close to the company.

Reduction in inventory levels reduces the time taken to count inventory and the clerical cost.
However with JIT, although inventory holding costs are close to zero, inventory ordering costs
are high.

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Inventory control systems
1. Re- order level system (inventory ordered at a particular level of inventory) it is also
called two bin system.
2. Periodic review system (inventory ordered at particular time intervals)
3. Mixed system. ( incorporating the 1& 2 above)

Calculating Re-order Level. (ROL)

1. Known demand and lead time

Having decided how much inventory to re-order, the next problem is when to reorder. The firm
needs to identify a level of inventory which can be reached before an order needs to be placed.

The ROL is the quantity of inventory on hand when an order is placed. When demand and lead
times are known with certainty the ROL may exactly,

ROL = demand in the lead time.

Question no 04

Using the data for Wolvo from Question no 02, assume that the entity adopts the EOQ as its
order quantity and that it now takes two weeks for an order to be delivered.
Calculate how frequently the entity will place an order? Calculate how much inventory it will
have on hand when the order is placed?

2. ROL with variable demand or variable lead time

When there is uncertainty over demand or lead times are known then the ROL will be
calculated as;

ROL = maximum demand x maximum lead time.

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These will lead to the creation of buffer stock.

Buffer Inventory (Minimum Stock Level)

• This is the inventory maintained to be used in an emergency.(usage being more than
average or lead time being more than average)

Buffer Stock = ROL – Average Usage

Average Usage = Average demand per day in units x Average re-order lead
time

The annual cost of = Buffer Stock x the annual holding cost for one
unit
holding buffer stock of the inventory system

Maximum Inventory level

• ROL +EOQ - (Minimum Usage X Minimum Lead Time)

Inventory warning levels

Two warning levels might also be used, to indicate when the quantity ofan item in inventory is
either:
• higher than should be expected, or
• below the buffer stock level.

If the quantity of inventory goes above the maximum level or below the minimum level, the
inventory manager should monitor the position carefully, and where appropriate take control
measures.

The maximum inventory level will occur when a new order has just been delivered by the
supplier, the order has been delivered within the minimum lead time, and demand has been at
a minimum during the lead time.

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Question no 05

Identify which of the following is not a required assumption for the basic EOQ model?

A. The lead time is zero

B. There are no stock-outs
C. The demand is known and constant
D. The purchase price is constant regardless of order quantity

Question no 06

Monthly demand for a product is 10,000 units. The purchase price is $10/unit and the entity's
cost of finance is 15% pa. Warehouse storage costs per unit pa are $2/unit. The supplier charges
$200 per order for delivery. Holding costs should include the 15% finance costs. Calculate the
EOQ.

Question no 07

Doris uses component V22 in its construction process. The entity has a demand of 45,000
components pa. They cost $4.50 each. There is no lead time between order and delivery, and
ordering costs amount to $100 per order. The annual cost of holding one component in inventory
is estimated to be $0.65. A 0.5% discount is available on orders of at least 3,000 components and
a 0.75% discount is available if the order quantity is 6,000 components or above.

1. Calculate the EOQ.

2. Calculate the total annual costs for the entity.

3. Calculate the cost of ordering 6,000 units and identify any savings that could be made.

4. Ignoring discounts, assume that the entity adopts the EOQ as its order quantity and that it now
takes three weeks for an order to be delivered. Calculate how frequently the entity will place an
order?

5. Calculate how much inventory it will have on hand when the order is placed?

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Question no 08

Which ONE of the following would not normally be considered a cost of holding inventory?

A. Inventory obsolescence
B. Insurance cost of inventory
C. Interest cost of cash invested in inventory
D. Loss of sales from a stock-out.

Question no 09

An entity uses the economic order quantity model (EOQ model). Demand for the entity's product is 36,000
units each year and is evenly distributed each day. The cost of placing an order is $10 and the cost of
holding a unit of inventory for a year is $2.

How many orders should the entity make in a year?

A. 60
B. 120
C. 300
D. 600

Question no 10

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Question no 11

Which of the following is LEAST relevant to the simple economic order quantity (EOQ)
model for inventory?
A Safety stock
B Annual demand
C Holding costs
D Order costs

Question no 12

PB uses 2,500 units of component X per year. Its production director has calculated that the
cost of placing and processing a purchase order for component X is $185, and the cost of
holding one unit of component X for a year is $25.

What is the economic order quantity (EOQ) for component X and, assuming a 52-week year,
what is the average frequency at which purchase orders should be placed?

Question no 13

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Question no 14

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