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9. Inventory Fundamentals

Chapter 9   Inventory Fundamentals Introduction ·          All businesses and institutions require inventories.  As inventories are used, th... thumbnail 1 summary

Chapter 9 

Inventory Fundamentals

·         All businesses and institutions require inventories.  As inventories are used, their value is converted into cash, which improves cash flow and return on investment.  There is a cost for carrying inventories, which increases operating costs and decreases profits.
·         Aggregate inventory management involves: flow and kinds of inventory needed, supply and demand patterns, functions that inventories perform, objectives of inventory management and costs associated with inventories.  Inventory is not only managed at the aggregate level but also at the item level.  Decision rules about inventory include: (1) which individual inventory items are most important, (2) how individual items are to be controlled, (3) how much to order at one time, and (4) when to place an order.
Inventory and the Flow of Material
·         One often-used inventory classification is related to the flow of materials into, through, and out of a manufacturing organization.  Raw materials are purchased items received which have not entered the production process.  Work-in-process (WIP) is raw materials that have entered the manufacturing process and are being worked on or waiting to be worked on.  Finished goods are the finished products of the production process that are ready to be sold as completed items.  Distribution inventories are finished goods located in the distribution system.  Maintenance, repair, and operational supplies (MRO) are items used in production that do not become part of the product.
Functions of Inventories
·         In batch manufacturing, the basic purpose of inventories is to decouple supply and demand.  Inventory serves as a buffer between: supply and demand, customer demand and finished goods, finished goods and component availability, requirements for an operation and the output from the preceding operation, and parts and materials to begin production and the suppliers of materials.
·         Anticipation inventories are built up in anticipation of future demand.  Safety stock is held to cover random unpredictable fluctuations in supply and demand or lead-time.  Its purpose is to prevent disruptions in manufacturing or deliveries to customers.  Safety stock is also called buffer stock or reserve stock.  Items purchased or manufactured in quantities greater than needed immediately create lot-size inventories, sometimes called cycle stock.  It is the portion of inventory that depletes gradually as customers’ orders come in and is replenished cyclically when suppliers’ orders are received.  Transportation inventories exist because of the time needed to move goods from one location to another such as from plant to a distribution center or a customer.  They are sometimes called pipeline or movement inventoriesHedge inventory is purchased to minimize the market fluctuations of raw materials traded on the worldwide market.  MRO items are used to support general operations and maintenance, but which do not become directly part of a product.
Objectives of Inventory Management
·         A firm wishing to maximize profit will have at least the following objectives: maximum customer service, low-cost plant operation, and minimum inventory investment.  Inventories help to maximize customer service by protecting against uncertainty.  If inventory is carried, there has to be a benefit that exceeds the costs of carrying that inventory.  Someone once said that the only good reason for carrying inventory beyond current needs is if it costs less to carry it than not.
·         Inventories help make a manufacturing operation more productive in four ways: (1) Inventories allow operations with different rates of production of operate separately and more economically. (2) By leveling production, manufacturing can continually produce an amount equal to the average demand. (3) Inventories allow manufacturing to run longer production runs. (4) Inventories allow manufacturing to purchase in larger quantities, which results in lower ordering costs per unit and quantity discounts.
·         Costs used for inventory management decisions: item cost (landed price), carrying costs, ordering costs, stockout costs, and capacity-associated costs.
Financial Statements and Inventory
·         An asset is something that has value and is expected to benefit the future operation of the business.  Liabilities are obligations or amounts owed by a company.  Owner’s equity is the difference between assets and liabilities.  The accounting equation:         

                                                               Assets = liabilities + Owner’s equity
·         The balance sheet is usually shown with the assets on the left side and liabilities and owner’s equity on the right side.  Capital is the amount of money the owners have invested in the company.  Retained earnings are increased by the revenue a company makes and decreased by the expenses incurred.
·         Income (profit) – The primary purpose of a business is to increase the owner’s equity by making a profit.
                                       Income = revenue – expenses
·         Revenue comes from the sale of goods or services and often is made as a promise to pay at a later date, called an account receivable.
·         Expenses are the costs incurred in the process of making revenue, usually categorized into cost of goods sold and general and administrative expenses.  Cost of goods sold are the costs incurred to make the product.  General and administrative expenses include all other costs in running a business.
·         Income Statement.
·         When inventory is purchased as raw material, it is recorded as an asset.  When it enters production, it is recorded as work-in-process inventory (WIP) and, as it is processed, its value increases by the amount of direct labor applied to it and the overhead attributed to its processing.  The material is said to absorb overhead.  When the gooda are ready for sale, they do not become revenue until they are sold.
·         Businesses develop financial statements showing the cash flows into and out of the business.  Any shortfall of cash must be provided for, perhaps by borrowing.  This type of analysis is called cash flow analysis.
·         From a financial point of view, inventory is an asset and represents money that is tied up and cannot be used for other purposes.  Inventory has a carrying cost – the costs of capital, storage, and risk.  Two measures that quantify inventory investment and relate to sales are the inventory turns ratio and days of supply :
           Inventory = annual cost of goods sold / average inventory in dollars
           Days of supply = inventory on hand / average daily usage
·         Control of inventory is exercised by controlling individual items called stock-keeping units (SKU’s).  ABC inventory classification system answers which items are important and how they are controlled.  Classifying items according to their importance can be based on annual dollar usage.  The ABC principle is based on Pareto’s law. A items – About 20% of the items account for about 80% of the dollar usage.  B items – About 20% of the items account for about 15% of the dollar usage.  The balance (50%) are 5% of the dollar usage.
·         Using the ABC approach, there are two general rules to follow: (1) Have plenty of low-value items.  (2) Use the money and control effort saved to reduce the inventory of high-value items.
A items: high priority and tight control
B items: medium priority and normal controls