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Item Inventory Management

Introduction
Overview

Welcome to the Item Inventory Management course!

Many individuals think of inventory exclusively in terms of manufacturing environments.


But that perspective is too limited, as firms in virtually every industry segment have some
form of inventory to manage. Manufacturing firms frequently have distribution inventories,
and a key to success for the distribution function of the business is effective and efficient
management of inventory. Many service industries also have significant inventories to
manage as part of providing a service to the customer. All firms have supplies that are
used within their business. These supplies need to be managed from an inventory
perspective.

Item inventory management deals with the control and planning of individual items in
inventory both in monetary value and physical location of the item. Inventory is treated
in the financial statements as an asset, but inventory can also be a liability to the firm.
How well a firm manages aggregate inventories to support the business strategies will
determine whether the inventory is an asset or a liability. Similarly, selecting appropriate
planning and control techniques for individual items will determine whether the inventory
for that item is an asset or a liability for the firm.

Example

A manufacturer of copier machines has a distribution facility for spare parts and
field service technicians carry inventory in their vehicles. When a field service
technician completes a job, they are supposed to process a work ticket, which in
turn sends a signal to the distribution center that a replenishment part is needed.
When the order point is reached at the distribution facility for the particular item,
an order is generated to replenish the distribution facility inventory.

However, the communication signal in the technicians van sometimes


disconnects, the transaction does not occur, and the usage is not recorded. From
a control perspective, the perpetual inventory system indicates that the
technician still has the part while it has actually been used. In this situation, the
expense on the profit and loss statement is understated, and the assets on the
balance sheet are overstated. When a cycle count or periodic inventory is
completed, the inventory may be written off on the financial records.

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Inventory Management Techniques

The inventory policies and procedures must be consistent with and supportive of the
strategies of the firm, the environment in which it operates, and the functional strategies.
Those policies and procedures, along with the environment, determine which techniques
are appropriate for specific items in that environment.

This course explores techniques for controlling inventory, as well as commonly used
methods for determining the value of inventory. It also explores techniques for planning
item inventories. Click the arrow to read what questions these techniques answer.

When to replenish the inventory

How much to order when replenishing the inventory

What costs are associated with ordering the inventory

The techniques are based on the nature of the demand and volatility of demand patterns.
The overall fit of these methods will determine the direction that management will take
when monitoring item inventory. Otherwise, a negative outcome will occur if the
technique applied to a situation does not fit.

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Course Objectives

The objectives of this course are to provide you with a thorough understanding of
managing item inventory to support the overall operation of a business.

Upon completion of this course, you will be able to:

Select inventory planning methodologies that are appropriate for a given


situation.

Given the required data, calculate the statistical reorder point, economic order
quantity, and statistical safety stock quantity.

Given the basic data, calculate the value of inventory based on commonly used
valuation methods.

Select inventory management control methodologies that are appropriate for a


given situation.

If you need to understand specific terms, you can easily link to the APICS Dictionary.

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ORDER REVIEW TECHNIQUES
Overview

Order review techniques address the question of when to place a replenishment order for
inventory. There are several order review methods, some with variations. The methods
that are covered in this course can be classified into three categories: fixed quantity,
fixed interval, and deterministic. All of these methods attempt to balance the cost of
maintaining inventory with the cost of not having it when it is needed. There is no single
method that is best for all situations or for all items in a single instance.

Regardless of the environment, determining when to place an order is an important


function in the organization. It is imperative to understand the anomalies associated with
variables that affect overall demand of an item. The ordering method can be based on
statistical or deterministic models of inventory behavior.

Statistical models, which utilize probabilistic techniques, are based on triggering


the replenishment order when inventory reaches a fixed level or when a fixed
interval of time has elapsed.
Deterministic models are based on the fact that characteristics such as
demand, date, and physical characteristics are known. No uncertainty is included
in the model.

Whether a statistical or deterministic order review technique is used is influenced by the


nature of demand for an item, the level of demand, and the stability of demand over time.
In this topic, we will discuss commonly used order review methods and analyze where
the methods are appropriate to use.

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Fixed Reorder Point Methods

The basis of all fixed reorder point methods is that a replenishment order should be
placed when the inventory reaches a predetermined level. For example, a grocery
store orders 300 units of an item when the inventory reaches 100 units. The methods all
attempt to have some level of inventory on hand at all times. The point at which the
replenishment order is triggered is referred to as the order point or reorder point.

Statistical order points


Statistical order point is a system that places an order for a lot whenever the quantity on
hand is reduced to a predetermined level. This system can be used effectively for items
with relatively stable independent demand. Independent-demand items include finished
goods, spare parts, MRO items, and other manufacturing supplies. The reorder point is
the sum of the projected demand through the replenishment lead-time plus the safety
stock. Examples of statistical order point models would include supplies used in service
businesses, and office supplies such as forms, brochures, and booklets in industry
segments such as banking, insurance, and other financial services.

Visual review
Visual review is a system where a physical review of the stock on hand is used rather
than a perpetual inventory system. The visual review system is completed by walking up
and down aisles of inventory and visually scanning and, if necessary, counting on-hand
inventory to determine reorder quantities.

Two-bin system
Two-bin system is a common method of operating a visual review order point system. It is
appropriate for the management of independent-demand, low-value items with short
lead-times, such as screws used in an assembly. In a two-bin system, the inventory is
kept in two containers, and the active container is used to satisfy demand. When the
active container becomes empty, the replenishment order is placed. The second
container has enough inventory to cover the expected demand through lead-time plus
safety stock.

Minimum and maximum


Minimum and maximum (min-max) is merely a variation of statistical order point. The
minimum is the reorder point, and the maximum is the order point plus the ordering
quantity. However, the reorder point technique is a fixed-order quantity technique,
whereas the minimum and maximum technique is not considered a fixed-order method.

Kanban
Kanban is a system that will send a signal called a kanban to authorize the
movement of material or product from the supplying location to the consuming location.
Kanbans can also be used to signal the authorization to produce additional product. One
big benefit of a kanban system is that it puts limits on inventory buildup. A container
bearing a kanban can also act as a limit. When it is full, no additional product can be
made or moved into that location. The use of kanbans is an adaptation of the order point
technique because the kanban represents the fixed reorder quantity.

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Time-phased order point
Time-phased order point is based on the principle that ordering will occur in time to
receive material when the available stock balance reaches the safety stock level. This
technique accounts for both independent and dependent demand over the lead-time. The
ability to handle dependent demand differentiates it from the reorder point technique.
Including known demand enables the planner to account for sales promotions, seasonal
conditions, or other customer orders in addition to the forecast.

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Statistical Order Point Model

The statistical order point model is a tool of statistical inventory control. It is appropriate
when the underlying assumptions apply. There is a precise formula for calculating the
order point. For these reasons, the coverage of this method is more detailed than for the
other models. The model shows that when the inventory position for a given item falls
below the order point, a fixed replenishment quantity is ordered.

The order point is determined through the following calculation:

For example, if the weekly usage for a product is 300 units, lead-time is three weeks, and
safety stock requirement is one weeks worth of usage, the order point would be equal to
1,200 units ((300 units per week x 3 weeks) + 300 units of safety stock for one week of
demand).

Statistical Order Point Model

Following is a graphical illustration of the order point system.

On-hand is the inventory balance which is increased by the amount of the


replenishment order received.
Order point is the point at which an order must be placed so that it can be
received before the inventory level reaches zero.
Lead-time is the time between order placed and order received.
Safety stock is carried to buffer against shortages and stockouts.

Statistical order point is best used with independent-demand items that have a minimum
variability of usage. The method assumes that future customer demand will closely
resemble past demand. The technique requires that inventory planners continuously
review both historical usage and lead-times so that changes in demand caused by
trends, seasonality, sales promotions, and general economic conditions can be reflected
in the elements of the order point calculation.

