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Intro to Finance
Table of Contents
Unit 11 Overview: Working Capital Management
11.1 Working Capital Cycle and Policies
11.2 Cash and Marketable Securities Management
11.3 Inventory Management
11.4 Accounts Receivable Management
11.5 Short-term Financing

Inventory management is crucial for businesses to balance costs and meet customer demand. It involves tracking raw materials, work-in-progress, finished goods, and maintenance supplies. Effective management optimizes stock levels, minimizes costs, and ensures smooth operations.

Key concepts include economic order quantity, reorder points, and inventory control systems. Just-in-time techniques and ABC classification help businesses streamline processes and focus on high-value items. Understanding these principles is essential for efficient inventory management.

Inventory Management

Types of inventory in production

  • Raw materials inventory
    • Unprocessed materials used to create finished products (lumber, steel, plastics)
    • Serve as inputs for the production process
    • Must be purchased and stored until needed for production
  • Work-in-progress (WIP) inventory
    • Partially completed products in various stages of the production process
    • Represents the value of materials, labor, and overhead incurred but not yet turned into finished goods
    • Ties up capital and requires storage space until completion
  • Finished goods inventory
    • Completed products ready for sale to customers
    • Represents the final output of the production process
    • Must be stored and managed until sold and delivered to customers
  • Maintenance, repair, and operating (MRO) inventory
    • Supplies and materials used to support production but not directly incorporated into finished products (spare parts, lubricants, cleaning supplies)
    • Ensures smooth operation of production equipment and facilities
    • Requires regular monitoring and replenishment to avoid production disruptions

Economic order quantity calculation

  • Economic order quantity (EOQ)
    • Optimal order quantity that minimizes total inventory costs
    • Balances the trade-off between ordering costs and holding costs
    • Formula: $EOQ = \sqrt{\frac{2DS}{H}}$
      • $D$ = Annual demand in units
      • $S$ = Fixed cost per order (setup costs, transportation costs)
      • $H$ = Annual holding cost per unit (storage, insurance, opportunity cost)
  • Reorder point (ROP)
    • Inventory level at which a new order should be placed to prevent stockouts
    • Considers lead time and safety stock to ensure continuous supply
    • Formula: $ROP = (Daily\ demand \times Lead\ time) + Safety\ stock$
      • Daily demand = Average number of units sold per day
      • Lead time = Time between placing an order and receiving the inventory
      • Safety stock = Extra inventory held to prevent stockouts due to unexpected demand or supply delays

Inventory control system analysis

  • Periodic inventory system
    • Inventory levels are reviewed and orders placed at fixed intervals (weekly, monthly)
    • Benefits: simplicity, less frequent ordering, suitable for low-value items
    • Costs: higher average inventory levels, increased risk of stockouts
  • Perpetual inventory system
    • Inventory levels are continuously monitored and updated with each transaction
    • Benefits: real-time inventory tracking, lower risk of stockouts, better decision-making
    • Costs: higher setup and maintenance costs for technology and systems
  • ABC inventory classification
    • Categorizes inventory items based on their value and importance
      1. A items: high value, critical to production (20% of items, 80% of value)
      2. B items: moderate value, less critical (30% of items, 15% of value)
      3. C items: low value, least critical (50% of items, 5% of value)
    • Benefits: focuses management attention on high-value items, optimizes inventory control efforts
    • Costs: time and resources required for classification and differentiated management

Just-in-time inventory techniques

  • Just-in-time (JIT) inventory management
    • Production and inventory strategy that aims to minimize inventory holding costs by receiving materials just as they are needed
    • Key principles:
      1. Pull system: production is triggered by customer demand, not forecasts
      2. Small, frequent deliveries from suppliers
      3. Continuous improvement to reduce waste and inefficiencies (lean manufacturing)
    • Benefits:
      • Lower inventory holding costs
      • Reduced space requirements
      • Improved cash flow
    • Challenges:
      • Requires strong supplier relationships and reliable deliveries
      • Increased risk of stockouts if supply chain disruptions occur (natural disasters, labor strikes)
      • Higher transportation costs due to frequent deliveries