Ordering Cost

Published on December 2016 | Categories: Documents | Downloads: 77 | Comments: 0 | Views: 313
of 20
Download PDF   Embed   Report

Comments

Content

Order ing Cost

    

Clerical costs of preparing purchase orders Some spent finding suppliers and expediting orders Transportation costs Receiving costs (E.g. unloading and inspection)

   

order deliveries are late quality problems occur demand increases unexpectedly lead times are not accurately forecast

Inventory Management Business must have methods and procedures that offer ample flexibility to meet unusual and sometimes unreasonable demands on their resources -- personnel, equipment and facilities and operational. Exceptional customer service also includes providing top quality products at reasonable costs. Businesses must keep a careful rein on their inventories. Having too much inventory and/or not having enough stock is considered primary direct causes of business failures. There are several definitions of Inventory Management. Among them are: Inventory Management is “the practice of planning, directing and controlling inventory so that it contributes to the business' profitability”. Inventory management can help business be more profitable by lowering their cost of goods sold and/or by increasing sales. Inventory Management is “making sure that items are available when customers call for it, but not too much stock so that inventory turnover goals are met” - Juhi Gonzales, Inventory Management and Systems ConsultingInventory Management is “the art and science of managing to have the RIGHT PRODUCT, at the RIGHT TIME and PLACE, in exactly the RIGHT AMOUNT, at the BEST POSSIBLE PRICE”. Effective Inventory Management "Effective inventory management allows a distributor to meet or exceed his (or her) customers’ expectations of product availability with the amount of each item that will maximize the distributor’s net profits." Myths in Inventory Management Amazingly, there are so many myths about Inventory Management. Some of them sound idiotic but they do really happen in the “Real World” of business. Sometimes, it’s best to learn from other people’s (business people?) mistakes or misunderstandings and incorporate our findings in our own business. Myth: The “SALES” data that we have in our company records, is all we need for inventory management” WRONG! : Inventory management systems do not use sales data. They must be supported by accurate demand information-which is totally different! Myth: The more expensive a software system is, the better it will help us control our inventory.

WRONG! : The BEST inventory forecasting and planning system available today, costs under $1000 and they work as well as any other system in the market. Myth: “Our real problem is our people- they just don’t do their jobs the way they should!” WRONG! : In working with thousands of inventory managers, no one is that stupid or lazy! The problem is that most managers have received NO training, and/ or have the wrong tools (systems) to work with, or none at all. This is rarely their fault! Myth: We keep all of our sales histories by month, and this data is all we need to make good forecasts for inventory planning. WRONG! : Using monthly sales data is one of the major contributors to poor inventory forecasting and planning. It inevitably leads to inaccurate safety stock calculations and other projections and, thus, not having the inventories that our companies need when we need them! Myth: Our company’s accounting system includes an “Inventory Control” module and, therefore, if our people would only use it right, our inventories should be fine. WRONG! : The GREATEST MYTH of all! No accounting system- no matter how good it may be at performing acconting functions, and most are very good- can ever provide the data and/ or analysis required to precisely manage any company’s inventories! Your company or business needs (No! MUST Have) an inventory management system. Myths in Inventory Management Amazingly, there are so many myths about Inventory Management. Some of them sound idiotic but they do really happen in the “Real World” of business. Sometimes, it’s best to learn from other people’s (business people?) mistakes or misunderstandings and incorporate our findings in our own business. Myth: The “SALES” data that we have in our company records, is all we need for inventory management” WRONG! : Inventory management systems do not use sales data. They must be supported by accurate demand information-which is totally different! Myth: The more expensive a software system is, the better it will help us control our inventory. WRONG! : The BEST inventory forecasting and planning system available today, costs under $1000 and they work as well as any other system in the market. Myth: “Our real problem is our people- they just don’t do their jobs the way they should!” WRONG! : In working with thousands of inventory managers, no one is that stupid or lazy! The problem is that most managers have received NO training, and/ or have the wrong tools (systems) to work with, or none at all. This is rarely their fault! Myth: We keep all of our sales histories by month, and this data is all we need to make good forecasts for inventory planning. WRONG! : Using monthly sales data is one of the major contributors to poor inventory forecasting and planning. It inevitably leads to inaccurate safety stock calculations and other projections and, thus, not having the inventories that our companies need when we need them! Myth: Our company’s accounting system includes an “Inventory Control” module and, therefore, if our people would only use it right, our inventories should be fine. WRONG! : The GREATEST MYTH of all! No accounting system- no matter how good it may be at performing acconting functions, and most are very good- can ever provide the data

and/ or analysis required to precisely manage any company’s inventories! Your company or business needs (No! MUST Have) an inventory management system. References: 1.) http://www.execpc.com/~matplan/page3.html Back to Index

