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Chapter 4

Chapter 4. Ordering and Accounting for Inventory. Ordering, Receiving and issuing materials. Ordering, Receiving and issuing materials. Documents. Double entry. Double entry. Control Procedures. Chapter 5 Order Quantities and Reorder Levels. Types of Inventory. Raw materials

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Chapter 4

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  1. Chapter 4 Ordering and Accounting for Inventory

  2. Ordering, Receiving and issuing materials

  3. Ordering, Receiving and issuing materials

  4. Documents

  5. Double entry

  6. Double entry

  7. Control Procedures

  8. Chapter 5 Order Quantities and Reorder Levels

  9. Types of Inventory • Raw materials • Purchased parts and supplies • Work-in-process (partially completed) products (WIP) • Items being transported • Tools and equipment

  10. Independent and Dependent Demand Inventory • Independent demand • items demanded by external customers (Kitchen Tables) • Dependent demand • items used to produce final products (table top, legs, hardware, paint, etc.) • Demand determined once we know the type and number of final products

  11. Inventory and Quality Management • Customers usually perceive quality service as availability of goods they want when they want them • Inventory must be sufficient to provide high-quality customer service in TQM

  12. Inventory Costs • Holding cost • cost of holding an item in inventory • Ordering cost • cost of replenishing inventory • Shortage cost • temporary or permanent loss of sales when demand cannot be met

  13. Holding & Ordering Costs Minimise total of holding, ordering and stock-out costs

  14. The cost of Holding Inventory A company uses components at the rate of 6,000 units per year, which are bought in at a cost of £1.20 each from the supplier. The company orders 1,000 units each time it places an order and the average inventory held is 500 units. It costs $20 each time to place an order, regardless of the quantity ordered. The total holding cost is 20% per annum of the average inventory held. The annual holding cost will be $ The annual ordering cost will be $

  15. Solution • The annual holding cost will be $120 • 500 units * $1.20 * 20 % • The annual ordering cost will be $120 • 6,000/1,000 = 6 • 6 * 20 = $120

  16. The cost of Holding Inventory • A company has recorded the following details for Component 427 which is sold in boxes of 10 components. Component 427 is currently ordered in batches of 240 boxes at a time. The average inventory held is 120 boxes. • Ordering cost $32 per order placed • Purchase price $20 per box of 10 components • Holding cost 10% of purchase price • Monthly demand 1,500 components

  17. The cost of Holding Inventory • Required: • Calculate the annual holding cost and the annual ordering cost for Component 427. • Annual holding cost = average inventory held x cost per box x 10% = 120 x $20 x 10% = $240 • Annual ordering costs = (1800/240) *32 = $240

  18. Ordering Costs • Associated with placing orders • Includes : • Administrative costs : fixed costs per Order • Delivery costs: Fixed charge per delivery order, behave as variable costs • Increased in number of orders will have an increase in ordering costs

  19. Water Tank Analogy for Inventory Inventory Level Supply Rate Buffers Demand Rate from Supply Rate Inventory Level Demand Rate

  20. Economic Order Quantity (EOQ) Models • EOQ • optimal order quantity that will minimize total inventory costs • Basic EOQ model • Production quantity model

  21. Annual cost ($) Total Cost Slope = 0 holding Cost = Minimum total cost CcQ 2 CoD Q Ordering Cost = Optimal order Qopt Order Quantity, Q EOQ Cost Model

  22. Economic Order Quantity The EOQ minimises the total of holding, ordering & stock-out costs √ 2C0D Q=EOQ = Ch Where : Q= Reorder Quantity (EOQ) D = demand per annum. C0 = Cost of placing one order Ch = cost of holding one unit per year Annual ordering costs =C0D/Q Annual holding cost = Ch*Q/2

  23. Economic Order Quantity • Average Inventory held is equal to half of the EOQ=EOQ/2 • The number of orders in a year = Expected annual demand/EOQ • Total annual holding cost=Average Inventory (EOQ/2) * holding cost per unit of Inventory • Total annual ordering cost = Number of orders * cost of placing an order.

  24. Total Annual Cost • Total Annual Cost = PD + (Co * D/Q) + (Ch* Q/2) • There is also a formula that allows us to calculate the Total Annual Costs (TAC) i.e. the total of purchasing costs, holding costs and ordering costs : • Note that the formula for the TAC is not provided in your exam.

  25. Total Annual Cost • Total Annual Cost = PD + (Co * D/Q) + (Ch* Q/2) Where: • P = Purchase cost per unit • D = Demand per annum • Co = Cost of placing one order • Ch = Cost of holding one unit for one year • Q = Reorder quantity (EOQ)

  26. Assumptions of Basic EOQ Model • Demand is known with certainty and is constant over time • No shortages are allowed • Lead time for the receipt of orders is constant • Order quantity is received all at once

  27. Example • A company uses components at the rate of 500 units per month, which are bought in at a cost of $1.20 each from the supplier. It costs $20 each time to place an order, regardless of the quantity ordered. • The total holding cost is 20% per annum of the value of inventory held. • EOQ ? • The total annual cost ?

  28. Example • A company is planning to purchase 90,800 units of a particular item in the year ahead. The item is purchased in boxes each containing 10 units of the item, at a price of $200 per box. A safety inventory of 250 boxes is kept. • The cost of holding an item in inventory for a year (including insurance, interest and space costs) is 15% of the purchase price.