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Demand Fluctuation

When demand is greater or less than expected, the replenishment order will still be
placed when the order point is reached, but the timing of the order will change. If demand
is greater or less than expected when using the statistical order point technique, then the
inventory planner will need to make some adjustments to the process. These
adjustments will be based on whether or not the variability of demand is short- or long-
term. Some individual needs to review the situation when the order is released earlier or
later than planned and determine whether it was caused by random variation in demand
or by a change in the demand pattern. If caused by random variation, no action is
required. If caused by change in the demand pattern, the forecast model must be revised.

If demand is greater than projected during the replenishment lead-time, the order point
will be reached sooner and the replenishment order will be placed sooner than expected.
If demand is less than projected, the reorder point will not be reached as soon as
projected and the replenishment order will be placed later than originally projected. There
is a risk of stockout if the increase in demand is substantial. There is a risk of surplus
inventory if the decrease in demand is substantial.

The statistical order point model for an item is shown below. The dark red line labeled
"Actual Demand" has been added. It represents the projected on-hand balance for the
item if the recent level of actual demand continues in the future. If that is the case, the
reorder point will be reached when the on-hand inventory reaches the reorder point and
the replenishment order will be received sooner than indicated. The planner or analyst
responsible for this item must determine whether the higher level demand is a temporary
condition or a shift in the demand pattern. If it is determined to be a shift in the demand
pattern, the forecast model will have to be initialized and the order point and safety stock
levels will have to be recalculated.

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Fixed-Interval Review Methods

The basis of fixed-interval methods is that the inventory is reviewed on a fixed time
interval and a replenishment order is placed at that time for the difference between the
current inventory and the target inventory. These methods also attempt to have some
inventory on hand at all times.

For example, if 500 units are on hand and the maximum targeted inventory level is 1,600
units, the order quantity would be 1,100 to replace the items shipped during the period.

Examples of use of fixed-interval methods include:

Inventory in the tanks of a fuel station are checked daily, twice a week, or weekly
depending on the sales volume. There is a delivery the next day of enough fuel
to fill each tank.

A snack products delivery person goes to stores on a regular cycle and replaces
the items that have been sold since the last visit.

This model is also known as a periodic order quantity review system, time-based order
system, and a fixed-interval order system.

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Material Requirements Planning

Time-phased material requirements planning (MRP) begins with the master production
schedule (MPS) and other actual demand. It then determines the quantity of all material
required to produce those items, as well as the date that the materials are required.
Time-phased MRP is accomplished by exploding the bill of material and offsetting
requirements by the appropriate lead-times.

Some general principles to remember about time-phased MRP:

Materials plan must extend over a long enough period to cover the longest lead-
time of any component in a single-level bill of materials and the sum of the lead-
times in a multi-level bill.
Materials plan should be revised frequently in order to react to changes in
demand or supply.
The shorter the time period used, the more effective the materials plan will be.

For example, a plan in weekly periods revised every week would be more effective than
one in monthly periods revised only once a month. Keep in mind, the plan is just that.
Making it more precise and revising it more often can quickly reach a point of diminishing
returns.

In contrast to the other methods, time-phased material requirements planning attempts to


replenish inventory just before the additional supply is needed. This topic is covered in
depth in other courses.

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Fit of Methods

There are many ways to determine the fit of each method to a specific situation. All of
them require an understanding of several factors and good judgment. Lets look at how
the nature of the demand for an item, the stability of demand over time, and the value
and classification of an item influences the choice of techniques and the overall fit of the
method.

Value/Classification of
Method Name of Demand Stability over Time
Item
Statistical
Independent Relatively stable demand Does not affect fit
Order Point
Applicable to low-volume,
Demand may not be
Visual Review Independent/Dependent low-cost items, classified as
consistent over time
C items
Applicable to low-volume,
Two-Bin Demand may not be
Dependent low-cost items, classified as
System consistent over time
C items
Demand occurs at a Applicable to low-volume,
Minimum and
Independent/Dependent relatively constant and low-cost items, classified as
maximum
known rate C items
Demand may not be
Kanban Dependent Does not affect fit
consistent over time
Demand occurs at a
Time-Phased
Independent/Dependent relatively constant and Does not affect fit
Order Point
known rate
Fixed Interval
Review Independent Relatively stable demand Does not affect fit
Method
Material
Demand may not be
Requirements Independent/Dependent Does not affect fit
consistent over time
Planning

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Topic Summary

Order review techniques address the question of when to place a replenishment order.
There are many such methods and variations of some methods. The methods all attempt
to balance the cost of maintaining inventory with the cost of not having it when it is
needed.

The nature of the demand for an item, the stability of demand over time, and the value
and classification of an item will influence the choice of techniques and the overall fit of
the method.

The basis of all of the fixed-order-point methods is that a replenishment order


should be placed when the inventory reaches a predetermined level. The
methods all attempt to have some level of inventory on hand at all times.

The basis of the fixed-interval review methods is that the inventory is reviewed
on a fixed time interval and a replenishment order is placed at that time for the
difference between the current inventory and the target inventory. These
methods attempt to have some level of inventory on hand at all times.

Material requirements planning is a deterministic method. In contrast to the


other methods, it attempts to replenish inventory just before the additional supply
is needed.

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LOT-SIZING TECHNIQUES
Overview

In addition to determining the timing of a replenishment order, a firm must also decide the
quantities to be replenished. This process is called lot-sizing. The lot size is the amount
of material to be ordered from a supplier or produced internally to meet demand.

The costs associated with lot-sizing include the costs to order and the costs to carry the
product, with the overall objective of maintaining a balance between these two
categories.

Several methods and variations of lot-sizing techniques can be used. They are chosen
based on economics, overall timing, quantities, and the pattern of demand.

When the demand pattern is stable, techniques that are appropriate include
economic order quantity and fixed-order quantity.
When the demand pattern is dynamic, techniques that are appropriate include
lot-for-lot, fixed-period quantity, and period order quantity.

No single method is best for all situations or for all items in a given situation. However,
selecting the appropriate mix of lot-sizing methods will help reduce ordering, setup, and
carrying costs, as well as the overall levels of work-in-process inventory.

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Lot-Sizing Costs Carrying Costs

The overall objective of the lot-sizing techniques is to balance the costs of carrying
inventory with the cost of ordering inventory. Carrying costs vary directly with the level of
inventory, while ordering costs vary directly with the number of orders placed. Both the
ordering costs and the carrying costs are partially dependent on the unit cost of the item.

Carrying costs are those incurred by the very fact that an item is in stock. The cost of
carrying inventory is usually defined as a percentage of dollar value of inventory per unit
of time (generally one year). Costs to carry inventory increase as the level of inventory
increases. The components of the cost of carrying inventory are included in the list to the
right.

The change in the carrying costs is assumed to be linear over the range of quantities
being considered. However, what happens if increasing the lot size for one item fills the
last available space in a warehouse? Additional storage space must be acquired and that
is not an incremental change.

For example, when the freezer is full, the firm has to buy an additional freezer space or
rent storage at a cold storage warehouse. Or, if an existing storage area becomes full,
the firm may be able to change the configuration to increase the capacity. When
inventory levels are reduced enough, a storeroom may be closed and the space can be
used for other purposes, such as sub-leasing to other companies.

Opportunity cost
Opportunity cost, or cost of money, is the rate of return if the funds invested in
inventory were deployed elsewhere. For example, the cost of capital for inventory
investment may be 20% in the case where a new machine would yield a 20%
return on investment.

Storage facility
This is the cost of the facility and operating it. These costs would not occur if
inventory did not exist. This is a fixed cost that is incurred to accommodate the
highest level of inventory. Examples include storeroom costs, material handling
equipment, and necessary records.

Cost of stocking and handling


These are the costs of moving, storing, and accounting for the goods and for
maintaining their security.

Taxes and insurance


Many organizations will incur expense on inventory taxes. Some are based on
inventory investment at a particular time of the year, while others are based on
the average inventory investment for the entire year. Inventories, like most other
assets, are covered by insurance which is usually carried as a part of other
company insurance policies.