Why is Inventory Management Important? 1.) Inventory management can help business be more profitable by lowering their cost of goods sold and/or by increasing sales. Consider a typical company - ABC Company with the following income statement: Sales $ 2,000,000 Cost of Goods Sold 1,100,000 Gross Profits 900,000 Gen. Administrative Expenses 402,000 Marketing Expenses 350,000 Net Income before taxes $ 148,000 ========== Not bad -- return on sales is over 7%. Now, suppose that through application of sound inventory management principles, ABC Company was able to reduce the cost of goods sold by 3%. And because there is less inventory, let's say that carrying costs (warehouse storage charges, insurance, finance charges, etc) is reduced by 2% of the general administrative expense. Those minimal cost reductions result in significant increase on net income: Sales $ 2,000,000 Cost of Goods Sold 1,067,000 Gross Profits 933,000 Gen. Administrative Expenses 394,000 Marketing Expenses 350,000 Net Income before taxes $ 189,000 =========== Small costs reductions due to application of sound inventory management principles resulted in very significant increase (28%) in net income! Lower cost of goods sold is achieved by making the inventory smaller and therefore turn more often; while making sure that stocks are large enough will result in increased sales because products are available when Customers call for it. Inventory management is balancing those two opposing factors for optimum profitability. 2.) Conduct an inventory audit that answers the following questions:
  

What is your inventory turnover performance? Are you carrying too much inventory and paying more for interest and/or storage charges? If you can improve your inventory turnover performance, how much will your gross profits increase? What is your service level performance? Are you losing potential or current Customers (and revenues) because you are out-of-stock of the products they

want? If you can improve your service level, how much will be the increase in your sales revenues?  How accurate are your records?  Are you losing Customers (and sales revenues) because your inventory records are not accurate enough – they show you have some in stock but actually, none?  Or are you overstocked on some products because your records showed that you didn't have any and you ordered some, when in fact you have lots? (Please note: Quality of answers to these questions will depend on available records or information maintained by your organization.)  Set up either a manual or computer-based inventory control system to better manage inventory.  Where required, provide contractual project leadership from installation into conversion and start-up of new system.Where also required, develop a procedure manual and train staff in using new system.  If an inventory system is in place, review current processes to make it better. Where required, provide contractual inventory management to carry out recommendations and resolve unsatisfactory conditions. 3.) Improve Customer Service 4.) Reduce Inventory Investment 5.) Increase Productivity 6.) Prevent Poor Inventory Record Accuracy Inventory record errors are costly. No computer system, be it old or new, will work properly if the transactions are not entered correctly. The costs of poor inventory record accuracy are not always apparent to management. Consider the following results, all of which increase production costs and reduce profits:  Unanticipated stock-outs  Decreased production efficiency  Higher investment in safety stocks  Requirement for staging of items to determine availability or shortages  Invalid data for inventory replenishment system  More obsolete and excess inventory Some of these costs can be quantified. Others are intangible, but nevertheless do exist and can be substantial. It is important to have inventory records, which are accurate. Most experts agree that this accuracy must be at least 95% and even higher for critical or high unit value items. The key to accurate records is the implementation of a sound cycle counting system.