  29. Example cont… • The cost of placing and receiving orders is to be estimated from cost data collected relating to similar orders, where costs of $5,910 were incurred on 30 orders. It should be assumed that ordering costs change in proportion to the number of orders placed. 2% should be added to the above ordering costs to allow for inflation. Assume that usage of the item will be even over the year. • The order quantity which minimises total costs is ? • This will mean ordering the item every weeks ?

  30. Bulk Discounts

  31. Bulk Discount • The steps involved in calculating the EOQ when quantity discounts are available are as follows: • If a quantity discount is accepted this will have the following effects: • – The annual purchase price will decrease. • – The annual holding cost will increase. • – The annual ordering cost will decrease

  32. Bulk Discount • To establish whether the discount should be accepted or not, the following calculations should be carried out. • – Calculate TAC with the discount. • – Compare this with the annual costs without the discount (at the EOQ point).

  33. Bulk Discount • 1) Calculate the EOQ, ignoring discounts. • (2) If the EOQ is smaller than the minimum purchase quantity to obtain a bulk discount, calculate the total for the EOQ of the annual inventory holding costs, inventory ordering costs and inventory purchase costs.

  34. Bulk Discount • (3) Recalculate the annual inventory holding costs, inventory ordering costs and inventory purchase costs for a purchase order size that is only just large enough to qualify for the bulk discount. • (4) Compare the total costs when the order quantity is the EOQ with the total costs when the order quantity is just large enough to obtain the discount. Select the minimum cost alternative.

  35. Bulk Discount • (5) If there is a further discount available for an even larger order size, • repeat the same calculations for the higher discount level.

  36. TC = ($10 ) ORDER SIZE PRICE 0 - 99 $10 100 – 199 8 (d1) 200+ 6 (d2) TC (d1 = $8 ) TC (d2 = $6 ) Inventory cost ($) holding cost Ordering cost Q(d1 ) = 100 Qopt Q(d2 ) = 200 Quantity Discount Model

  37. Example • A company uses components at the rate of 500 units per month, which are bought in at a cost of $1.20 each from the supplier. It costs $20 each time to place an order, regardless of the quantity ordered. • The supplier offers a 5% discount on the purchase price for order quantities of 2,000 items or more. The current EOQ is 1,000 units. • The total holding cost is 20% per annum of the value of inventory held. • Should the discount be accepted?

  38. Gradual Replenishment • Manufacturing their own products internally. • Involve deciding whether to produce large batches at long intervals OR produce small batches at short intervals. • EBQ (economic batch quantity) model. • As the items are being produced, there is a machine setup cost. This replaces the ordering cost of the EOQ.

  39. EBQ • In the EOQ, inventory is replenished instantaneously whereas here, it is replenished over a period of time. • Depending on the demand rate, part of the batch will be sold or used while the remainder is still being produced. • For the same size of batch (Q), the average inventory held in the EOQ model (Q/2) is greater than the average in this situation

  40. Economic Batch Quantity The number of manufactured items to produce in a batch, to minimise total costs √ 2C0D Ch(1-D/R) EBQ = Where : D = demand p.a. C0 = Cost of setting up batch Ch = cost of holding one unit per year R = Annual replenishment (annual production) rate Annual setup costs =C0D/Q Annual holding cost = Ch*Q/2 (1-D/R)

  41. Example EBQ • Production is at a rate of 500 units per week. • Demand is 10,000 units per annum; evenly spread over 50 working weeks. • Setup cost is $2,700 per batch. • Storage cost is $2.50 per unit for a year. • Calculate the economic batch quantity (EBQ) for Item X.

  42. Example EBQ • AB Ltd makes a component for one of the engines that it builds. It uses, on average, 2,000 of these components, steadily throughout the year. • The component costs $16 per unit to make and it costs an additional $320 to setup the production process each time a batch of components is made. The holding cost per unit is 10% of the unit production cost.

  43. Example EBQ • The company makes these components at a rate of 200 per week, and the factory is open for 50 weeks per annum. • Required: Calculate the EBQ.

  44. Re-order levels • Reorder level –Place replenishment order • Lead time – this is the time expected to elapse between placing an order and receiving an order for inventory. • Reorder quantity – when the reorder level is reached, the quantity of inventory to be ordered is known as the reorder or EOQ. • Demand – this is the rate at which inventory is being used up. It is also known as inventory usage.

  45. Re-order levels The pre-determined level of inventory at which order is placed, to avoid stock-outs. Re-order level = usage per day * lead time in days When lead time and demand in lead time is not constant : Re-order level = maximum usage*maximum lead time Maximum Inventory level = Re-order level + re-order quantity – (minimum usage*minimum lead time) Minimum Inventory level (buffer stock) = Re-order level – (average usage *average lead time) Average inventory = (Re-order quantity / 2) + minimum inventory

  46. EOQ Inventory Order Cycle Demand rate Order qty, Q Inventory Level ave = Q/2 Reorder point, R Lead time Lead time 0 Time As Q increases, average inventory level increases, but number of orders placed decreases Order Placed Order Received Order Placed Order Received

  47. Example reorder level. • A company uses Component M at the rate of 1,500 per week. The time between placing an order and receiving the components is five weeks. • The reorder quantity is 12,000 units. • Required: • Calculate the reorder level.

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