ordering cost

8/13/2019 Ordering Cost

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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 unusualand sometimes unreasonable demands on their resources -- personnel, equipment and

facilities and operational. Exceptional customer service also includes providing top qualityproducts at reasonable costs.Businesses must keep a careful rein on their inventories. Having too much inventory and/ornot 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 sothat it contributes to the business' profitability.Inventory management can help businessbe 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 Consulting-Inventory Management is the art and science of managing to have the RIGHT PRODUCT, atthe 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 distributors net profits."Myths in Inventory ManagementAmazingly, there are so many myths about Inventory Management. Some of them soundidiotic but they do really happen in the Real World of business. Sometimes, its best tolearn from other peoples (business people?) mistakes or misunderstandings andincorporate our findings in our own business.

Myth: The SALES data that we have in our company records, is all we need for inventorymanagementWRONG! : Inventory management systems do not use sales data. They must be supportedby accurate demand information-which is totally different!

Myth: The more expensive a software system is, the better it will help us control ourinventory.


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WRONG! : The BEST inventory forecasting and planning system available today, costsunder $1000 and they work as well as any other system in the market.Myth:Our real problem is our people- they just dont 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 goodforecasts for inventory planning.WRONG! : Using monthly sales data is one of the major contributors to poor inventoryforecasting and planning. It inevitably leads to inaccurate safety stock calculations andother projections and, thus, not having the inventories that our companies need when weneed them!Myth: Our companys 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 maybe at performing acconting functions, and most are very good- can ever provide the dataand/ or analysis required to precisely manage any companys 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 soundidiotic but they do really happen in the Real World of business. Sometimes, its best tolearn from other peoples (business people?) mistakes or misunderstandings andincorporate our findings in our own business.

Myth: The SALES data that we have in our company records, is all weneed for inventorymanagementWRONG! : Inventory management systems do not use sales data. They must be supportedby accurate demand information-which is totally different!

Myth: The more expensive a software system is, the better it will help us control ourinventory.WRONG! : The BEST inventory forecasting and planning system available today, costsunder $1000 and they work as well as any other system in the market.Myth:Our real problem is our people- they just dont 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 wrongtools (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 goodforecasts for inventory planning.

WRONG! : Using monthly sales data is one of the major contributors to poor inventoryforecasting and planning. It inevitably leads to inaccurate safety stock calculations andother projections and, thus, not having the inventories that our companies need when weneed them!Myth: Our companys 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 maybe at performing acconting functions, and most are very good- can ever provide the data


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and/ or analysis required to precisely manage any companys inventories! Your company orbusiness needs (No! MUST Have) an inventory management system.

References:1.) http://www.execpc.com/~matplan/page3.html

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Why is Inventory Management Important?1.) Inventory management can help business be more profitable by lowering their cost ofgoods sold and/or by increasing sales.Consider a typical company - ABC Company with the following income statement:

Sales $ 2,000,000Cost of Goods Sold 1,100,000Gross Profits 900,000Gen. Administrative Expenses 402,000Marketing 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, ABCCompany was able to reduce the cost of goods sold by 3%. And because there is lessinventory, let's say that carrying costs (warehouse storage charges, insurance, financecharges, etc) is reduced by 2% of the general administrative expense. Those minimal costreductions result in significant increase on net income:

Sales $ 2,000,000Cost of Goods Sold 1,067,000Gross Profits 933,000

Gen. Administrative Expenses 394,000Marketing Expenses 350,000Net Income before taxes $ 189,000

===========Small costs reductions due to application of sound inventory management principlesresulted in very significant increase (28%) in net income!Lower cost of goods sold is achieved by making the inventory smaller and therefore turnmore often; while making sure that stocks are large enough will result in increased salesbecause products are available when Customers call for it. Inventory management isbalancing 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 muchinventory and paying more for interest and/or storage charges?

If you can improve your inventory turnover performance, how much will your grossprofits increase?

What is your service level performance? Are you losing potential or currentCustomers (and revenues) because you are out-of-stock of the products they
https://www.msu.edu/course/prr/473/oldstuff/Inventory%20Management.htm#Introductionhttps://www.msu.edu/course/prr/473/oldstuff/Inventory%20Management.htm#Introductionhttps://www.msu.edu/course/prr/473/oldstuff/Inventory%20Management.htm#Introduction


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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 orinformation maintained by your organization.)

