Financial management course

1. 12/6/2022
Prepared By
Dr. Mahmoud Otaify
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Inventory Management
What is
inventory?
• Raw materials, work in process (partially
finished goods), finished goods
What is
objective of its
management?
• is to turn it over as quickly as possible
without stockouts.
How firm
control
inventory?
• COMMON TECHNIQUES
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COMMON TECHNIQUES FOR
MANAGING INVENTORY
ABC System
Economic
Order Quantity
(EOQ) Model
Just-in-Time
(JIT) System
Computerized
Systems for
Resource
Control
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1. ABC inventory system
A
Group
B
Group
C
Group
includes items with the largest
dollar investment (80%).
Large number of
items that
require a
relatively small
investment.
items that account for
the next largest
investment in inventory
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receive the most
intense monitoring
Daily verification of
each item’s inventory
level
Items are frequently
controlled through
periodic, perhaps
weekly, checking of
their levels
Two-bin method:
each item is
stored in two
bins.
level of monitoring
determining an item’s optimal
order size that minimizes total
inventory cost
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Economic Order Quantity (EOQ) Model
Order
costs
fixed costs of
placing and
receiving orders
The more orders a
firm places, the
higher are order
costs
carrying
costs
Variable costs per
unit of holding an
item of inventory
for a specific
period of time
Such costs as
storage,
insurance,
opportunity
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Measured in dollars per unit per
period
Measured in dollars per order
Order
cost
Carrying
cost
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The EOQ model
analyzes the
tradeoff between
order costs and
carrying costs to
determine the
order quantity that
minimizes the total
inventory cost.
usage in units per period
carrying cost per unit per period
cost per order
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EOQ Model - Example
MAX
Company
has an A
group
inventory
item that is
vital to the
production
process.
This item
costs
$1,500, and
MAX uses
1,100 units
of the item
per year.
Order cost
per order =
$150
Carrying
cost per unit
per year =
$200
MAX wants
to determine
its optimal
order
strategy for
the item.
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When to place an
order?
The reorder point reflects the number of days of lead time
the firm needs to place and receive an order and the firm’s
daily usage of the inventory item.
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EOQ Model – Example (continued)
MAX
Company
has an A
group
inventory
item that is
vital to the
production
process.
MAX uses
1,100
units of
the item
per year.
Assuming
that MAX
operates
250 days
per year
if MAX
knows it
takes 2
days to
place and
receive an
order
When
should
MAX
place
the
order?
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Daily usage = 1,100 units/250 days = 4.4 units per day
Reorder point = 2 X 4.4 = 9 units so MAX places the order
when the inventory falls
to 9 units
What is risk in
calculating
reorder point?
 That lead times and usage rates may not precise
 most firms hold safety stock (extra inventory) to prevent stockouts of
important items.
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EOQ Model – Example (modified)
MAX
Company
has an A
group
inventory
item that is
vital to the
production
process.
MAX uses
4.4 units
of the item
per day.
if MAX
knows it
takes 2
days to
place and
receive an
order
MAX
wants to
maintain a
safety
stock of 4
units
When
should
MAX
place
the
order?
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Reorder point = (2 X 4.4) + 4= 13 units
so MAX places the order
when the inventory falls
to 13 units
safety
stock
Just In time (JIT)
System
JIT Techniques minimizes inventory investment by having materials
arrive at exactly the time they are needed for production
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materials should
arrive at exactly the
time they are needed
for production
have only work-in-
process inventory
uses no/very little
safety stock
JIT’s goal is to attain
manufacturing
efficiency. So it
requires
Timely delivery that
needs Extensive
coordination
requires high-quality
parts from suppliers
Failure of
materials to
arrive on time
quality
problems
shutdown of
the production
line
Computerized
Systems for
Resource
Control
Materials requirement planning (MRP) System
Manufacturing resource planning II (MRP II) System
Enterprise resource planning (ERP) System
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Materials requirement planning (MRP) System
Method
• MRP Applies EOQ concepts to determine how much to order
• Using a computer, MRP simulates each product’s bill of
materials, inventory status, and manufacturing process.
Function
to determine
what materials to order and
When to order them
Objective
• is to lower the firm’s inventory investment without impairing
production
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Available
inventory
balances
Production
needs
Time for work
in process
Lead time
MRP
System
computer simulates material requirements by
comparing production needs to available
inventory balances
MRP system determines when orders
should be placed for various items on the bill of
materials
Bill of Materials
(list of all parts
and materials)
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Manufacturing Resource Planning II (MRP II)
MRP system models the firm’s processes
so that the firm can assess and monitor
the effects of changes in one area of
operations on other areas.
Ex., it allows the firm to determine the
effect of an increase in labor costs on
sales and profits
This system generates production plans as well as
numerous financial and management reports.
Using a sophisticated computer system
integrates data from numerous areas such as finance, accounting,
marketing, engineering, and manufacturing,
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Enterprise Resource Planning (ERP ) System
Production Dep. can call up sales information and immediately
know how much must be produced to fill customer orders.
Because ERP electronically integrates all of a firm’s
departments
The system can eliminate production delays and control costs
ERP systems automatically note changes, such as a supplier’s inability to
meet a scheduled delivery date,
expands the focus to the external environment by
including information about suppliers and customers.
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Problem (1) EOQ analysis
Thompson Paint Company uses 60,000 gallons of
pigment per year. The cost of ordering pigment is $200
per order, and the cost of carrying the pigment in
inventory is $1 per gallon per year. The firm uses
pigment at a constant rate every day throughout the
year.
(Note: Use a 365-day year.)
1. Calculate the EOQ.
2. Assuming that it takes 20 days to receive an order
once it has been placed, determine the reorder point
in terms of gallons of pigment.
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Problem (2) EOQ analysis - student
Enviro Exhaust Company purchases 1,200,000
units per year of a component with a purchase
price of $50. The fixed cost is $15 per order, and
the carrying cost is 30% of the purchase price.
1. Calculate the EOQ based on the data given.
2. Calculate the EOQ if the order cost is zero.
What is the implication to the firm if there is a
decrease in the order cost?
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Problem (3) EOQ, reorder point, and safety stock
Outdoor Living Manufacturers uses 1,000 units of a product per
year. Its fixed cost is $28 per order, while the carrying cost is $5 per
unit per year. The lead time is 5 days and, therefore, the firm keeps
7 days’ usage in inventory as safety stock. (Note: Use a 365-day year
where required.)
1. Calculate the EOQ and the average inventory.
2. How many orders will Outdoor Living Manufacturers place
during 1 year?
3. When should Outdoor Living Manufacturers place its orders?
4. Suppose Outdoor Living Manufacturers does not keep safety
stock. Explain the changes, if any, which will occur in (1) order
cost, (2) carrying cost, (3) total inventory cost, (4) reorder point,
and (5) EOQ.
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