Economic Order Quantity Economic Order Quantity, better known as EOQ, is a mathematical tool for determining the order quantity that minimizes the costs of ordering and holding inventory. It attempts to minimize total inventory cost by answering the following two questions. 1) How much should I order? ( Economic Order Quantity ) 2) How often should I place each order? ( Cycle Time ) This model assumes that the demand equation faced by the firm is linear. In other words,

the rate of demand is constant or at least nearly constant. The goal is to minimize total inventory cost. Inventory costs are made up of Holding and Ordering cost. Holding cost include the cost of financing the inventory along with the cost of physically maintaining the inventory. These costs are usually expressed as a percentage of the value of the inventory. Ordering cost include the cost associated with actually placing the order. These include a labor cost as well as a material and overhead cost. The equation for total inventory cost is developed as follows: Total Inventory Cost (TIC) = Holding Cost + Ordering Cost TIC = (Average Inventory)(Holding cost per unit) + (Number of orders per year)(Ordering cost per order) Assumptions of Basic EOQ Model:
    

Demand is known with certainty Demand is relatively constant over time No shortages are allowed Lead time for the receipt of orders is constant The order quantity is received all at once

Simple Economic Order Quantity Example: A truck manufacturer uses 120,000 headlight assemblies a year in the production of a certain model truck. Daily production of this truck is reasonably stable through out the year. The cost of each headlight assembly is $150.00. The company's incremental order (acquisition) cost is $40.00 per order. Its incremental inventory carrying cost is 33% of the

average inventory value per year. What is the optimum order quantity? How many orders will be placed in a year? Development of EOQ Model The development of the EOQ (Economic Order Quantity) inventory model consists of five steps: (a.) List ASSUMPTIONS concerning the inventory situation Assumptions are: Demand rate is constant, recurring and known No stockout are allowed Orders are delivered at once All costs are assumed to be known and constant All orders are placed independently (no joint orders) (b.) Develop a COST EQUATION (MODEL) QUALITATIVELY (c.) Develop a COST EQUATION (MODEL) QUANTITIVELY MODEL QUANTITIVELY: TC = K(D/Q) + HC(Q/2) + DC (d.) Minimize the total cost equation (model) (e.) Find REORDER QUANTITY & REORDER POINT OPTIMAL RE-ORDER QUANTITY Q* = square root [(2 x D x K)/(H x C)] Where: D = annual demand in units K = ordering cost per order H = carrying cost per unit expressed as a fraction of cost of an individual unit Q = reorder quantity Q* = optimal reorder quantity C = cost of an individual item TC = total annual inventory cost Just-In-Time Management (JIT)
      

In traditional settings, inventories of raw materials and parts, finished goods and all, were kept as a buffer against the possibility of running out of needed item. In recent years, however, managers have come to realize that large buffer inventories are costly. Consequently, many companies have completely changed their approach to production and inventory management. These manufacturers have adapted a new strategy for controlling the flow of manufacturing in a multistage production process. In a just-in-time (or JIT) production system, raw materials and parts are purchased or produced just in time to be used at each stage of the production process. This approach to inventory and production management brings considerable cost savings from reduced inventory levels. The key system to the JIT System is the “pull” approach to controlling manufacturing. To visualize this approach, look at Exhibit (c), which displays a simple diagram of a multistage

production process. The flow of manufacturing activity is depicted by the solid arrows running down the page from one stage of production to the next. However, the signal that triggers more production activity in each stage comes from the next stage of production. These signals, depicted by the dashed- line arrows, run up the page. We begin with sales at the bottom of the exhibit. When sales activity warrants more production of finished goods, the goods are “pulled” from the production stage III by sending a signal that more goods are needed. Similarly, when production employees in stage III need more input, they send a signal back to stage II. This triggers production activity in stage II. Working our way back up to the beginning of the process, purchases of raw materials and parts are triggered by a signal that they are needed in stage I. This pull system of production management, which characterizes the JIT approach, results in a smooth flow of production and significantly reduced inventory levels. The result is considerable cost savings for the manufacturer. Essential Aspects to JIT 1.reduction/minimisation of inventory in supply chains. Lessons have been learnt from Japanese methods where substantial efficiencies are gained from frequent deliveries of small quantities to meet immediate demands. This compares with methods of stock control such as the calculation of economic order quantities. 2.the application of Kanban - a "pull" system of production/materials control 3.an employee participation and involvement strategy involving the securing of commitment and changed work practices leading to elimination of waste Kanban At Toyota, the production system used tickets/cards to control immediate material flows between a work station and another down-stream . The up-stream station (the server) receives tickets calls for small, fixed quantities from a down-stream user (the client). On sending the supplies, a production "kanban" is generated requesting the previous upstream server to make/supply a replacement quantity. Thus: users "pull" off supplies as required direct shop-floor communication between client and supplier replaces instructions issued by a remote center control point.  materials requirements planning and other systems get rapid feedback on progress or delays. Kanban involves fine-tuning and quick response to changes.  planning (medium and longer-term planning) is still needed for capacity along the supply chain. Kanban allows fine tuning.  fixed quantity bins or containers or pallets are used to signal replenishment needs (reminiscent of a traditional two-bin system of stock control). When the first bin is empty, a new full bin can be moved in within the usage time from the second bin). With well-designed floor layouts this system adds considerably to the efficiency of the operational environment. With the integration of computer systems internally and externally with suppliers systems - Kanban data and instructions can flow between the linked systems. JIT is Not Possible Without....
 