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Obsolescence or spoilage
Risk of obsolescence or spoilage comes from engineering changes, misuse, or
spoilage of the goods. These costs are incurred because the goods are no longer
salable or usable. This could be due to changing sales patterns and customer
desires or to the fact that the item has lost its useful qualities over time. From a
spoilage perspective, material carried in inventory may get damp, dried out, or
dirty from handling.

Pilferage
Pilferage represents the risk that the goods will be stolen.

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Lot-Sizing Costs Ordering and Unit Costs

Ordering Costs

Ordering costs are based on the number of orders placed and are independent of the
quantity being ordered. They are incurred each time an inventory replenishment order is
generated. The costs of ordering can be either those of placing purchase orders to buy
material from a vendor or those associated with ordering a manufactured lot from the
plant.

Costs associated with placing a purchase order include material planning and
requisitioning, selecting a supplier, placing a purchase order, expediting,
inspecting, delivering material to a storeroom, and processing and paying an
invoice.
When a manufactured lot is ordered from the plant, costs are incurred for
paperwork, machine setup, normal start-up scrap that results from the first
production of the new setup, and other one-time costs that are a function of the
number of lots ordered or produced.

Overall, determining other order preparation costs can be a delicate process. For
instance, the inventory balance might need to be verified before placing a replenishment
order.

Unit Costs

Unit costs consist of the purchase price of the raw material or component from the
supplier or the manufacturing cost of the unit, which includes direct material, direct labor,
and overhead. If purchasing raw material or components from a supplier, the unit cost is
determined during the negotiation process for that particular item and can be found on a
supplier quote or invoice. In some situations the unit cost can be the landed value, which
consists of the item cost, freight, duty, and taxes.

For an item that is manufactured in-house, accounting, purchasing, and engineering will
all be involved in calculating the overall standards.

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Total Costs

The total cost for an order lot size is the cost of ordering plus the cost of carrying the
inventory. Determining how much to order at one time involves balancing the ordering
costs and the carrying costs. The total cost curve is relatively flat around the least
total cost point.

Total cost curve

Based on the cost versus lot size graph, there is a key point to take into
consideration. There is an order quantity in which the sum of the ordering costs
and carrying costs is at a minimum. However, the order quantity can deviate
slightly from this point, with cost optimization remaining within balance.

The procedure to determine the total cost of a lot-sizing decision is as follows:

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Ordering Costs Demonstration

Lets look at how ordering costs are calculated. The calculation for annual ordering costs
is:

There are two ways of reducing the annual ordering costs:

Reduce the cost per order.


Reduce the number of orders per year.

Examples

See below to see how ordering costs can vary based on the order lot size

Lot Size 1,000


If the projected usage is 12,000 units and the cost per order is $100, the ordering
cost of a lot size of 1,000 units would be $1,200 ((12,000 units / 1,000 units) x
$100 per order).

Lot Size 500


If the projected usage is 12,000 units and the cost per order is $100, the ordering
cost of a lot size of 500 units would be $2,400 ((12,000 units / 500 units) x $100
per order).

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Carrying Costs Demonstration

Now lets look at how carrying costs are calculated. The calculation for annual carrying
costs is:

There are three ways to reduce the annual carrying cost for an item:

Reduce the average inventory.


Reduce the unit cost of the item.
Reduce the carrying cost rate.

A problem with calculating the carrying cost is determining the average inventory when
the usage of the item is lumpy. In the latter half of the 20th century, there were a large
number of articles and papers written comparing methods for specific demand patterns
and each proved that a specific method was best for that demand pattern. However,
when comparing lot sizes or lot-sizing methods, assuming that the average inventory is
one-half the lot size typically provides sufficient accuracy, because whatever demand
pattern is assumed will change over time.

Examples

Lot Size 1,000


If the unit cost of the item used in the previous example were $20 and the
carrying rate were 25%, the annual carrying cost of a lot size of 1,000 units would
be $2,500 ((1,000 units / 2) x $20 per unit x .25).

Lot Size 500


If the unit cost of the item used in the previous example were $20 and the
carrying rate were 25%, the annual carrying cost of a lot size of 500 units would
be $1,250 ((500 units / 2) x $20 per unit x .25).

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Comparing Alternative Lot Sizes

The total annual cost of a specific lot size is simply the sum of the annual ordering cost
and the annual carrying cost. The ordering costs and carrying costs associated with two
different lot sizes can be compared for efficiencies. Using the data from the previous
examples, the total annual cost-related-to-lot sizes of 500 and 1,000 units would be:

Lot Size Comparison

Lot Size 500 1,000


Ordering
$ 2,400 $ 1,200
Costs
Carrying
1,250 2,500
Costs
Total
$ 3,650 $ 3,700
Costs

In this example, the lot size of 500 units would have the lower total annual cost.

If the results of the comparison arent aligned with the overall objectives of the business,
the firm can change one or more of the variables in the calculation, including the order
quantity, average inventory, carrying cost as a percentage, cost per order, and the cost of
the item.

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Changes to Carrying Costs

Continuing the previous example, what changes in the ordering costs or the carrying
costs would be required to make the lot size of 1,000 units the lower-cost alternative?
The difference between the cost of carrying the larger and smaller lot sizes would have to
be reduced by at least $50, or the cost of ordering the smaller lots would have to increase
by at least $50. A combination of reducing the carrying cost and increasing the ordering
cost could also make the larger lot size the lower-cost alternative.

How can the rate related to the cost of carrying inventory be determined? The total cost
of the larger lot size must be lower than the total cost of the smaller lot size when the
annual usage, unit cost, and ordering costs are held constant. That is the carrying rate
that makes the total cost of the two different lot sizes equal. The equation that needs to
be solved is to find the point where the total annual costs are equal for both alternatives
as follows.

Example

Lets solve for our example. When the appropriate values are substituted, the
calculation is:

(12 x 100) + ((1,000/2) x 20 x carrying rate) = (24 x 100) + ((500/2) x 20 x


carrying rate)

1,200 + (10,000 x carrying rate) = 2,400 + (5,000 x carrying rate)

(10,000 x carrying rate) - (5,000 x carrying rate) = 2,400 - 1,200

2,400 1,200 = .24 or 24% carrying rate


10,000 5,000

If the carrying rate is less than 24% and the usage, item cost, and ordering costs
remain the same, the lot size of 1,000 units will be the lower-cost alternative.

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Changes to Ordering Costs

The ordering cost that makes the total cost of the two alternatives equal can be
calculated in a similar manner. The starting equation is the same, but it is solved for the
ordering cost as follows:

Lets solve for our example. When the appropriate values are substituted, the calculation
is:

12 x ordering costs + ((1,000 / 2) x 20 x .25) = 24 x ordering costs + ((500 / 2) x 20 x .25)

12 x ordering costs + 2,500 = 24 x ordering costs + 1,250

2,500 1,250 = (24 12) x ordering costs

1,250 = 12 x ordering costs = 104.17 ordering cost

In conclusion, if the ordering cost is greater than 104.17, the larger lot size will be the
lower-cost alternative.

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Economic Order Quantity

The economic order quantity (EOQ) is a statistical inventory control tool that uses a fixed-
order quantity rule to specify the number of units to be ordered each time an order is
placed. The EOQ is the quantity that balances the cost of ordering with the cost of
storage. EOQ is an example of a push inventory system where the acquisition of
inventory is initiated in anticipation of future demand, not in reaction to present demand.

There are very few, if any, situations in which the elements of cost and demand are
known with any degree of certainty, and they are seldom constant. The EOQ calculation
should be used as a guide and to understand the trade-off involved. As the order quantity
increases, more average inventory is stored with the consequent increase in storage
costs, but the number of orders placed is reduced with the consequent decrease in
ordering costs.

Lets look again at the total cost graph that was previously exhibited, clearly showing this
trade-off.

The total cost curve is relatively flat near the low point and precision is not required. The
EOQ can be calculated precisely to several positions to the right of the decimal point, but
who is going to produce, stock, or use those tenths, hundredths, thousandths, or ten-
thousandths of a unit?

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Assumptions for Economic Order Quantity

The EOQ model is based on several assumptions.

