Inventory Management - Essay Example

Inventory Management Inventory Management Outline Report to board of Directors of Wooden Wonder Ltd Background Presentation on current issues Economic Order Quantity Re-order level Real Life Examples Advantages of Holding Inventories Disadvantages of Holding inventories Alternative methods of inventory management Bin Systems Periodic Review System Just in time (JIT) Recommendations to board of director References REFLECTIVE JOURNALS Report to Board of Directors Company: Wooden Wonders Ltd Subject: Inventory Management Date: ISSUE: Minimise the costs of ordering and holding inventory BACKGROUND Inventory is a major investment for many companies. Manufacturing companies can easily be carrying inventory equivalent to between 50% to 70% revenue of the business. It is therefore necessary to reduce the levels of inventory held to the necessary minimum. Generally there is balancing act between profitability and liquidity in inventory management system. As in financial management knowledge carrying inventory involves a major working capital investment and therefore levels need to be very tightly controlled. The cost is not just that of purchasing goods, but also storing, insuring, and managing them once they are in inventory. Keeping inventory levels high is expensive owing to purchase cost, holding cost and also attached some other risks like theft/damage/obsolescence. On the other side if inventory levels are kept too low, the business faces alternative problems like stock outs, high re order cost, setup cost and lost quantity discounts. The objective of good inventory management is therefore to determine the optimum reorder level and optimum re order quantity. AS in Wooden Wonders Ltd the opinion is asked on the issue of ensuring the inventory levels in the company in a balancing situation. The main purpose of is to ensure that the inventory levels in the company are sufficient but not surplus. Presentation on the current issues As it is stated in information that is provided by the company that finance team of Wooden Wonders LTD have recently been reviewing that inventory management system for the company and they have decided FIFO as a recording method. The team is also looking at various ways in which cost savings can be made. According to me for any manufacturing business, Economic order quantity and Calculations of reorder level are the best methods to determine the optimum inventory order quantity and reorder level. These two models are also useful to determine the optimum inventory order quantity and reorder level for Wooden Wonders Ltd. For better understandings of board of directors these models are explained deeply for the purpose of more advantage. Economic order quantity (EOQ) Economic order quantity is easy tool to minimize the inventory costs. The main aim of the EOQ model is to minimize the total cost of holding and ordering inventory. To minimize the total cost of holding and ordering inventory, it is necessary to balance the relevant cost. (Financial accounting. F9, Page 212 Kaplan Pub) These relevant costs are The variable costs of holding the inventory The fixed cost of placing the order Holding costs: The model assumes that it costs a certain amount to hold a unit of inventory for a year. Therefore, as the average level of inventory increases, so too will the total annual holding costs incurred. When new batches or items of inventory are purchased or made at periodic intervals, the inventory levels are assumed to exhibit the following pattern over time. If the X is the quantity ordered, the annual cost would be calculated with the help of this formula: Holding cost per unit * Average Inventory ; CH * X/2 CH stands for holding cost per unit We can therefore see an upward sloping, linear relationship between the re-order quantity and total annual holding costs. Ordering costs: The model assumes that a fixed cost is incurred every time an order is placed. Therefore, as the order is quantity increases, there is a fall in the number of orders required, which reduces the total ordering cost. If D is the annual expected sales demand, the annual order cost is calculated as: Order cost per order * no. of orders per anum ; Co * D/x Co stands for order cost per unit However, the fixed nature of the cost results in a downward sloping curved relationship. Graphical Explanation of EOQ: When the re-order quantity chosen minimises the total cost of holding and ordering, it is known as the EOQ. For more information visit this article http://ir.washburnlaw.edu/bitstream/10425/114/1/Origins%20of%20the%20Economic%20Order%20Quantity%20Formula.pdf For the knowledge of board of directors it is necessary to state that there are also some assumptions of EOQ model. These are: Demand and lead time are constant are known: There is an assumption in of EOQ model is that this model assumes that demand for the period and the lead time is always constant. This model will fail if the demand for the periods is not constant. Purchase price is constant: EOQ model assume that the purchase prices for the period is always constant. Changes in the purchase will results into the failure of this model. No Buffer inventory: EOQ model assume that there is no need of buffer inventory for the calculation of optimum order quantity. But practically these assumptions are critical and should be discussed with finance team of Wooden Wonders Ltd when considering the validity of the model and its conclusions