   

reliable delivery short distances between client and server consistent quality so that server performance and throughput is unaffected stable, predictable production schedules and ability to respond quickly to small fluctuations in demand. If the production system itself is flexible with quick set up times for product changes - then the data flowing in the JIT system and the ability of servers to respond are critical. Key Features to JIT Approach

How does a JIT system achieve its vast reductions in inventory and associated cost savings? A production-systems expert lists the following key features of the JIT approach. 1) A smooth, uniform production rate. An important goal of a JIT system is to establish a smooth production flow, beginning with the arrival of materials from suppliers and ending with the delivery of goods to customers. Widely fluctuating production rates result in delays and excess work-in-process inventories. These non-value-added costs are to be eliminated. 2) A pull method of coordinating steps in the production process. Most manufacturing processes occur in multiple stages. Under the pull method, goods are produced in each manufacturing stage only as they are needed at the next stage. This approach reduces or eliminates work-in-process inventory between production steps. The result is a reduction in waiting time and its associated non-value-added cost. The pull method of production begins at the last stage of the manufacturing process. When additional materials and parts are needed for final assembly, a message is sent to the immediate preceding work center to send the amount of materials and parts that will

be needed over the nexrt few hours. Often this message is in the form of a withdrawal Kanban, a card indicating the number and type of parts requested from the preceding work center. The receipt of withdrawal Kanban in the preceding work center triggers the release of a production Kanban, which is another card specifying the number of parts to be manufactured in that work center. Thus, the parts are “pulled” from a particular work center by a need for parts in the subsequent work center. This pull approach to production is repeated all the way up the manufacturing sequence toward the beginning. Nothing is manufactured at any stage until its need is signaled from the subsequent process via a Kanban. As a result, no parts are produced until they are needed, no inventories build up, and the manufacturing process exhibits a smooth, uniform flow of production. 3) Purchase of materials and manufacture of subassemblies and products in small lot sizes. This is an outgrowth of the pull method of production planning. Materials are purchased and goods are produced only as required, rather than for the sake of building up stocks. The result is a reduction in storage and waiting time, and the related non-value-added costs. 4) Quick and inexpensive setups of production machinery. In order to produce in small lot sizes, a manufacturer must be able to set up production runs quickly. Advanced manufacturing technology aids in this process, as more and more machines are computercontrolled. 5) High quality levels for raw material and finished products. 6) Effective preventive maintenance of equipment. If goods are to be manufactured just in time to meet customer orders, a manufacturer cannot afford significant production delays. By strictly adhering to routine maintenance schedules, the firm can avoid costly down time from machine breakdowns. 7) An atmosphere of teamwork to improve the production system. A company can maintain a competitive edge in today’s worldwide market only if it is constantly seeking ways to improve its product or service, achieve more efficient operations, and eliminate non-value-added costs. 8) Multiskilled workers and flexible facilities. JIT Purchasing In addition to a JIT production approach, an effective business should implement JIT purchasing. Under this approach, materials and parts are purchased from outside vendors only as they are needed. This avoids the costly and wasteful buildup of raw material inventories. The following are five (5) key features of JIT purchasing. 1. Only a few suppliers. This results in less time spent on vendor relations. Only highly reliabled vendors are used, who can deliver high quality goods on time. 2. Long- term contracts negotiated with suppliers. 3. Materials and parts delivered in small lot sizes immediately before they are needed. 4. Only minimal inspection of delivered materials and parts. 5. Grouped payments to each vendor. Instead of paying for each delivery, payments are made for batches of deliveries according to the terms of the contract. This reduces costly paperwork for both the vendor and the purchaser. JIT is an important operational system for manufacturing and supplying companies to adopt and implement. Technically, procedurally and managerially it requires attention to:

data, information and communication. assessment of requirements programmes to change the structure of production, materials handling, manufacturing processes and distribution facilities  improved methods of controlling unit supply costs  consideration of the buyer-supplier partnership and the possibility of strategic collaboration. If change is piecemeal and management attention wanes then JIT may fail. An integrated perspective is needed with coherent strategic direction and increases in productivity/effectiveness at each operational level so that the whole supply chain has a competitive edge EOQ vs. JIT The EOQ model minimizes the total cost of ordering and holding purchased inventory. Thus, this inventory management approach seeks to balance the cost of ordering against the cost of storing inventory. Under the JIT philosophy, the goal is to keep all inventories as low as possible. Any inventory holding costs are seen as inefficient and wasteful. Moreover, under JIT purchasing, ordering costs are minimized by reducing the number of vendors, negotiating long- term supply agreements, making less frequent payments, and eliminating inspections. The implication of the JIT philosophy is that inventories should be minimized by more frequent deliveries in smaller quantities. Conclusion In any business, make it big or small, we must understand that taking good care of our inventory is very important. If we as managers do not understand the concept of good inventory management, we must learn to be familiar with it and its applications. One of the reasons for the failure of a business is its inventory management. There are many ways to fight failure, and we can start from here. There are new technology that can help us maintain and supervise our inventory. What we can do is learn, implement and evaluate our business. And you can start with your INVENTORY!!!!! Definition and Measurement Working capital, also referred to as net working capital (NWC), is an absolute measure of a company’s current operative capital employed and is defined as: (Net) working capital = Current assets − Current liabilities Current assets are assets which are expected to be sold or otherwise used within one fiscal year. Typically, current assets include cash, cash equivalents, accounts receivable, inventory, prepaid accounts which will be used within a year, and short-term investments. Current liabilities are considered as liabilities of the business that are to be settled in cash within the fiscal year. Current liabilities include accounts payable for goods, services or supplies, short-term loans, long-term loans with maturity within one year, dividends and interest payable, or accrued liabilities such as accrued taxes. Working capital, on the one hand, can be seen as a metric for evaluating a company’s operating liquidity. A positive working capital position indicates that a company can meet its short-term obligations. On the other hand, a company’s working capital position signals its operating efficiency. Comparably high working capital levels may indicate that too much

  

money is tied up in the business. The most important positions for effective working capital management are inventory, accounts receivable, and accounts payable. Depending on the industry and business, prepayments received from customers and prepayments paid to suppliers may also play an important role in the company’s cash flow. Excess cash and nonoperational items may be excluded from the calculation for better comparison. As a measure for effective working capital management, therefore, another more operational metric definition applies: (Operative) net working capital = Inventories + Receivables − Payables − Advances received + Advances made where: inventory is raw materials plus work in progress (WIP) plus finished goods; receivables are trade receivables; payables are non-interest-bearing trade payables; advances received are prepayments received from customers; advances made are prepayments paid to suppliers. When measuring the effectiveness of working capital management, relative metrics (for example, coverage) are generally applied. They have the advantage of higher resistance to growth, seasonality, and deviations in (cost of) sales. In addition to better comparison over time, they also allow better benchmarking of operating efficiency with internal or external peers. A frequently used measure for the effectiveness of working capital management is the socalled cash conversion cycle, or cash-to-cash cycle (CCC). It reflects the time (in days) it takes a company to get back one monetary unit spent in operations. The operative NWC positions are translated into “days outstanding”—the number of days during which cash is bound in inventory and receivables or financed by the suppliers in accounts payable. It is defined as follows: CCC1 = DIO + DSO − DPO where: days inventories outstanding (DIO) = (average inventories ÷ cumulative cost of sales) × 365 = average number of days that inventory is held; days sales outstanding (DSO) = (average receivables ÷ cumulative sales) × 365 = average