Set up either a manual or computer-based inventory control system to bettermanage inventory.

Where required, provide contractual project leadership from installation intoconversion and start-up of new system.Where also required, develop a proceduremanual 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 Service4.) Reduce Inventory Investment5.) Increase Productivity6.) Prevent Poor Inventory Record Accuracy

Inventory record errors are costly. No computer system, be it old or new, will workproperly if the transactions are not entered correctly. The costs of poor inventory recordaccuracy are not always apparent to management. Consider the following results, all ofwhich 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 andcan be substantial. It is important to have inventory records, which are accurate. Mostexperts agree that this accuracy must be at least 95% and even higher for critical or highunit value items. The key to accurate records is the implementation of a sound cyclecounting system.

Economic Order QuantityEconomic Order Quantity, better known as EOQ, is a mathematical tool for determiningthe order quantity that minimizes the costs of ordering and holding inventory. It attemptsto 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,
https://www.msu.edu/course/prr/473/oldstuff/Inventory%20Management.htm#Introductionhttps://www.msu.edu/course/prr/473/oldstuff/Inventory%20Management.htm#Introductionhttps://www.msu.edu/course/prr/473/oldstuff/Inventory%20Management.htm#Introduction


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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 andOrdering cost. Holding cost include the cost of financing the inventory along with the costof physically maintaining the inventory. These costs are usually expressed as a percentageof 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. Theequation for total inventory cost is developed as follows:Total Inventory Cost (TIC) = Holding Cost + Ordering CostTIC = (Average Inventory)(Holding cost per unit) + (Number of orders per year)(Orderingcost 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 acertain model truck. Daily production of this truck is reasonably stable through out theyear. 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


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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 fivesteps:(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) QUANTITIVELYMODEL 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 QUANTITYQ* = square root [(2 x D x K)/(H x C)]Where: D = annual demand in units

K = ordering cost per orderH = carrying cost per unit expressed as a fraction of cost of an individual unit

Q = reorder quantityQ* = optimal reorder quantityC = cost of an individual item

TC = total annual inventory costJust-In-Time Management (JIT)

In traditional settings, inventories of raw materials and parts, finished goods and all, werekept 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 forcontrolling the flow of manufacturing in a multistage production process.In a just-in-time (or JIT) production system, raw materials and parts are purchased orproduced just in time to be used at each stage of the production process. This approach toinventory and production management brings considerable cost savings from reducedinventory levels.The key system to the JIT System is the pull approach to controlling manufacturing. Tovisualize this approach, look at Exhibit (c), which displays a simple diagram of a multistage


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production process. The flow of manufacturing activity is depicted by the solid arrowsrunning down the page from one stage of production to the next. However, the signal thattriggers 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 atthe 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 goodsare needed. Similarly, when production employees in stage III need more input, they senda signal back to stage II. This triggers production activity in stage II. Working our way backup to the beginning of the process, purchases of raw materials and parts are triggered by asignal that they are needed in stage I. This pull system of production management, whichcharacterizes the JIT approach, results in a smooth flow of production and significantlyreduced 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 fromJapanese methods where substantial efficiencies are gained from frequent deliveries of

small quantities to meet immediate demands. This compares with methods of stockcontrol such as the calculation of economic order quantities.

2.the application of Kanban - a "pull" system of production/materials control3.an employee participation and involvement strategy involving the securing ofcommitment and changed work practices leading to elimination of waste

KanbanAt Toyota, the production system used tickets/cards to control immediate material flowsbetween 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 previousupstream 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 isempty, 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 ofthe operational environment.

With the integration of computer systems internally and externally with supplierssystems - Kanban data and instructions can flow between the linked systems. JIT is Not

Possible Without....


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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 uptimes for product changes - then the data flowing in the JIT system and the abilityof servers to respond are critical.

Key Features to JIT Approach

How does a JIT system achieve its vast reductions in inventory and associated costsavings? 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 asmooth production flow, beginning with the arrival of materials from suppliers and endingwith the delivery of goods to customers. Widely fluctuating production rates result indelays and excess work-in-process inventories. These non-value-added costs are to beeliminated.