The demand rate is constant, recurring, and known. Basically, this model
assumes that the demand equation faced by the firm is linear with random
variation.

The ordering cost is independent of the quantity ordered.

The lead-time is constant and known. The ordering times given will result in new
orders arriving exactly when the inventory level reaches zero.

The formula can handle only one type of item at a time.

Orders arrive in a single batch.

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Variations of Economic Order Quantity

The basic economic order quantity procedure determines the number of units for which
the total cost is lowest for the given assumptions and data. There are many variations of
the basic model. Commonly used ones include EOQ in monetary units, non-
instantaneous receipt model, and quantity discount model.

Despite the variations of the EOQ model, this approach has several limitations. Even with
the inelasticity of the total cost curve in the vicinity of the EOQ, the EOQ and the reorder
point methods may be the high-cost strategies. Click the arrow to see some reasons why.

These methods require the definition of a fixed annual demand, and they dont
consider exactly when demand occurs.

They overemphasize the minimum total inventory costs, rather than considering
carrying and ordering costs as contributions to the total.

The EOQ computation is dependent on stated values for annual demand, interest
rates, cost of ordering, and cost of the item, any or all of which could fluctuate
with the economy.

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Procedure for Economic Order Quantity

The overall goal of the economic order quantity (EOQ) model is to minimize total
inventory cost. As previously mentioned, inventory costs are made up of carrying and
ordering costs. The basic procedure for the EOQ equation is shown below.

See below to review what the formula and its variations can allow you to determine.

Optimal quantity to order


Total cost
Average lot size inventory level
How much should be ordered at one time
Maximum inventory level

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Economic Order Quantity Demonstration

Lets do an EOQ calculation. A widget has an annual demand of 30,000 units, a unit cost
of $6, ordering costs of $4, and a carrying cost rate of 15%. The widgets are ordered
based on the EOQ. The EOQ for this example would be calculated as follows:

When the EOQ has been set, the equation can be solved for any of the factors. For
example, the formula for solving the unit cost of the item is:

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Economic Order Quantity with Quantity Discounts

One assumption upon which the basic EOQ formula is based is that the unit cost of the
item is constant for the range of lot sizes being considered. That may not be the case for
purchased items. Suppliers may offer discounts for larger orders. Lower transportation
rates may also be available for larger orders.

When evaluating the discounts, the buyer must consider all of the relevant costs. The unit
cost will decrease by the discount amount. The ordering costs will be reduced since
fewer orders will be placed for the larger quantities ordered. The carrying costs will
increase due to the increase in the lot size inventory. When quantity discounts are
offered, the EOQ is determined by calculating the annual cost of each alternative and
then selecting the one with the lowest annual cost.

Quantity discounts are frequently offered based on the monetary value ordered. In
addition, the discount may be based on the monetary value of the order for a single item
or a basket of items. For that reason, the EOQ in monetary units is typically used when
evaluating the alternatives. The EOQ in monetary units is based on the annual usage in
monetary units. Because the annual usage is expressed in monetary units, there is no
need for the unit cost in the formula.

The formula for the EOQ in monetary units (EOQm) is:

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EOQ with Quantity Discount Demonstration

Lets look at the impact of a quantity discount on the EOQ. A steel rod has an annual
demand of 20,000 units, a unit cost of $5, ordering costs of $3, and a carrying rate of
18%. The steel rods are ordered based on the EOQ, but the supplier has offered a
discount of 3% on orders of $5,000 or more.

First, lets calculate the EOQ in monetary units without a discount. You do the calculation
first, then click on the EOQ Solution button to compare your calculation to the solution.

EOQ Solution

The EOQ in monetary units would be 1825.74.

Now, the total annual cost with and without the discount from the supplier can be
compared. Click the button below to review the comparison.

Annual Cost Comparison

The total annual cost of the larger lot size with the discount is $2819.32 less than
the total annual cost of the economic order quantity ($100,329.32 - $97,323.80).
If all other factors were equal, the lot size would be increased to take advantage
of the discount.

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Lot-for-Lot Method

Other lot-sizing methods that can be used with or without material requirements planning
include lot-for-lot, fixed-order quantity, fixed-period quantity, and period order quantity.

The lot-for-lot (L4L) method can be used in a material requirements planning (MRP) grid
format. It is a lot-sizing technique commonly used in just-in-time (JIT) situations, in
conjunction with safety stock. In this method, planned orders are equal to the net
requirements in each period.

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Fixed Order Quantity Method

The fixed-order quantity method will always suggest that planned orders be released
for a predetermined fixed quantity. The predetermined quantity can be established based
on experience using the economic order quantity (EOQ) formula discussed earlier in this
course. Another variation of this technique would be a pull system or kanban.

For example, in the MRP grid below, the fixed-order quantity is 400. An order for the
fixed-order quantity is placed every time the inventory reaches a predetermined order
point. The order point is set at a level where there is sufficient inventory to cover the
demand from the time material is ordered from the supplier until it is received in the
warehouse.

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Other Lot-Sizing Methods

The fixed-period quantity method is an MRP lot-sizing technique that sets the lot size
equal to the net requirements for a given number of periods. The fixed-period quantity
method is also known as the periods-of-supply method. For example, a firm may order 20
days of supply for A items, 60 days of supply for B items, and 300 days of supply for C
items.

In addition, there are many others methods that are used in specific situations. They
include:

Least unit cost


Least total cost
Part period balancing
Wagner-Within algorithm

Many organizations historically used least total cost and least unit cost for machining
operations. As organizations have reduced setup costs, the use of these methods has
declined.

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Period Order Quantity

The period order quantity (POQ) is more complex than the techniques previously
reviewed, so it will be discussed in-depth. The POQ technique uses the EOQ model to
calculate the net requirements for a given number of periods. When utilizing the POQ
method, residual inventory does not exist since quantities are maintained until the next
requirement. In comparison, the EOQ model discrete demand results in residual
inventory. See each step below for more information.

Step 1.

Use the formula to calculate the EOQ.

A = Annual usage in units. The projected usage is usually over the next 12 months, but
the cycle of recalculating the model could be as short as one month.
S = Ordering costs in dollars, which are costs of placing a purchase or production order.
i = Annual inventory carrying costs as a decimal, which is the cost to carry one unit of
inventory for one year.
c = Unit cost, which may be the items standard cost or the actual cost quoted by the
supplier.

Step 2.

Divide the annual requirements by the EOQ to calculate the number of orders per year.

Step 3.

Divide the number of requirements planning periods per year by the number of orders per
year in Step 2 to calculate the period order quantity.

Step 4.

Begin with the first period that has a net requirement and place an order to cover that
requirement. Then add the requirements until the number of periods specified by the
POQ are covered.

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Period Order Quantity Demonstration

The period order quantity procedure can be demonstrated as follows:

Given Data Annual Usage (A) = 2,400 Units


Cost per Order (S) = $50
Carrying Cost (i) = .22
Cost per Unit (C) = $75.77
Planning Periods per Year = 50

Step 1
Calculate the EOQ.

Step 2
Calculate the number of orders per year.

Step 3
Calculate the POQ.

Step 4
Plan the POQ orders.

We will now apply these results to a given set of net requirements, with an associated
lead-time of two periods. Click the button to see the solution.

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POQ Solution

The EOQ is 120 units, and the POQ is 3. The planned order receipt of 220 units in Period
4 was calculated based on the POQ of 3, which entails combining the forecast demand
for Periods 4, 5, and 6 (60 + 90 + 70). This method does not minimize ordering and
carrying costs, but it is frequently less costly than ordering items each period or
subjectively selecting a fixed order period.

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Comparison of Methods

The following table represents a comparison of the lot-sizing techniques previously


discussed. This table shows that no method is appropriate for all situations. The task is to
select the methods that are most appropriate for each situation and to change methods
when the situation changes.

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Topic Summary

Lot-sizing answers the question of how much to order at one time. There are a variety of
methods, and variations of some methods. No single method is best for all situations or
for all items in a given situation. Each method tries to balance the costs of ordering with
the costs of carrying inventory. Costs associated with lot-sizing techniques include
carrying costs, ordering costs, and unit cost.

