Inventory Management Control - Essay Example

? Inventory Management Control Inventory Control Executive summary Inventory management is a serious issue in the modern society; it provides a company with a competitive edge compared to other similar companies. Generally, the word inventory is used to make reference to any kind of resource that has economic value and is subject to maintenance in order to fulfill the present as well as the future needs of that organization. According to Dervitsiotis (123) Inventory is defined as an idle resource of any type for as long as such a resource has an economic value. Resources Inventory is maintained to provide desirable service to clients as well as achieve sales turnover estimates. Investment in large inventories believed to have an adverse effect on a firm’s cash flow as well as working capital. It basically represents a considerable portion of entire capital investment in any entity. It is in as a result essential to create a balance between the advantages of having a resources inventory of resources and the costs associated with maintenance in order to establish the optimum inventory level associated with each and every resources and keep the inventory costs minimal. Holding of stock can be quite expensive and hence controls are necessary to make sure that stock levels are kept at as low as possible. Stocks need to be controlled based on rational policies to create a balance between the cost of holding and the demand for the same. One of the approaches often adopted is the economic order quantity for stock replenishment which results into lowered holding cost reduces as well as a low total yearly inventory cost. Although maintaining exact EOQ is sometime impossible, working within vicinity of it outcomes in lower total yearly inventory cost is possible and commendable. Holding cost is considered a straight line that directly varies with ordering quantity. This is according to the classic EOQ model and is substantially true for non-perishable products. This research will check through linear regression the relation of holding cost with time and quantity that it is a curve. Introduction In the period of recession of each and every firm is keen on to cutting their costs and inventory cost management plays a vital role in this endeavor. Managing inventory effectively is an important way of regulating costs and, as a result, improving the profitability of organization. Given that a higher quantity is not the best … and a lower quantity is not similarly the best … there has to be some “Economic order quantity (EOQ)” which ensures minimal total variable costs associated with the inventory (Cardenas 950). Total variable costs are often computed based on a yearly terms and incorporates two components, which are the costs of ordering and holding inventory. Yearly ordering cost is defined as the number of orders that one places multiplied by the marginal or incremental cost one incurs for every order. This incremental cost incorporates various components such as the costs of preparing purchase orders, making pay for vendor's invoice, as well costs associated with inspection and handling of the material upon arrival. It is not easy to estimate these components precisely but a ball?park figure is good a good option for doing this. The holding costs are used within the EOQ model needs to also be marginal in nature. Such may include although not limited to insurance, taxes, as well as storage charges (Liberatore 394). Some of the entities also include the interest cost associated with the money tied up within the inventory. In classical EOQ model, as the quantity rises holding cost as well rise proportionally i.e. it remains lineal to the time function although in real life, the cumulative holding cost is indeed a convex time function due to the fact that the handling and holding costs work side by side to rise alongside cumulative rise in daily cost due to wastage, pilferage as well as obsolescence (Liberatore 395). This is however not common with non-perishable goods such as engineering components. Generally, Materials management is concerned basically with planning and control of materials. Control is a process by which events are made to conform to a plan. Therefore to control materials, there must be a store, where to buy, when to buy, and how much to buy. The items to be stored will be dictated by the basic functions of the firm and the customers it serves. The suppliers to be selected will be influenced by such factors as the ability of the supplier to supply the quantity of the right quality at the right time and at the right price (right from the point of view of the purchaser). Continuous stock checking is the checking by counting of physical quantities of materials in stores regularly, a few at a time, until items are checked at least once a year. Statement of problem The problem of stores control has been in existence for too long. This Problem is still with us to date and is a universal rather than a peculiar problem. Thus, it is not limited to a single organization or discipline but to all business disciplines. Many business entities from across the globe have not accorded inventory control stock the attention it deserves despite the varied importance it deserves. However, various if not all engineering disciplines have recognized the challenge and have in turn heavily invested in inventory control management methods that facilitate success, one of them being the EOQ model. The main problem to be addressed in this paper dwells on lubrication oil. While it is a regularly required material within a machine shop, its storage costs may inflate due to the special conditions it requires for storage. The model developed will attempt to strike a balance. Objective of study This study aims to develop an EOQ model, use it to calculate EOQ of lubrication oil used in a machine shop and hence show that at this point the total yearly inventory cost is kept minimal. Methodology The focus was on a machine shop lubrication oil needs. The research establishes an economic order quantity using the classic EOQ model. The model provides information with regard to the required order, which involves a tradeoff between yearly holding cost and yearly ordering cost as well as ensuring minimal total inventory cost, is incurred (Keth, Muhlemen, & Oakland 214). In real life holding cost in non-constant as presumed by classic EOQ model where it is given by straight line, it is in actual sense a curve. It is shown via regression analysis the dependence of holding cost on the number of days. Components of Inventory Cost: Most, if not all inventory decision rules involve some form of economic criteria.  