2) A pull method of coordinating steps in the production process. Most manufacturingprocesses occur in multiple stages. Under the pull method, goods are produced in eachmanufacturing stage only as they are needed at the next stage. This approach reduces oreliminates work-in-process inventory between production steps. The result is a reduction inwaiting 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 tothe immediate preceding work center to send the amount of materials and parts that will


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be needed over the nexrt few hours. Often this message is in the form of a withdrawalKanban, a card indicating the number and type of parts requested from the precedingwork center. The receipt of withdrawal Kanban in the preceding work center triggers therelease of a production Kanban, which is another card specifying the number of parts to bemanufactured 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 productionis repeated all the way up the manufacturing sequence toward the beginning. Nothing ismanufactured at any stage until its need is signaled from the subsequent process via aKanban. 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 purchasedand 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-addedcosts.4) Quick and inexpensive setups of production machinery. In order to produce in small lotsizes, a manufacturer must be able to set up production runs quickly. Advanced

manufacturing technology aids in this process, as more and more machines are computer-controlled.5) High quality levels for raw material and finished products.6) Effective preventive maintenance of equipment. If goods are to be manufactured just intime to meet customer orders, a manufacturer cannot afford significant production delays.By strictly adhering to routine maintenance schedules, the firm can avoid costly down timefrom machine breakdowns.7) An atmosphere of teamwork to improve the production system. A company canmaintain a competitive edge in todays worldwide market only if it is constantly seekingways to improve its product or service, achieve more efficient operations, and eliminatenon-value-added costs.

8) Multiskilled workers and flexible facilities.JIT Purchasing

In addition to a JIT production approach, an effective business should implement JITpurchasing. Under this approach, materials and parts are purchased from outside vendorsonly as they are needed. This avoids the costly and wasteful buildup of raw materialinventories. 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 highlyreliabled 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 aremade for batches of deliveries according to the terms of the contract. This reduces costlypaperwork for both the vendor and the purchaser.

JIT is an important operational system for manufacturing and supplying companies toadopt and implement. Technically, procedurally and managerially it requires attention to:


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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 inproductivity/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 againstthe 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 ofvendors, negotiating long- term supply agreements, making less frequent payments, andeliminating inspections. The implication of the JIT philosophy is that inventories should be

minimized by more frequent deliveries in smaller quantities. ConclusionIn any business, make it big or small, we must understand that taking good care of ourinventory is very important. If we as managers do not understand the concept of goodinventory management, we must learn to be familiar with it and its applications. One of thereasons for the failure of a business is its inventory management. There are many ways tofight failure, and we can start from here. There are new technology that can help usmaintain and supervise our inventory. What we can do is learn, implement and evaluateour business. And you can start with your INVENTORY!!!!!

Definition and MeasurementWorking capital, also referred to as net working capital (NWC), is an absolute measure of acompanys 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 fiscalyear. 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 orsupplies, short-term loans, long-term loans with maturity within one year, dividends andinterest payable, or accrued liabilities such as accrued taxes.

Working capital, on the one hand, can be seen as a metric for evaluating a companysoperating liquidity. A positive working capital position indicates that a company can meetits short-term obligations. On the other hand, a companys working capital position signalsits operating efficiency. Comparably high working capital levels may indicate that too much


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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 companys cash flow. Excess cash and nonoperational items may beexcluded from the calculation for better comparison.

As a measure for effective working capital management, therefore, another moreoperational 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 (forexample, 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 overtime, they also allow better benchmarking of operating efficiency with internal or externalpeers.

A frequently used measure for the effectiveness of working capital management is the so-called cash conversion cycle, or cash-to-cash cycle (CCC). It reflects the time (in days) ittakes a company to get back one monetary unit spent in operations. The operative NWCpositions are translated into days outstandingthe number of days during which cash isbound in inventory and receivables or financed by the suppliers in accounts payable. It isdefined 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


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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 acceleratesthe CCC, but also goes hand in hand with further improvements. Figure 1 illustrates how anNWC 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 capitalemployed. Improved processes will also lead to reduced costs and higher earnings beforeincome and taxes (EBIT).