The EOQ model is based on several assumptions:

Demand rate is constant, recurring, and known.


Carrying cost rate is independent of the quantity ordered.
Lead-time is constant and known.
Formula can handle only one type of item at a time.
Orders arrive in a single batch.

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Topic Summary (continued)

The overall goal of the model is to minimize total inventory cost. As previously mentioned,
inventory costs are made up of carrying and ordering costs. The economic order quantity
model is as follows:

In order to utilize the EOQ model with quantity discounts, annual usage in monetary units
(annual volume multiplied by the unit cost) multiplied by the ordering cost will be the
numerator. The carrying cost as a percentage (carrying rate) is the denominator.

Other commonly used methods include:

Lot-for-lot
Fixed quantity
Fixed-period quantity
Period order quantity

More complex methods are used in specific situations.

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SAFETY STOCK TECHNIQUES
Overview

Safety stock is a quantity of stock to keep in inventory to protect against unexpected


fluctuations in supply and demand. There are several techniques that can be used to
manage safety stock.

Fixed-quantity technique which is based on usage of a set amount of inventory

Time period safety stock technique which is based on usage over a designated
time frame

Statistical safety stock technique which is based on a mathematical calculation


using the standard deviation or mean absolute deviation of demand forecast
errors

Since the relationship between customer service level and safety stock is an integral
piece of the organization, we will first discuss a basic fixed-service-level technique and
how fluctuations in lead-time are addressed.

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Customer Service Level and Safety Stock Relationship

The customer service level and safety stock relationship shown in the chart below is for
normal distribution of the demand. Similar curves represent other distributions of the
demand. For this example, a desired service level of 50% will result in a safety stock level
of zero, whereas a desired service level of 90% would require a significant investment in
safety stock. It would be difficult to maintain enough safety stock to ensure a 100%
service level, because there is a very small possibility that an order will be placed for one
more unit than is stocked. Factors explained on the following screens are associated with
the customer service level and safety stock relationship graph.

Safety stock relationship graph

Reducing the variability of supply or demand, the level of service desired, or the time
covered are the only ways to reduce the level of safety stock.

If the level of safety stock is high, it would imply that unnecessary funds are tied
up in the inventory, unnecessary carrying costs are being incurred, and the risk
of the inventory becoming obsolete is increasing.
If the level of safety stock is not adequate, it means that the risk of not having the
item when it is needed is increased. That could lead to lost sales or a slowdown
of production.

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Safety Stock Level

The first question that must be answered is whether safety stock is required for an item.
Once the decision has been made that safety stock is needed for an item, a technique
must be selected and the level of safety stock must be determined. These all require
management policy decisions and should be an integral part of an inventory strategy. The
business question that is to be answered is: How much safety stock is appropriate for this
item at this point in time?

Primary Factors

The primary factors that affect the choice of safety stock technique are:

Nature of demand for the item


Is the item subject to independent demand only, dependent demand only, or a
combination of the two?

Degree of variability in supply & demand


How much variability is there in demand, lead-time, quality, and other factors?

Secondary Factors

Other factors that affect the choice of technique and the variables used in the calculation
of safety stock level include the following.

Effect of a stockout
The effect of a stockout is based on the variability of demand for the product. A
firm may need to determine the overall costs of avoiding a stockout, such as
expediting costs and overtime.

Lead-time for the item


The longer the lead-time, the greater the level of safety stock.

Cost of the item


Cost of the item can determine the level of safety stock, as higher valued items
may consume financial resources that could otherwise be used for other
initiatives.

Desired level of service


The higher the desired level of service, the higher the level of safety stock.

Availability of demand history


The lack of historical data may lead a firm to increase their safety stock levels
based on uncertainty of demand patterns.

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Stage of product life cycle
The stage of the item in its product life cycle will determine safety stock levels in
all cycles.

o In the introduction phase, it is important to carry sufficient safety stock to


support production while recognizing the risk of engineering changes.
o I During the growth phase, a firm will want to minimize the risk of a
stockout.
o I During the maturity phase, a firm will need to balance its safety stock
investment with the level of customer service, supplier and
replenishment lead- times, production cycle times, and volume and mix
flexibility.
o I During the decline phase, a firm will need to satisfy the customer
service level targets while minimizing the risk of those parts becoming
inactive.

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Fixed Quantity Technique

The safety stock quantity in the fixed-quantity technique is not systematically updated
to reflect changes in demand or usage. This technique allows the planner to specify an
items safety stock level separate from the recommendation of the system. This is the
simplest technique. It is used for items that require frequent reviews, or where the overall
target for safety stock is zero.

See below to learn where the fixed safety stock technique might be used.

A new part is being introduced and there is no historical demand of a similar item
that could be used as a benchmark for predicting future demand.

When the quality and delivery reliability for a new item are not known, the firm
may set a fixed quantity of safety stock to provide enough protection to cover the
range of realistic quality levels and delivery times.

An item is being phased out of production. It needs to be monitored, so the firm


doesnt end up with obsolete inventory.

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Time Period Safety Stock Technique

Time period safety stock technique is also referred to as the time supply or periods of
supply method. It is simple to determine and easy to understand. The safety stock level is
set to cover a specified number of periods of demand. Additionally, a partial number of
periods can be specified. The number of periods remains constant and the level of safety
stock is automatically changed by the system when demand or usage changes.

Time period safety stock is calculated based on forecasted demand, actual demand, or a
hybrid method utilizing both types of demand. Inventory systems which base demand on
a monthly forecast will extend the forecasted monthly usage by the number of time
periods, based on an assumption of steady usage in future time periods. This occurs with
a forecast of independent-demand parts where forecasting is based on statistical, fixed-
order, or fixed- period techniques.

The calculation of the safety stock level is projected usage per period multiplied by
the safety stock time period. For example, the calculation for an item with a monthly
demand forecast of 100 units and a safety stock time period of half a month would be 50
units (100 units X 0.5). A similar calculation could be made for an item with dependent
demand by adding the demand over the safety stock time period.

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Statistical Techniques

Statistical safety stock is calculated using statistical methods based on the historical
deviation of actual from planned usage. Statistical techniques are based on the work of
Brown, Robert G. 1959, Statistical Forecasting for Inventory Control, 1st ed. McGraw-Hill
Book Company, New York. They provide the highest degree of management control in
terms of being able to fine-tune variables in order to affect calculated safety stock
quantity.

The statistical techniques are all based on the assumptions of statistical inventory control
and the nature of the normal distribution. These methods are most appropriate for items
with only independent demand. If these assumptions are 'not valid, the expected results
may not be realized.

There are several variations of the method that are based in well-grounded statistics, but
they are more difficult to understand. The variations include: constant safety factor,
equal service, maximum service, minimum shortages, and minimum annual cost.

The statistical technique related to customer service levels and lead-time fluctuation
will be discussed later in this topic.

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Comparison of Techniques

Safety stock level is determined by management policy. Three techniques commonly


used at the item level are:

Statistical safety stock is calculated using statistical methods based on the


historical deviation of actual from planned usage.
Fixed safety stock is set at a fixed quantity, regardless of the usage rate.
Time period safety stock is set to cover a specific number of periods of
demand.

The techniques can be compared as follows:

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Basic Fixed Service Level Technique

The most commonly used statistical technique is the u technique. This method
determines the safety stock level required to achieve a level of service defined by the
number of periods without a stockout. It does not directly consider the number of
exposures to stockout or the magnitude of the stockout. For example, a service level of
95% would mean that one could expect a stockout in five of the next one hundred
months.

The method is based on a table of safety factors that is based on the formula for the area
under a normal distribution. It relates the desired service level to the number of standard
deviations or mean absolute deviations. When the forecast interval and the lead-time are
not similar, a modification of the basic formula is required.

Table of safety factors

The following table shows safety factors for various levels of customer service.
The table is based on a relationship where standard deviation is equal to 1.25
times the mean absolute deviation.

