Introductory Corporate Finance: Working Capital Management - Inventory Management, EOQ Model Reorder Point Safety Stock Just-In-Time ABC Analysis Inventory Turnover

What This Is

Inventory management is a critical aspect of corporate finance that involves managing the flow of goods from raw materials to finished products. Effective inventory management can help companies reduce costs, improve customer satisfaction, and increase profitability. For example, consider a company like Apple that sells millions of iPhones every quarter. If Apple's inventory management is poor, it may end up with excess inventory, leading to holding costs, obsolescence, and potential losses. On the other hand, if Apple's inventory management is excellent, it can ensure that customers receive their products on time, reducing the risk of lost sales and improving customer loyalty.

Key Formulas & Models

• EOQ (Economic Order Quantity) = ?(2DS/H): where D is demand, S is ordering cost, and H is holding cost per unit. This formula helps companies determine the optimal order quantity to minimize total inventory costs.
• Reorder Point (ROP) = (Average Demand x Lead Time) + Safety Stock: where average demand is the expected demand over a certain period, lead time is the time it takes to receive new inventory, and safety stock is the additional inventory held to mitigate stockouts. This formula helps companies determine when to reorder inventory.
• Safety Stock = (Desired Service Level x Standard Deviation of Demand x Lead Time): where desired service level is the percentage of time the company wants to meet customer demand, standard deviation of demand is the measure of demand variability, and lead time is the time it takes to receive new inventory. This formula helps companies determine the additional inventory needed to mitigate stockouts.
• Just-In-Time (JIT) Inventory System = (Lead Time x Desired Service Level): where lead time is the time it takes to receive new inventory, and desired service level is the percentage of time the company wants to meet customer demand. This formula helps companies determine the optimal lead time to achieve JIT inventory levels.
• ABC Analysis = (Inventory Value x Percentage of Total Inventory): where inventory value is the value of each item in the inventory, and percentage of total inventory is the percentage of total inventory value represented by each item. This formula helps companies categorize inventory into A (high-value, high-usage), B (medium-value, medium-usage), and C (low-value, low-usage) categories.
• Inventory Turnover = Cost of Goods Sold / Average Inventory: where cost of goods sold is the total cost of producing and selling products, and average inventory is the average value of inventory held over a certain period. This formula helps companies measure inventory efficiency and identify areas for improvement.

Step-by-Step Calculation

1. Determine the demand for the product.
2. Calculate the ordering cost and holding cost per unit.
3. Use the EOQ formula to determine the optimal order quantity.
4. Determine the lead time and desired service level.
5. Calculate the reorder point and safety stock.
6. Use the JIT inventory system formula to determine the optimal lead time.

Common Mistakes

• Mistake: Using a fixed ordering cost instead of a variable ordering cost.
• Correction: Use a variable ordering cost that reflects the actual cost of placing an order.
• Counterexample: If the ordering cost is $100 per order, but the company places 10 orders per month, the total ordering cost is $1,000 per month, not $100 per order.
• Mistake: Ignoring the holding cost per unit when calculating the EOQ.
• Correction: Include the holding cost per unit in the EOQ formula to ensure that the optimal order quantity is determined correctly.
• Counterexample: If the holding cost per unit is $10 per month, and the demand is 100 units per month, the total holding cost is $1,000 per month, not $0.

Exam / CFA Tips

• Be careful when using the EOQ formula, as it assumes that the demand is constant and the lead time is fixed.
• When using the JIT inventory system, ensure that the lead time is optimal to achieve the desired service level.
• When using the ABC analysis, ensure that the inventory value is accurate and up-to-date.
• Be prepared to calculate inventory turnover and identify areas for improvement.

Quick Practice Problem

A company has an average inventory of $100,000 and a cost of goods sold of $500,000. What is the inventory turnover?

Answer: 5 Explanation: Inventory turnover = Cost of Goods Sold / Average Inventory = $500,000 / $100,000 = 5.

Last-Minute Cram Sheet

• EOQ = ?(2DS/H)
• ROP = (Average Demand x Lead Time) + Safety Stock
• Safety Stock = (Desired Service Level x Standard Deviation of Demand x Lead Time)
• JIT Inventory System = (Lead Time x Desired Service Level)
• ABC Analysis = (Inventory Value x Percentage of Total Inventory)
• Inventory Turnover = Cost of Goods Sold / Average Inventory
• In M&M Proposition I (no taxes), firm value is independent of capital structure – but with taxes, value increases with debt due to the interest tax shield.
• The EOQ formula assumes that the demand is constant and the lead time is fixed.
• The JIT inventory system assumes that the lead time is optimal to achieve the desired service level.
• The ABC analysis assumes that the inventory value is accurate and up-to-date.