Managing the Three Operational Components of NWCSo, what are the relevant levers of working capital management, and how are theyapplied? In effect, receivables and payables are just different ways of financing inventories.Companies need to manage all three components simultaneously across the value chain soas to drive fundamental reductions in asset levels. Given the wide range of possibleactions, 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 impairflexibility and performance. These actions will vary depending on industry and competitivesituation, and have to be adapted to country specifics and regulations. In the followingparagraphs some typical (but just exemplary) levers are described.

Reduce InventoriesExcess inventory is one of the most overlooked sources of cash, typically accounting for


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almost half of the savings from working capital optimization projects. By streamliningprocesses within the companyas well as processes involving suppliers and customerscompanies 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 helpcompanies 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, top-performing companies establish advanced and demand-driven logistics concepts with theirsuppliers, 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 withmutual benefits.

Optimized production processes: An important lever to reduce work-in-progress inventoryis the redesign of production processes. The main objectives here are to reduce non-value-adding time (white-space reduction) and excessive inventory between production steps.

Promising measures are removing bottlenecks and migrating from push concepts todemand-driven pull systems.

Service level adjustments: An increased service level for products which are critical to thecustomer (and thus allow higher prices) and a decreased service level for products whichare uncritical to the customer will not only lead to optimized stocks. A more sophisticatedapproach to calculating security stocks based on target availability and deviations inproduction and demand will also reduce out-of-stock situations for critical parts.

Variance management: Reducing product complexity and carefully tracking demand ofproduct 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 shouldtake place as late in the process as possible.

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Speed Up Receivables CollectionMany companies are early payers and late collectorsa formula for squandering workingcapital. Other companiesparticularly project-based businesses and manufacturers oflarge, costly products with lengthy production cycleshave cash flow problems caused bya mismatch in timing between costs incurred and customer payments. Therefore, efficient

management of receivables and prepayments received is crucial. An optimization can yieldsignificant potential.

Invoicing cycle: The main target in this respect is to get invoices to the customers asquickly as possible. Processes and systems should be aligned to allow invoicing promptlyafter dispatch or service provision. All disruptions of the process by unnecessary interfacesshould be eliminated. Furthermore, companies should reduce invoicing lead times bymultiplying their invoicing runs.


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Early reminders/dunning cycles: Experience shows that a number of customers seem topostpone their payments to the receipt of the first payment reminder. Early reminders andshort dunning cycles thus have a direct impact on late payments. Best-in-class companiesreduce 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 effectivemeans to avoid overdue payments.

Payment terms: Renegotiated payment terms will lead to reduced DSO. The first step isoften a harmonization and reduction of available conditions to decrease discretionaryapplication. When preparing negotiations, companies should analyze their customersbargaining power and specific preferences in order to identify improvement potential inthe terms and conditions for payments.

Payment schedule: Companies operating in project business should introduce moreadvantageous 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 advancescan significantly improve liquidity.

Rethink Payment Terms with SuppliersIf fast-paying companies are at one end of the spectrum, then companies that lean on thetrade and use unpaid payables as a source of financing are at the other. Between thesetwo extremes there is a more effective, integrated approach to payment renegotiationthat takes into account all aspects of the customersupplier relationship, from price andpayment terms to delivery time frames, product acceptance conditions, and internationaltrade definitions.

Payment cycle: Payment runs for payables should be limited to the required frequency.Here, of course, country- and industry-specific business conventions apply. Moderateadjustments of payment runs just require some changes in the accounting systems, andtend 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 easilyimplemented 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 allpayment 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 takeinto account supplier specifics. For those with liquidity constraints the focus should lie onprices, whereas for suppliers with high liquidity the payment term can often be extended.

Product acceptance conditions: Connecting the settlement of payables to the fulfillment ofall contractual obligations may result in significant postponements of respective payments.


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Enforcing supplier compliance to stipulated quality, quantity, and delivery dates is also thebasis for optimized, demand-oriented supply concepts. Prerequisite is full datatransparency 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 beenimplementing various systems linked to short-term planning and reporting.