The steps in the procedure are:

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The initial safety stock calculation is:

Note: Each organization needs to define the convention that will be used for rounding the
calculated safety stock. In this course, safety stock will be rounded to complete units.
Since safety stock is held to compensate for variability, the calculated value will be
rounded up to the next larger integer.

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Basic Fixed Service Level Technique Demonstration

Lets look at how safety stock varies based on changes in the desired service level for a
given standard deviation. Recall the formula is:

The table below shows the number of units that would be required to accommodate
various levels of customer service for an item with a standard deviation of 323 units. As
you can see by the example, the higher the desired level of customer service, the higher
the amount of safety stock required.

The safety factors are from the table of safety factors. Click the term if you want to review
the table again.

Table of safety factors

The following table shows safety factors for various levels of customer service.
The table is based on a relationship where standard deviation is equal to 1.25
times the mean absolute deviation.

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Basic Fixed Service Level Technique Demonstration

The basic formula for adjusting lead-time is based on the assumption that the forecast
interval is equal to or greater than the replenishment lead-time. However, an adjustment
to the formula is required when this assumption is not valid. This adjustment is based on
the ratio of the lead-time divided by the forecast interval and a statistical factor usually
known as Beta ().

Beta
The Beta factor in the formula is typically set in the range of 0.5 to 0.7. If the beta
factor is equivalent to 1, the increase is directly proportional to the increase or
decrease in lead time.

The table provides Beta factor multipliers for several lead-time intervals.

Utilizing a simplified model, the full equation for safety stock model related to lead-time
adjustments is:

Note that this formula produces the same result as the basic safety stock formula when
the ratio of lead-time to forecast interval is 1.

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Adjusting for Lead-Time Demonstration

Utilizing the safety stock model related to lead-time adjustments, we will calculate the
adjusted safety stock.

The following table compares the adjusted safety stock level based on different levels of
beta factors. The overall comparison results in 11.6 pieces for a Beta of .5, and 14.5
pieces for a Beta of .7. The company will determine if the units related to the adjusted
safety stock are rounded up to the next whole number or left as calculated.

5.25 x 1.73 x 1.28 = 11.63 units

5.25 x 2.16 x 1.28 = 14.52 units

In conclusion, the higher the beta, the higher the amount of safety stock on hand as the
level of uncertainty related to fluctuations in lead-time increases.

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Topic Summary

Safety stock is maintained to compensate for variability in supply or demand. It is not


planned to be used. The level of safety stock can be reduced by reducing the variability
of supply or demand, the level of service desired, or the time period covered.

There are three commonly used techniques:

Statistical safety stock is calculated using statistical methods based on the


historical deviation of actual from planned usage.
Fixed safety stock is set at a fixed quantity, regardless of the usage rate.
Time period safety stock is set to cover a specific number of periods of
demand.

The techniques can be compared as follows:

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Topic Summary Continued

The most commonly used statistical technique is the constant safety factor technique.
The safety stock level required to achieve a level of service is defined by the number of
periods without a stockout. It does not directly consider the number of exposures to
stockout or the magnitude of the stockout.

The formula for the safety stock equation is as follows:

If the forecast interval is less than the replenishment lead-time, the formula must be
adjusted.

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INVENTORY CONTROL TECHNIQUES
Overview

The process of inventory valuation is one of the most important steps in producing the
financial statements for both internal and external reporting.

From an internal reporting perspective, it is important that integrity exists


between the profit and loss statement, balance sheet, and statement of cash
flows.
From an external reporting perspective, stakeholders have a certain level of
expectation related to performance that will need to be effectively communicated.

This topic will introduce commonly used methods for establishing the value of the goods
in inventory. Additionally, the inventory valuation process also provides a review of the
methods of verifying inventory accuracy including audits, periodic counts, and cycle
counting, as well as some inventory performance measures that were introduced in a
prerequisite course.

The focus in this course is on how these tools can be used to implement the inventory
strategy, rather than on definitions and calculations.

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Inventory Valuation

Inventory is considered an asset on the balance sheet. It is typically one of the larger
assets of a firm, and it affects the calculation of any performance measurement that
includes assets. Inventory that exits the system as a part of goods or services that were
delivered to the customer must be accounted for in the cost of sales. The cost of sales
affects the reported profits of the firm; therefore, the inventory valuation affects any
performance measurements that include cost of sales or profits.

Needless to say, determining the value of inventory is very important to many inside and
outside the organization. There are several methods for determining the value of
inventory. The value of inventory involves more than multiplying the cost of the item by
the number of units, since most accounting practices allow for inventory either at cost or
at its market value.

The passage of time may have made the inventory worth more or less than its cost. In
times of rapid inflation, all goods increase in value as they reside in the storage facility
because the cost of replacing them is increasing; the opposite is true in times of rapid
deflation. Some goods may depreciate in value while sitting in storage and other may
appreciate.

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Inventory Valuation Methods

Once the firms accounting management has determined the components of inventory
cost, inventory value can then be calculated. There are six recognized methods by which
a company can value its inventory.

Taxing authorities and/or securities regulating agencies may limit an organization to using
the FIFO, LIFO, or average-cost methods in determining the overall value of inventory.
Firms often adopt the LIFO approach for the tax benefits during periods of high inflation.
Characteristics of these firms include rising prices for raw materials and labor, more
variable inventory growth, an absence of other tax-loss carry- forwards, and large size.
When firms switch from FIFO to LIFO in valuing inventory, there is likely to be a drop in
net income and a concurrent increase in cash flows because of the tax savings. The
reverse will apply when firms switch from LIFO to FIFO.

Dependent upon the taxing authority and given the income and cash flow effects of
inventory valuation methods, it is often difficult to compare firms that use different
methods. There is, however, one way of adjusting for these differences. In many
countries, firms that use the LIFO approach to value inventories must specify in a
footnote the difference in inventory valuation between FIFO and LIFO. This difference is
termed the LIFO reserve. This can be used to adjust the beginning and ending
inventories and, consequently, the cost of goods sold, and to restate income based upon
FIFO valuation.

Actual cost
Value based on a specific received quantity and invoiced price for a given time period.

Average cost
Value assigned to inventory based on the total number of each inventory item purchased
at a specific cost.

First-in, First-out (FIFO)


Assumes inventory leaves in the same sequence as it arrives oldest goods leave first.

Last-in, First-out (LIFO)


Assumes the most recent arrivals in inventory are consumed first.

Replacement
Inventory cost based on a projected cost to replace items.

Standard cost
Inventory cost based on predetermined rates for direct material, labor, and overhead.

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Inventory Valuation Methods Demonstration

Lets compare the six inventory valuation methods. The data below represents inventory
valuation receipts, inventory valuation issues, and inventory balances on-hand which will
be used to calculate the value of ending inventory using the six methods.

Actual Cost Method

The actual cost method assumes that the organization can track the actual cost of an
item throughout the manufacturing process to the specific purchase order or production
that has produced the item. This allows the actual costs of a specific item to be charged
to either production or sales. The actual cost method of inventory valuation is
synonymous with specific cost method. The value of each item on each transaction
must be determined, and the method requires lot control of inventory. This method is
typically used when the inventory is customer-owned or there are progress payments
involved.

Assuming that of the 30 units in the 26 April ending inventory 15 were purchased on 16
March and the remaining units were purchased on 10 April, what are the cost of goods
sold and the value of ending inventory based on the actual cost method? Click the button
to view the solution.

Actual Cost Method Solution

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Average Cost Method

When the average cost method is used, the average cost for all items in inventory is
recalculated after each receipt. That average unit cost is used for all issues and for
establishing the inventory value until the next receipt for the item occurs. This method is
appropriate for inventory where the cost of a unit is volatile over time and the actual cost
method cannot be justified. In a period of changing costs, the inventory valuation and
cost of goods sold would be close to the current market value of the goods.