As a result, it is very important to comprehend the cost of inventory, which can be broken down into the finer details as shown below. Item Cost  This refers to the cost of purchasing/production of individual inventory items (lubrication oil).  This cost may be reduced by mass production/ordering due to large scale economies. The cost of a bulk purchase is usually reduced by a huge (trade) discount. Cash (settlement) discounts might not be accounted for due to the fact that early payment decisions are usually not included in the inventory management system.  Freight cost (also import duties and so on) may also be part of the lubrication oil cost if it varies with the quantity purchased (Keth, Muhlemen, & Oakland 312). The lubrication oil cost can often be estimated, with perfect accuracy, directly from the available records.  Ordering/setting up cost: The ordering cost is related with ordering a batch of the focus items.  Ordering cost is non-dependent on the quantity ordered; it is assigned to the whole batch.  This cost.  Transportation cost as well as handling charges might not be included if they are fixed per purchasing order. Similarly, for a manufacturing concern, setting up costs are those costs related to placing an order of a batch of commodities to be produced/ordered irrespective of the quantity in the batch (Keth, Muhlemen, & Oakland 318).  These include the paperwork of the production order, costs necessary to set up production machine for a run, following up the order, among others.   Holding (or Carrying) Cost: The holding cost is related to keeping items in inventory for a period of time.  It is typically charged as a % of the item cost per unit duration.  The holding cost usually consists of three components:  1. Opportunity cost of capital: When items are carried in inventory, the capital invested is not available for other purposes.  2. Storage cost: This cost includes variable space cost, insurance, wages, protective clothing/containers, and so on. In theory, only variable costs are included because fixed costs remain unchanged for different sizes of reorder quantity when we, say, consider the economic order quantity.  3. Costs of obsolescence, deterioration and loss – Obsolescence costs, including possible rework or scrapping, should be assigned to items which have a high risk of becoming out of fashion.  Perishable goods should be charged with deterioration costs which include costs of preventing deterioration. The costs of loss include pilferage and breakage costs associated with holding items in inventory.  The holding cost is more difficult to determine accurately.  The opportunity cost of capital cannot be directly derived from historical records but may only be estimated on the basis of current financial considerations (Keth, Muhlemen, & Oakland, 1994).  Costs of storage, obsolescence and etc can be estimated from company records plus special cost studies; however, it is difficult to separate the fixed and variable components and only to include those variable ones into the holding cost.  The effect of price level changes is the most difficult one for estimation.   Stock out Cost: It reflects the economic consequences of running out of stock.  There are two cases here.  First, items are backordered.  Second, the sales are lost.  In cases, the cost of administration on backorders, the loss of profit from the sales forgone, and the savings on holding less inventory may be calculated.  However the loss of goodwill or future business associated with both cases is very difficult to calculate and is often handled indirectly by specifying an acceptable stock out risk level. Economic Order Quantity Model The economic order quantity model is a classic independent demand inventory system that provides many useful ordering decision .the basic question the correct order size to minimize total inventory cost. This issue revolves around the tradeoff between yearly holding cost and yearly order cost (Keth, Muhlemen, & Oakland 345). The EOQ model seeks to determine an optimal order quantity where the sum of yearly order cost and the yearly inventory holding cost is minimized. Assumptions of the economic order quantity model 1. The demand is known and constant. 2. delivery times is known and constant 3. replenishment is instantaneous 4. prices is constant 5. the holding cost is known as constant 6. ordering cost is known and constant 7. stock outs are not allowed Deriving the of EOQ The economic order quantity can be can be derived easily from the total yearly inventory cost formula using simple calculus the total inventory cost is the sum of the yearly purchase cost , the yearly holding cost and the yearly order cost. The formula can be shown as TAIC = total yearly inventory cost Q is the only known variable in the TAIC equation. The optimum q can be obtained by taking first derivative of TAIC with respect to Q and then setting it to equal to zero. Now setting it equal to zero The second derivative of TAIC is Taking an example, the following data are availed for use: From this, it can be observed that the EOQ yearly total cost is minimal, as the order quantity is reduced, yearly holding cost reduces but yearly ordering cost raises as a result yearly total cost rises. When we raise order quantity yearly holding cost rises and yearly order cost decreases but yearly cost rises, the trade off point is EOQ order where total yearly cost is least (Lucey, 186). The graph shows that there is need to work within the vicinity of EOQ. . Graph shows that holding cost is a straight line but in real life this assumption may not hold more especially for delicate to store items due to the fact that it grows commutatively .This is best shown in the next example. In this example, a variation of the economic order quantity (EOQ) model is considered whereby cumulative holding cost is a not a linear time function. Here it is shown that it is an approximation of the maximum order quantity for delicate to store inventory items goods, such as lubricating oil, where there are delivery surcharges due to non-frequent ordering, and managers find themselves frequently using markdowns to stabilize demand (Lucey, 224). It is shown that the holding cost curve parameters can be evaluated via a regression approach from the product’s regular holding cost (storage plus capital costs), lifetime, as well as markdown policy. This