He has recently focused on a review of the stock holding of raw materials, consumablesand maintenance spares and having conducted a full physical stock take and valuation atquarter ended 31 March he is concerned at the lack of control that exists in ordering issueand control of some stock items.

At a recent management meeting John had agreed with Steve Ambrose, the MD, that oneof his short-term objectives as management accountant would be a full review of workingcapital requirements and its control.

He reports his concerns expressed regarding the control of stocks and Steve asks him toprepare a presentation on the issues of inventory control for the next managementmeeting, 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 substantialportion of total assets employed. Inventory control comprises accounting and the physicalcontrol of materials, work-in-progress and finished goods.

Accounting control is effected by the use of a series of control accounts for each categorylisted above and stores ledger accounts relating to quantities and values of stock on hand.

Physical control comprises strategy for buying, handling, storing, issuing, supervising thestores 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 ofestablishing control levels is to ensure that excessive stocks are not carried and workingcapital is not sacrificed, thereby avoiding the likelihood of being out of stock of anymaterial.

What are the factors to be considered when establishing control levels?

These include:


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i Working capital available and the cost of capital.

ii Average consumption or production requirements.

iii The re-order period the period between placing the order and receiving delivery.

iv Storage space available.

v Market conditions.

vi Economic order quantity.

vii Possibility of loss through deterioration or obsolescence.

viii Costs of ordering, receiving, inspecting and accounting.

The stock levels used in inventory control systems for both accounting and physicalmeasures are minimum stock, maximum stock, re-order level and the re-order quantity oreconomic order quantity; and I suggest that we implement such controls across our rangeof 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 asupplier. It takes into account the re-order level and average consumption in the averagedelivery 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 riskof loss through deterioration and obsolescence. It takes account of the re-order level, there-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 intoaccount the maximum usage in the maximum delivery period.

Re-order quantity or economic order quantity: This is the quantity which is mosteconomical to order as it minimises the costs of ordering and the carrying costs such asstorage, insurance and interest on capital.

Once the re-order quantity has been determined, the other control levels can bedetermined 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 minimumdelivery period).


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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

Usage per month: 1200 units maximum900 units minimum

Estimated delivery period: maximum 4 monthsminimum 2 months

Re-order quantity: 3000 units

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 monthlysummary 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 month3 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: Quantity Balance

Month 1 Opening balance 5000 Issues 1200 3800

Month 2 Issues 1100 2700 Receipt of order 3000 5700

Month 3 Issues 1200 4500

Month 4 Issues 1200 3300Month 5 Issues 1100 2200 Receipt of order 3000 5200

Month 6 Issues 1100 4100

When graphed this profile shows:


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6000 MAXIMUM LEVEL

5000 RE-ORDER LEVEL

4000

UNITS3000

2000

MINIMUM LEVEL

1000

1 2 3 4 5 6MONTHS

The graph shows the movement of stock and the levels kept within the predeterminedlevels of control.

In the model illustrated so far, the re-order quantity is given. However, consideration mustnow 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 areincurred. If this was the only factor for consideration, we would make the order as large aspossible, thus benefiting from maximum discounts. But, as previously mentioned, we mustconsider the holding costs.

The economic order quantity is that quantity which minimises the total of the starting andcarrying costs.

There are two methods of determining this. One is the tabular method, the other bymathematical model.

(i) Mathematical formulaWhere Q = Economic order quantity

A = Annual demand in unitsP = Cost of placing an orderS = Cost of holding one unit in stock for one year


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Q = 2APS

Assume that in case of a further stock item COV 6, 6000 units are required annually andthat 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 250.20

Q = 1225 units or 5 orders per annum

Tabular Method

(1) Order size 600 1200 2000 3000 6000(2) Frequency of orders 10 5 3 2 1(3) Average stock (1/2 batch size) 300 600 1000 1500 3000

(4) Starting costs (no. of orders x 25) 250 125 75 50 25(5) Carrying costs (average stock x

0.20)60 120 200 300 600

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 CostTotalcost

500 Economic Carryingorder costquantity

400 1200

300

200


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100

0

1 2 3 4 5 6

Order size 000s units

Conclusion

I intend to apply these controls and this model to a sample of stock items over the nextfew months to determine the possible savings in terms of investment in working capital.

ordering cost

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