This method is also appropriate when the life cycle of items is very short, because the
items could be phased out before the standards are established. The new value of the
stock is the value of the inventory before the receipt plus the cost of the receipt. The new
average cost is the new value of the inventory divided by the number of units in inventory
after the receipt.

What are the cost of goods sold and the value of ending inventory based on the average
cost method? See below to view the solution.

(a) = (5 x $10.00) + (100 x $10.50) = $1,100, average cost = $1,100/105 =


10.48
(b) = (15 x $10.48) + (100 x $11.00) = $1,257.20, average cost = $1,257.20/115
= $10.93
(c) = (30 x $10.93) + (90 x $11.00) = $1,317.90, average cost = $1,317.90/120
= $10.98

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First-in, First-out (FIFO) Method

Under FIFO, the cost of goods sold is based on the cost of material bought earliest in the
period, while the cost of inventory is based upon the cost of material bought later in the
year. This results in inventory being valued close to current replacement cost. During
periods of inflation, FIFO will result in the lowest estimate of cost of goods sold and the
highest net income among the three approaches.

What are the cost of goods sold and the value of ending inventory based on the FIFO
method? Click the button to view the solution.

FIFO Method Solution

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Last-in, First-out (LIFO) Method

Under LIFO, the cost of goods sold is based on the cost of material bought toward the
end of the period, resulting in costs that closely approximate current costs. The inventory,
however, is valued on the basis of the cost of materials bought earlier in the year. During
periods of inflation, LIFO results in the highest estimate of cost of goods sold and the
lowest net income among the three approaches.

What are the cost of goods sold and the value of ending inventory based on the LIFO
method? Click the button to view the solution.

LIFO Method Solution

Replacement Method

The replacement method attempts to use the current cost or market value of replacement
for inventory transactions and valuation. Both the inventory valuation and cost of goods
sold reflect the market value of the inventory. If there are items that remain in inventory
for long periods of time, this method requires regularly updating the replacement cost. If
the items are purchased or manufactured frequently, the last cost can be used.

The lower of cost or market rule must be executed to determine the correct replacement
cost. Guidelines for selecting the proper market value are as follows:

If replacement cost is below the floor, floor = market value


If replacement cost is above the ceiling, ceiling = market value
If replacement cost falls between the ceiling and floor, replacement cost = market
value

Assume the replacement cost is $12.00 per unit. What are the cost of goods sold and the
value of ending inventory based on the replacement method? Click the button to view the
solution.

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Replacement Method Solution
The expected replacement cost of $12.00 per unit is above the ceiling. With 350
units issued from inventory, the value of cost of goods sold is $3,850.00 ($11.00
x 350 units). With 30 units left on hand, the value of ending inventory is $330.00
($11.00 x 30 units). The following table represents how the replacement cost per
unit was determined.

Lower of cost or market rule

Market value is the replacement cost


Replacement cost is tested for reasonableness against the ceiling and floor
Ceiling is the net realizable value (selling price less disposal)
Floor is the net realizable value less a normal profit margin

Standard Cost Method

The standard cost method of inventory valuation is the simplest of the methods. A
standard cost is established for each item and all transactions, including the inventory
valuation, are based on that standard cost. The financial standard is typically established
and evaluated on an annual basis, or when there is a significant design or processing
change. Separate operating standards may be maintained for performance
measurement.

One of the advantages of standard costing is that the company usually only needs to
revalue inventory once a year. The standard cost permits managers to calculate ongoing
cost variances occurring in material, labor, and overhead.

Variance analysis enables managers to investigate root causes of cost change and take
remedial action when necessary. This method is widely used and is appropriate in a
stable environment. It encourages incremental cost reduction efforts.

Assume the standard cost for the item is $10.68 per unit. What are the cost of goods sold
and the value of ending inventory based on the standard cost method?

Standard Cost Method Solution

There were 350 units total issued from inventory, and there are 30 units
remaining on hand. The value of cost of goods sold is $3,738.00 (350 units x
$10.68 per unit). The value of ending inventory is $320.40 (30 units x $10.68 per
unit).

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Comparison of Methods

The following table summarizes the results from the six methods. It shows the different
inventory valuations and cost of goods sold. Based on the table the overall effect on
profit, assets, and taxes are ranked from low to high. A rating of low would indicate the
least effect on these three categories, while a high ranking would indicate a greater
effect.

If it were possible to continually purchase inventory at the same price, the choice of a
valuation method would make no difference on either reported income or the balance
sheet. Because costs do change, the choice of an appropriate costing method is critical
in effectively managing inventory investment.

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Verifying Inventory Balances

Inventory verification is the process of counting material or product units, whether they
are on the production floor or in storage, and comparing the results with the balance-on-
hand perpetual records. The purpose is to determine accuracy levels in the perpetual
records, as well as to correct erroneous balances-on-hand. This is necessary to ensure
the operational effectiveness of manufacturing and distribution activities which includes
the execution of management instructions to issue or ship inventories as they were
planned or directed, based upon the reported balances in the perpetual record system.

Regardless of the inventory recordkeeping method, it is necessary to verify the inventory


balances. Verification can be performed for external reporting purposes to ensure that the
perpetual records match what you have in the stockroom, or to determine when to
replenish.

Three methods of verifying the inventory balances are:

Audits
Periodic inventory
Cycle count

The primary purpose of an audit is to determine the accuracy level. Audits are used to
spot- check balances. They provide a snapshot-in-time measurement of inventory
accuracy, based on count results of a sampling of inventory. For example, a location
audit is used to verify the inventory balance for all items in a location.

The methods for verifying inventory balances were explored in a prerequisite course. The
two methods that are most frequently used are periodic inventory and cycle count.

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Periodic Inventory

When a periodic inventory is used, a physical inventory is taken on a periodic basis


(annually, semi-annually, quarterly, or monthly), based on company policy. It is typically
thought of as an annual inventory for the financial reports, but it can be done at any
recurring interval. The physical inventory is frequently used to satisfy owners and auditors
that the financial value of the inventory is properly stated. It involves counting all existing
inventory items. From the perspective of material planners, the physical inventory
represents an opportunity to correct any inaccuracies in the records.

The process of taking a physical inventory consists of the steps in the illustration.

Typically, all production and stockroom activity is suspended during the physical
inventory and reconciliation process. Usually, a physical inventory will occur over a period
of time when the overall activity of an operation is at a low point. For example, a physical
inventory could occur at year-end, during an annual shutdown, or when production is at a
minimum.

Responsibility for taking the physical inventory usually resides with the materials
manager, who should ensure that a good plan exists and that it is followed. The three key
factors involved with a physical inventory include good housekeeping, proper parts
identification, and properly trained employees.

One of the most helpful techniques to improve physical inventory is discussing lessons
learned upon completion. This is usually the time when people are least inclined even to
think about physical inventory, but this is the time when problems that occurred during
physical inventory are fresh in everyones mind. This is also the time to discuss how
inventory discrepancies will be handled on the accounting records.

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Cycle Counting

Cycle counting involves taking inventories on a sample of specific items at regular


intervals so that records can be verified regularly, rather than on an annual basis. To the
right is a graphical representation of the steps involved in cycle counting.

The count frequency is set by the number of items in inventory and the desired level of
control. ABC analysis is frequently used to set the frequency of count. The counts are
scheduled so that each item is counted on a predetermined schedule, and the really
important items for example, gold beads or nuclear materials may be counted every
day or even for each shift. The least important items might be counted only once a year.

A blind count usually refers to a cycle count or physical inventory count where the
counter is given SKU and location information but no quantity information. A more
extreme version of a blind count occurs when the counters are given no information and
must document the SKU number, location, and quantity as they count.

The advantages of cycle counting include the timely detection and correction of
problems, a reduction in the amount of lost production time, and the quick identification of
mislabeled or misplaced parts by experienced personnel. Cycle counting avoids the
costly shutdown of production facilities and the high labor costs and overtime premiums
that typically result from completing the annual physical inventory in minimum time. An
effective cycle-counting program incorporates procedures to identify and eliminate the
root causes of errors.