number of days until a company is paid by its customers; days payables outstanding (DPO) = (average payables ÷ cumulative purchasing volume) × 365 = average number of days until a company pays its suppliers. Optimizing the three components of operative NWC simultaneously not only accelerates the CCC, but also goes hand in hand with further improvements. Figure 1 illustrates how an NWC optimization impacts the value added and free cash flow of a company. However, applying the right measures will not only increase value added by lowering capital employed. Improved processes will also lead to reduced costs and higher earnings before income and taxes (EBIT).

Managing the Three Operational Components of NWC So, what are the relevant levers of working capital management, and how are they applied? In effect, receivables and payables are just different ways of financing inventories. Companies need to manage all three components simultaneously across the value chain so as to drive fundamental reductions in asset levels. Given the wide range of possible actions, focus is critical. A realistic plan with clear priorities is the best approach. An overly ambitious agenda can overstrain internal capabilities and deliver suboptimal results. Instead, companies should concentrate on the most promising actions that will not impair flexibility and performance. These actions will vary depending on industry and competitive situation, and have to be adapted to country specifics and regulations. In the following paragraphs some typical (but just exemplary) levers are described. Reduce Inventories Excess inventory is one of the most overlooked sources of cash, typically accounting for

almost half of the savings from working capital optimization projects. By streamlining processes within the company—as well as processes involving suppliers and customers— companies can minimize inventory throughout the value chain. Enhanced forecast accuracy and demand planning: Improved forecast accuracy and regular updates of customer demand lead to a much more reliable planning process and help companies not only to reduce their inventory but also to improve the ability to deliver. Advanced delivery and logistics concepts: In order to keep inventories at lower levels, topperforming companies establish advanced and demand-driven logistics concepts with their suppliers, such as vendor-managed inventory, just in time (JIT) or just in sequence (JIS), and collaborate with their suppliers in terms of a holistic supply chain management with mutual benefits. Optimized production processes: An important lever to reduce work-in-progress inventory is the redesign of production processes. The main objectives here are to reduce non-valueadding time (“white-space reduction”) and excessive inventory between production steps. Promising measures are removing bottlenecks and migrating from push concepts to demand-driven pull systems. Service level adjustments: An increased service level for products which are critical to the customer (and thus allow higher prices) and a decreased service level for products which are uncritical to the customer will not only lead to optimized stocks. A more sophisticated approach to calculating security stocks based on target availability and deviations in production and demand will also reduce out-of-stock situations for critical parts. Variance management: Reducing product complexity and carefully tracking demand of product variants in order to identify low-turning products is one way to reorganize and tighten the assortment and concentrate on the most important products. Moreover, where applicable, components should be standardized. Customization of products should take place as late in the process as possible. Back to top Speed Up Receivables Collection Many companies are early payers and late collectors—a formula for squandering working capital. Other companies—particularly project-based businesses and manufacturers of large, costly products with lengthy production cycles—have cash flow problems caused by a mismatch in timing between costs incurred and customer payments. Therefore, efficient management of receivables and prepayments received is crucial. An optimization can yield significant potential. Invoicing cycle: The main target in this respect is to get invoices to the customers as quickly as possible. Processes and systems should be aligned to allow invoicing promptly after dispatch or service provision. All disruptions of the process by unnecessary interfaces should be eliminated. Furthermore, companies should reduce invoicing lead times by multiplying their invoicing runs.