model is a variant of the economic order quantity (EOQ) model where cumulative holding cost is an established to be a convex function of time; this is contrary to the classic EOQ model where the holding cost is given as a linear function of time. More especially, the cumulative holding cost for a single unit that has been stored for a duration given by t units of time is , where and are constants. When then the problem is reduced to the classic EOQ mode with h being the cost to hold one unit for one time period (Lucey, 301). This problem is an approximation of the optimal order quantity for lubricating oil within a machine shop. Product demand and cost are fairly constant over time, Nevertheless, the cost to stock the product increases over time, as is discussed below. Because products are delicate, meeting a constant demand over time with an aging product may require markdowns in their prices or removal of spoiled product. The use of either practice can be modeled as convex holding costs with time, as is shown in the examples below. The first markdown occurs at roughly half the product’s usable lifetime and is typically 15–50% of the product’s initial price. The second markdown takes place at 75% of product’s usable lifetime and is conventionally between 25 and 75% of the initial price (Harris 135). A 2nd contributor t convex holding cost is spoilage, or variable expected storage life. Within a product category, the percentage of individual units that spoil each day rises as the product ages. Spoilage can be estimated by a convex holding cost curve even in the absence of markdown pricing. In such a case, nonetheless, the order quantity in the model needs to be adjusted upwards to take account of the spoilage. Most papers on inventory models with deterministic demand consider that inventory spoils (decays) with time, at different patterns, and that demand depends on the level of inventory. Our application assumes a constant demand rate due to a markdown policy. We provide a simple methodology to estimate the holding cost curve parameters given a product’s lifetime, regular holding (storage + cost of capital) cost, and markdown policy or spoilage curve. Model Consider a product facing a constant demand rate . Fixed ordering cost is s replenishment lead-time is constant, and holding cost per unit rises with the time t that the product has been in stock according to, where and are constants (Harris, 136). The firm’s objective is to choose an order quantity that minimizes average combined ordering and holding costs over an infinite horizon. With an order quantity of Q, and constant demand rate d, the length of an order cycle is Q/d. During the first cycle, the inventory level varies with time 1 Equation agrees with the classical EOQ model when Estimating Holding Cost Parameters In this section, two examples are provided that show how the parameters and h and y can be estimated, using linear least squares regression, from the product holding cost h, the product’s lifetime T, and a given markdown policy or spoilage curve. Example 1: mark down policy Consider 500 ML of heritage lubrication oil, with T = 12 days (estimated storage), , and a markdown policy that decreases the product’s price by RS 0.50 on days 5 and 10. The cumulative holding cost curve per unit is given as a function of time in Table 1. Notice that at day 5, the cumulative holding cost jumps from 0.04 to 0.55 (0.01 + 0.50), which is a result to the product being marked down; similarly at day 10. Convex approximation is used, to the data in table 1 taking log on both side yields Table 1 1. 0.01 2. 0.02 3. 0.03 4. 0.04 5. 0.04 6. 0.55 7. 0.56 8. 0.57 9. 0.59 10. 1.10 11. 1.11 12. 1.12 Making use of a linear regression where the independent variable is t, and the dependent variable is , plot shows the cumulative holding cost and its convex approximation curve Analysis Regression equation Since This implies that 90% of variability in holding cost is explained by the number of days. The null hypothesis is given as While the alternative hypothesis will be given as Level of significance alpha=.05 Regression table p value is = When we compare p value with alpha, p value is less than alpha, therefore null hypothesis is rejected. We select alternative hypothesis that is holding cost depends on no of days. When we calculate holding cost it is increasing. We can see in the plot that holding cost is a curve rather than a straight line as assumed by classic EOQ model. Findings The tradeoff between yearly holding cost and order cost occur at EOQ order. If we order more holding cost will rise though yearly order cost decreases but the overall impact is total yearly inventory cost rises. If we order less holding cost will decrease but order cost rises effect is same total yearly inventory cost rises. At EOQ total inventory cost is minimum. Again we find that holding cost is not constant in case of perishable items it is not a straight line as assumed by classic EOQ model but curve. Conclusion Every entity wants to minimize its inventory cost .inventory is necessary to provide expected level of customer service ,lack of inventory can will result in lost sale which will reduce profit. But inventory blocks working capital at the same time perishable item will be spoiled and causes loss. If inventory is high it blocks cash flow and working capital. inventory cost has three components material cost ,holding cost and order cost, high inventory results in higher holding cost (specially in case of perishable materials) and lower order cost, if inventory is low it reduces holding cost and rises ordering cost ,ramification is raised total inventory cost. ECONOMIC ORDER QUANTITY is that point at which trade off between inventory holding cost and yearly order cost occur and total yearly inventory cost is minimum. Reference Cardenas, Barr ?on, “An easy method to derive EOQ and EPQ inventory models with backorders,” Computers and Mathematics with Applications, 2010, vol. 59, no. 2, pp. 948–952. Dervitsiotis, Kennedy. Operations Management. USA: McGraw-Hill series in Industrial Engineering and Management Science, 1981. Harris, Fredrick. “How many parts to make at once,” The Magazine of Management, 2011, 10, pp. 135–136. Keth, L. Arnold., Muhlemen Joseph., & Oakland Steven. Production and Operations Management. London: Pitman Publisher, 2009. Liberatore, Martin. “The EOQ model under stochastic lead time,” Operations Research, 2007, 27, pp. 391–396. Lucey, Terrence. (1992). Quantitative Techniques. London: Ashford Colour Press. Read More