because in practical situations demand and lead time may vary. Practical Example: For better understanding of board of directors, here is an example of the store names Stop and Slurp. Due to the limited room in the store and not enough resources to hire more helpers the management use the EOQ model for the knowing the optimum quantity for their business. Wooden Wonder Ltd can also use EOQ model for the assessment of optimum level quantity because the main purpose of the company is to save the extra cost that are associated with current inventory issues. Reorder level For an organization, after deciding how much inventory to re-order, the next problem is when to re-order. The organization need to identify a level of inventory which can reach before an order needs to be placed. If an order is places too late, the organizations may run out of inventory, a stock out, resulting in a loss of sales or loss of production. On the other side if the order is places too soon, the organization will hold too much inventory, and inventory holding cost will be excessive. As the Wood Wonders Ltd. Manufacture the items of house hold furniture and have a chain of department store over the UK and Europe, the managers of the company must have known about the reorder level to meet the customer’s demand properly. (Financial accounting.F9, Page 215 Kaplan Pub) Use of re-order level is a measure of inventory levels might fluctuate with the system. Point market ‘X’ the reorder level at which a new order is placed. The number of ordered unit each time is EOQ. Actual inventory level sometime fail s below the safety inventory level, and sometimes the re-supply arrives before inventories have fallen to the safety level. On average, however extra inventory holding will approximate the safety inventory. The size of safety inventory will depend on whether stock outs are allowed. When demand is known with certainty the Re-order level may be calculated exactly. If there were certainty, then the last unit of inventory would be sold as the next delivery is made. In real world, this ideal cannot be achieved. demand will vary from period to period, and Re order level must allow some buffer or safety inventory, the size of which is a function of maintaining the buffer (which increases as the level increase), running out of inventory (which decreases as the buffer increases) and the probability of the varying demand levels. Advantages and advantages of holding inventory As for the management concern there is necessary to reduce the cost of inventory at a balancing level to meet the production demand in any of manufacturing organizations. But there are also certain advantages and disadvantages of holding inventories. As it is mentioned earlier that carting inventory involves a major working capital investment and therefore levels need to be tightly controlled. Advantages of Holding Inventories: Stock outs: If a business runs out of a particular product used in manufacturing it may cause interruptions to the production process causing idle time, stockpiling of work in progress or possibly missed orders. Alternatively, running out of goods held for onward sales can result is dissatisfied customers and perhaps future lost orders if custom is switched to alternative suppliers. With the help of holding inventories business can prevent these circumstances and indirectly there will be no effect on the future production level and on business’s goodwill. For example in the case of a manufacturing business suppose in the case of Wooden Wonders Ltd, the department stores have considerable purchasing power to meet the demand for quick deliveries . If they do not hold the inventory at high level than quick deliveries schedule may not be fulfilled properly due to any stock out issue. And this factor will directly effect on the company’s goodwill. Reorder/Setup Cost: Each time the stock runs out, there is cost attached with new order and also existence of come setup charges. With the help of holding inventory at certain level can reduce the re-order cost and setup cost for any organization. Quantity discounts: by holding the large level of inventory the business can obtain quantity discounts on bulk purchases from suppliers. Disadvantages of holding inventories: Purchase costs: once the goods are purchased, capital is tied up in them and until sold on. This can result in to losing the opportunity cost for organizations. The revenue cannot be occurred until the sale of inventory items. Cost of storage space: there is need for storage space for holding the goods in inventory. The company must incur the expense relating to warehouse space. It can be in the form of rents or if using own space there is a loss of opportunity cost that are associated with the space. In addition there may also be some other requirements like controlled temperature or light which directly require extra funds. Other risks: There are also some other risks associated with holding inventory. For example after the storage of, they will need to be insured. In the case of specific equipment it may be needed to transport the inventory to where it is to be used. Practical example can be seen in the Medicine company where certain type of medicines require proper temperature, proper atmosphere. These all terms are cost associated with them. On the other hand Staff will be required to manage the warehouse and protect against theft. In the case the inventory levels are high the significant investment may