Early reminders/dunning cycles: Experience shows that a number of customers seem to postpone their payments to the receipt of the first payment reminder. Early reminders and short dunning cycles thus have a direct impact on late payments. Best-in-class companies reduce grace periods to a minimum or remind their customers of upcoming payments even before the due date. Establishing direct debiting with main customers is the most effective means to avoid overdue payments. Payment terms: Renegotiated payment terms will lead to reduced DSO. The first step is often a harmonization and reduction of available conditions to decrease discretionary application. When preparing negotiations, companies should analyze their customers’ bargaining power and specific preferences in order to identify improvement potential in the terms and conditions for payments. Payment schedule: Companies operating in project business should introduce more advantageous payment schemes that cover costs incurred. Percentage of completion (POC) accounting helps to define relevant payments along milestones. But also for companies with small series productions, the introduction of prepayments and advances can significantly improve liquidity. Rethink Payment Terms with Suppliers If fast-paying companies are at one end of the spectrum, then companies that “lean on the trade” and use unpaid payables as a source of financing are at the other. Between these two extremes there is a more effective, integrated approach to payment renegotiation that takes into account all aspects of the customer–supplier relationship, from price and payment terms to delivery time frames, product acceptance conditions, and international trade definitions. Payment cycle: Payment runs for payables should be limited to the required frequency. Here, of course, country- and industry-specific business conventions apply. Moderate adjustments of payment runs just require some changes in the accounting systems, and tend to be a “quick hit.” Avoidance of early payments: Payments before the due date should be strictly avoided. Payments should be accomplished with the next payment run after the due date (ex post). Switching from ex ante to ex post payments is common practice and entails an easily implemented lever for increasing payables. Payment conditions: A DPO increase can often be achieved by renegotiating payment conditions with suppliers. Best-practice approach here is to first get an overview of all payment terms in use and to define a clear set of payment terms for the future. Renegotiations with suppliers are based on these new standard terms. It is critical to take into account supplier specifics. For those with liquidity constraints the focus should lie on prices, whereas for suppliers with high liquidity the payment term can often be extended. Product acceptance conditions: Connecting the settlement of payables to the fulfillment of all contractual obligations may result in significant postponements of respective payments.

Enforcing supplier compliance to stipulated quality, quantity, and delivery dates is also the basis for optimized, demand-oriented supply concepts. Prerequisite is full data transparency on relevant events. Back-to-back agreements: Balancing the due dates of receivables and payables helps to avoid excessive prefinancing of suppliers and can even lead to a positive cash balance. Coverdrive Ltd Case Study Working Capital Management – Inventory Control Since joining Coverdrive, John Thistle the management accountant, has been implementing various systems linked to short-term planning and reporting. He has recently focused on a review of the stock holding of raw materials, consumables and maintenance spares and having conducted a full physical stock take and valuation at quarter ended 31 March he is concerned at the lack of control that exists in ordering issue and control of some stock items. At a recent management meeting John had agreed with Steve Ambrose, the MD, that one of his short-term objectives as management accountant would be a full review of working capital requirements and its control. He reports his concerns expressed regarding the control of stocks and Steve asks him to prepare a presentation on the issues of inventory control for the next management meeting, to which he plans to invite both the production and stores managers. Preliminary notes prepared by John in advance of the meeting In manufacturing and distributive trades, inventories (or stocks) constitute a substantial portion of total assets employed. Inventory control comprises accounting and the physical control of materials, work-in-progress and finished goods. Accounting control is effected by the use of a series of control accounts for each category listed above and stores ledger accounts relating to quantities and values of stock on hand. Physical control comprises strategy for buying, handling, storing, issuing, supervising the stores function and taking stock. Inherent in any system of inventory control is the concept of stock levels, which are normally expressed in physical units but may also be in money terms. The objective of establishing control levels is to ensure that excessive stocks are not carried and working capital is not sacrificed, thereby avoiding the likelihood of being out of stock of any material. What are the factors to be considered when establishing control levels? These include:

i ii iii iv v vi vii viii

Working capital available and the cost of capital. Average consumption or production requirements. The re-order period – the period between placing the order and receiving delivery. Storage space available. Market conditions. Economic order quantity. Possibility of loss through deterioration or obsolescence. Costs of ordering, receiving, inspecting and accounting.