be required in manage the inventory control systems. (HARMS, C. L. (2001). A comparison of inventory carrying cost in literature and in practice) Implication on Wooden Wood Ltd: There is need for a manufacturing company to hold optimum level of inventory in the stock to meet the demand. But there should be a relation between the level of demand and inventory level. Extra inventory can effect on the company performance because more funds are needed to manage the inventory in reasonable manner. On the other hand low inventories can lead to a shortfall in production. AS in the case of Wooden Wonders Ltd. Management of stores always insist to keep high level of inventories to meet some quick orders form costumers. But on the other side of coin the company is thinking to reduce the cost of holding high inventors level. In this case there is need for optimum quantity level that company should maintain in their stores to meet the projected level of demand. And with the help of optimum level company can surely achieve the target to reduce the cost that is attached with extra inventory. Alternative methods of inventory management In recent times a number of inventory management systems have been developed to maintain simplify the inventory management process. These systems includes Bin systems Periodic review Just in time (JIT) For the better understanding of Board of directors of Wooden Wonder Ltd, a short of these systems is described below. This summary clear the way of working of these systems. Bin systems: A simple visual reminder system for re-odering is called Bin system. There are two types of bin systems Two bin system: The system utilises two bins. For example one can be name as A, and second is B. Inventory is taken form A until the emptiness of A. After the consumption of A bin another order is placed for in the meantime, inventory is used from B bin. The standard inventory in B bin is the expected demand in the time between the order is placed and the inventory arriving. B bin also include some buffer inventory if in the case of any emergency. At the end when the new order is arrived B is filled up with the standard size and the consumption from A bin is started. This process is repeated again and again. The practical example of this can be seen in a manufacturing organization where raw material is needed in a large quantity. As it is also be applied to Wooden Wonder Ltd because the company always require huge inventory to run their sale operation in efficient manner. Company can spare its inventory in two bins and can repeat the process that is mentioned above. One Bin System: The above same approach is used by some organizations for a single bin with a red line within the bin indicating the re-order level. Practically these methods rely on the accurate estimates of lead time and demand in lead time. Periodic review system: Periodic review system is also referred to the term of constant order cycle system. Under this system inventory level is review at fixed interval. E.g. every one month. And according to review the new level of demand and lead time during the demand is made. Just in time (JIT): in modern environment just in time is an approach to operations planning and control based on the idea that goods and services should be produced only when they are needed. It state that the required goods are produced neither too early nor late. The Term: neither too early” represent the situation of not to build the inventory level and “nor late” described as the not the costumer has to wait. Simply the objective of the just in time system is to produce the products as they are required rather than for inventory. For more information please visit http://tutor2u.net/business/production/just-in-time.html Alternative method of inventory management that may be used to hold no inventory at all If the firm does not want to hold the inventory at all then JUST IN TIME (JIT) system can work as a best system in inventory management process. For example many manufacturing firms in japan follow the just in time production system. Another example of this can be seen in the case of TOYOTA MOTORS. Toyota’s production system based on the philosophy of "complete elimination of all wastes”, they are using the efficient techniques in their production process. Toyota Motors follow the JUST IN TIME system in their production process. TOYOTA MOTORS run their production process with the objective of making the vehicles ordered by customers in the quickest and most efficient way. The main purpose is to deliver the vehicles as quickly as possible. For more information, go to http://www.toyota-global.com/company/vision_philosophy/toyota_production_system/ Implication on Wooden Wonders Ltd: Management of Wooden Wonders Ltd stated their aim to control the extra costs attached with inventory management. As Wooden Wonders’ customers are department stores from across the UK and Europe, Wood Wooden can run its manufacturing cycle in the light of JIT approach. Management can reduce its inventory holding cost in efficient manner by this technique. For example, suppose the manufacturing process of Wooden Wonders consists of four consecutive stages. In a traditional manufacturing system there would be inventories of raw marital and finished goods, and also inventories for pat finished items between stage 1 and 2, between stage 2 and 3, between stage 3 and 4. But in JIT system there is no need for these things. All stages will be depended on each