The stock levels used in inventory control systems for both accounting and physical measures are minimum stock, maximum stock, re-order level and the re-order quantity or economic order quantity; and I suggest that we implement such controls across our range of stock. Minimum stock level: ‘The lowest level to which stocks should normally be allowed to fall, and is held as a buffer stock to be made available in situations of non-delivery by a supplier’. It takes into account the re-order level and average consumption in the average delivery period. Maximum stock level: ‘The highest level to which stock should normally be allowed to rise, otherwise too much working capital is tied up, thus sacrificing liquidity, and there is a risk of loss through deterioration and obsolescence’. It takes account of the re -order level, the re-order quantity and the minimum consumption in the minimum delivery period. Re-order level: ‘This is the level at which an order would normally be raised’. It takes into account the maximum usage in the maximum delivery period. Re-order quantity or economic order quantity: ‘This is the quantity which is most economical to order as it minimises the costs of ordering and the carrying costs such as storage, insurance and interest on capital’. Once the re-order quantity has been determined, the other control levels can be determined by the following formulae: Minimum stock level = Re-order level – (average usage in average delivery period). Maximum stock level = Re-order level + re-order quantity – (minimum usage in minimum delivery period).

Re-order level = maximum usage x maximum delivery period. Example: The following relates to stock item COV 5, calculate:    re-order level maximum stock level minimum stock level 1200 units maximum 900 units minimum maximum 4 months minimum 2 months 3000 units

Usage per month:

Estimated delivery period:

Re-order quantity:

Re-order level = 4 x 1200 = 4800 units Maximum level = 4800 + 3000 - (900 x 2) = 6000 units Minimum level = 4400 - (1050 x 3) = 1250 units The tabulation below shows a typical cycle of events for this stock item. This is a monthly summary and assumes that stock was received on the last day of month 2 and 5. Re-order levels would have been reached at the start of month 1, prior to the end of month 3 and towards the latter part of month 6. This summary is based on monthly receipts and issues. However the status of stock would be reported daily. Stock Item COV 5 (Units) Re-order and usage profile: Month 1 “ “ Month 2 “ “ Month 3 Month 4 Month 5 “ “ Month 6 Opening balance Issues Issues Receipt of order Issues Issues Issues Receipt of order Issues Quantity Balance 5000 3800 2700 5700 4500 3300 2200 5200 4100

1200 1100 3000 1200 1200 1100 3000 1100

When graphed this profile shows:

6000

MAXIMUM LEVEL

5000

RE-ORDER LEVEL

4000 UNITS 3000

2000 MINIMUM LEVEL 1000

1

2

3

4 MONTHS

5

6

The graph shows the movement of stock and the levels kept within the predetermined levels of control. In the model illustrated so far, the re-order quantity is given. However, consideration must now be given to the determination of the economic order quantity. When an order is placed with a supplier, certain start-up costs such as administration are incurred. If this was the only factor for consideration, we would make the order as large as possible, thus benefiting from maximum discounts. But, as previously mentioned, we must consider the holding costs. The economic order quantity is that quantity which minimises the total of the starting and carrying costs. There are two methods of determining this. One is the tabular method, the other by mathematical model. (i) Mathematical formula Q A P S = = = = Economic order quantity Annual demand in units Cost of placing an order Cost of holding one unit in stock for one year

Where

Q

=

2AP S

Assume that in case of a further stock item COV 6, 6000 units are required annually and that expenses relating to start up costs are £25 per order and carrying costs are £0.20 per unit per annum. Orders could be arranged in lots of 600, 1200, 2000, 3000 or 6000. Then:

Q

=

2 x 6000 x 25 0.20 1225 units or 5 orders per annum

Q Tabular Method (1) (2) (3)

=

Order size Frequency of orders Average stock (1/2 batch size)

600 10 300 £ 250 60

1200 5 600 £ 125 120

2000 3 1000 £ 75 200

3000 2 1500 £ 50 300

6000 1 3000 £ 25 600

(4) (5)

Starting costs (no. of orders x £25) Carrying costs (average stock x £0.20)

Total Cost

310

245

275

350

625

From this tabulation it appears that the EOQ is 1200 units as this minimises the total costs. Presented Graphically £600 Cost Total cost £500 Economic order quantity 1200 Carrying cost

£400

£300

£200

£100

0 1 2 3 4 Order size Conclusion I intend to apply these controls and this model to a sample of stock items over the next few months to determine the possible savings in terms of investment in working capital.


5

6 000’s units

Sponsor Documents

Or use your account on DocShare.tips

Hide

Forgot your password?

Or register your new account on DocShare.tips

Hide

Lost your password? Please enter your email address. You will receive a link to create a new password.

Back to log-in

Close