other. For the decision making process about JIT the management of the Wood Wooden company should discuss about the validity of this model in relation with industry conditions. Because the process in JIT system is depend upon each other and in the case of failure in any process all the system will result in to failure. (Performance management. Page 93 BPP Learning Media) Recommendations to board of directors The methods of minimizing inventory cost of for optimum order quantity are explained above deeply. As the company is performing too well in its operations and have chain of costumers across the Europe and UK. This information represents that the company have much goodwill in the market. The finance team of the company is also focusing on the issue of cost saving through inventory management. They have suggested, to use FIFO method as recording of inventory. In addition the company is focusing on the methods of minimiseing the costs of ordering and holding inventory. For this purpose company can use any of the above methods which suits with its economic conditions. Care should be taken before choosing any of the alternatives because any wrong step can directly affect the company’s good will. If the company does not want to hold inventory at all or at close to zero level for avoiding the cost related with inventory management than JUST IN TIME technique will act as the best method for inventory management. For this purpose more information about the industry position, behaviors and also information about the competitors are required to judge the effectiveness of this system for Wooden Wonder Ltd. Assistant management Accountant Wooden Wonder Ltd References (2005). Inventory management. [Lenexa, KS], ADVANSTAR Veterinary Healthcare Communications. http://www.toyota-global.com/company/vision_philosophy/toyota_production_system/ ASSOCIATION OF CHARTERED CERTIFIED ACCOUNTANTS (GREAT BRITAIN). (2008). Financial accounting. Wokingham, Berkshire, Kaplan Pub. CHARTERED INSTITUTE OF MANAGEMENT ACCOUNTANTS. (2005). Financial accounting fundamentals. Wokingham, Kaplan Foulks Lynch. (2008). ACCA, 2008/09. Paper F5, Performance management (PM). Wokingham, Kaplan Publishing. (2009). Fundamentals paper F5: performance management. [S.l.], BPP Learning Media. BRAGG, S. M. (2001). Just-in-time accounting how to decrease costs and increase efficiency. New York, Wiley. http://public.eblib.com/EBLPublic/PublicView.do?ptiID=121288. HARMS, C. L. (2001). A comparison of inventory carrying cost in literature and in practice. Thesis (M.S.)--Iowa State University, 2001. REFLECTIVE JOURNALS What did I learn from producing the coursework? First of all from this course work, I am clear now that inventory management is the key for any successful business. Especially it is the key measure for the success of any manufacturing business. With the help of good inventory management the balance between the profitability and liquidity can be maintained in efficient manner. Secondly the requirement of holding inventories at optimum level and advantages and disadvantages of holding inventory have updated my knowledge about inventory management. This knowledge will surely help me in future in the case of facing any of this kind of situation in practical field. In addition with the help of scenario in assignment, my motivation level is increased in a positive direction and I feel that I can perform well and analyse the data of any company in efficient manner. What problems did I encounter when completing the assignment? I faced many problems in completing of this assignment. The analytical or necessary data about the company performance, competitor’s behaviors, and about industry situation is not available. Proper decision can only be made in the light of all other information. Second thing is that it is not explained in the assignment that what kind of practical examples are required. I mean the term “practical Examples” included some general industry examples or some financial data of any company like EOQ level of companies. What would I do differently next time and what would have enabled me to do a better job? According to me this assignment has increased my analysing and decision making skills. I hope that next time I can work well with the help of gained techniques and work perform better under the any of different scenario. When completing the assignment, which learning outcomes did I find easiest / perform best at ? While attempting the assignment I found advantages and disadvantages of holding inventories is an easy task for me. The reason is for this is that this requirement is a straight forward knowledge based question and does not contain any specific research work or deep thinking. When completing the assignment, which learning outcomes did I find most difficult / perform worst at? Dealing with the practical examples was the difficult task for me because I was not able to understand clearly that what kind of examples I should use in this assignment. On the other hand limited data about the company, limit my scope about the decision of best inventory management strategy. Do I honestly believe that I have performed to the best of my ability? Up to some level I believe that I have performed just well not too well while attempting this assignment. Problems that I mentioned above demoralised me and my ability to perform better in this assignment. But I have tried my level best to attempt this assignment in accordance to my abilities. Read More