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Inventory Verification Policy Example

A firm that provides diagnostic equipment for medical professionals is required to service
the instruments after they are placed in the field. In order to maintain a high level of
customer service, the firm has spare parts inventory in three distinct areas: a national
distribution center, 30 strategically located parts depots, and 325 vans used by field
service technicians.

From a spare parts inventory perspective, there is $5 million of inventory in the


distribution center, $3 million in the parts depots, and $12 million in the field service vans.
The current policy for the verification of balances is based on inventory performance
accuracy which is defined as the number of picking instructions accurately executed
divided by the total picking instructions given, times 100.

Accuracy < 96%


If the inventory performance accuracy is below 96% for any of the locations, a
wall-to-wall or physical inventory double-count must be performed on the annual
verification date. Reconciliation to the perpetual records and adjustments to the
general ledger must be completed before year-end.

Accuracy 9698%
If the inventory performance accuracy is between 96-98%, a statistical sample
must be taken on the annual verification date. If the statistical sample shows that
the probable accuracy level of the entire inventory is below 96%, a wall-to-wall or
physical inventory double-count must be completed before year-end. This
includes reconciliation with the perpetual records and preparation of adjusting
entries to the general ledger.

Accuracy > 98%


If the inventory performance accuracy is above 98%, the location is not required
to perform a physical verification. Periodic audits will occur.

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Inventory Performance Measurements

In todays competitive world, customer satisfaction is of paramount importance and is a


strategic goal of most companies. Inventory investment must support the customer
service strategy. There should be little conflict between the two goals and inventory
management must be subordinate to and in support of customer service. To ensure that
inventory is being managed to achieve these objectives, performance measurements are
needed.

Customer service and investment costs are monitored by numerous measurements,


many of which are product- and/or industry-specific. Selection of the appropriate
measurements is extremely important. Since measurements drive behavior, properly
selected measurements are one of the best ways of improving customer service and
inventory management. It is imperative that deviations from the benchmarks established
for performance measurements are understood and corrective actions are taken.

Inventory performance measurements related to customer service include:

Percent complete orders shipped on schedule

This measurement does not account for the value or importance of an order and
is affected by the number of line items per order. It is a strong indicator of
customer satisfaction, since it represents how many customers receive their
orders complete and on time. The calculation is:

Percent total units shipped on schedule

This measurement is mainly used in a make-to-order environment. Although it


recognizes the difference in size of orders, it does not deal with value or
importance. The calculation is:

Percent demand filled

This measurement is used in a make-to-stock environment. The calculation is:

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Inventory turnover

Inventory turnover can be applied to historical or to future projections. It is the


relationship of average inventory to cost of sales. The calculation is:

For example, if the average inventory is $8 million and the annual cost of sales is
$24 million, then the turnover would be 3 turns ($24 million / $8 million).

Other inventory performance measurements include order days out of stock, total item
days out of stock, and total number and value of backorders.

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Classifications of Inventory

Firms can choose from many methods to identify their classifications of inventory. They
include:

Percent complete orders shipped on schedule

Flow of material
This includes flow of material from the supplier as well as the process as material
flows through the manufacturing facility to be prepared for shipment to a
customer. Material flow inventory can also include purchased items, raw
materials, work-in-process, finished goods, service parts, and MRO inventory.

Percent total units shipped on schedule

Relative importance of items, product lines, and commodity codes


Inventory can be classified by relative importance of an item (classified as an A,
B, or C item), the product line (mobile phones, two-way radios), and commodity
codes (based on different features offered on mobile phones). A firm will set the
boundaries between these classifications based on factors such as cost of the
item, stability of usage, and risk of obsolescence. A firm will typically have
different boundaries for specific items. The boundaries are typically stated in
terms of numbers of days supply or inventory turnover ratio.

Categories of inventory include:

Operating
The level of inventory for which there is a high level of confidence that it will be
used in the near future is operating inventory. This inventory is acquired to
support planned production and other demands.

For example, steel used to manufacture frames for bicycles would be operating
inventory.

Excess
An inventory level which is greater than the operating inventory target and any
other discretionary balances (e.g., safety stock, research and development, and
lot-sizing) and which has a reasonable likelihood of being used within the
planning time frame is excess inventory.

For example, a buyer purchased additional steel at a discounted rate, so


inventory on hand exceeds the planning horizon.

Surplus
Inventory that exceeds the targets for operating and excess inventory, but that
has some possibility of being used within the cumulative lead-time of products is
surplus inventory. This is frequently generalized even further to a 12-18 month
target.

For example, a company needed to purchase a minimum quantity of a special


alloy metal for a bicycle frame. Since the purchase was made, demand has
dropped significantly. This caused a surplus of the material.

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Inactive
Inventory in excess of the demand for the planning period that is not likely to be
used in the foreseeable future is inactive inventory.

For example, the demand for a bicycle frame produced from aluminum has
dropped significantly. The material has been inactivated in the system.

Obsolete
Inventory that is no longer used by the firm is obsolete inventory.

For example, a particular bicycle frame has been phased out of production, since
it was replaced by a new and improved model.

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Topic Summary

Inventory is typically one of the larger assets of a firm and the method of determining its
value affects the total assets and reported profits of the firm. A physical inventory, or
periodic basis, is most frequently used to satisfy owners and auditors that the financial
value of inventory is properly stated.

Six methods are typically used to value inventory. Each method has advantages and
each firm must consider several factors in choosing which method to use. In some cases,
the choice is dictated by taxing authorities and/or securities regulating agencies.
Inventory valuation methods include:

Actual cost which is typically used when inventory is customer-owned.

Average cost which is appropriate when the cost of a unit is volatile over time.

First-in, First-out (FIFO) which when used during inflation results in lowest cost
of goods sold and highest net income.

Last-in, First-out (LIFO) which when used during inflation produces the highest
cost of goods sold and lowest net income.

Replacement where both inventory valuation and cost of goods sold reflect
market value.

Standard cost where a standard cost is established, typically annually, for each
item and all transactions.

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Topic Summary Continued

Cycle counting involves taking inventories on a sample of specific items at regular


intervals, on a predetermined schedule, so that records can be verified regularly rather
than on an annual basis. Cycle counting avoids the costly shutdown of production
facilities and the high labor costs and overtime premiums that almost always result from
completing the annual physical inventory in minimum time.

The categories of inventory are:

Operating is the level of inventory for which there is a high level of confidence
that it will be used in the near future.

Excess is the inventory level which is greater than the operating inventory target
and any other discretionary balances, but still with a reasonable likelihood of
being used within the planning time frame.

Surplus is inventory that exceeds the targets for operating and excess inventory
and has some possibility of being used within the cumulative lead-time of
products.

Inactive is inventory in excess of the demand for the planning period and not
likely to be used in the foreseeable future.

Obsolete is inventory that is no longer used by the firm.

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CONCLUSION
Conclusion

Order review techniques address the question of when to place a replenishment order.
There are many such methods and variations of some methods. The methods all attempt
to balance the cost of maintaining inventory with the cost of not having it when it is
needed.

The following table summarizes how the nature of the demand for an item, the stability of
demand over time, and the value and classification of an item will influence the choice of
techniques and the overall fit of the method.

Value/Classification of
Method Name of Demand Stability over Time
Item
Statistical Relatively stable
Independent Does not affect fit
Order Point demand
Applicable to low-volume,
Demand may not be
Visual Review Independent/Dependent low-cost items, classified as
consistent over time
C items
Applicable to low-volume,
Two-Bin Demand may not be
Dependent low-cost items, classified as
System consistent over time
C items
Demand occurs at a Applicable to low-volume,
Minimum and
Independent/Dependent relatively constant and low-cost items, classified as
maximum
known rate C items
Demand may not be
Kanban Dependent Does not affect fit
consistent over time
Demand occurs at a
Time-Phased
Independent/Dependent relatively constant and Does not affect fit
Order Point
known rate
Fixed Interval
Relatively stable
Review Independent Does not affect fit
demand
Method
Material
Demand may not be
Requirements Independent/Dependent Does not affect fit
consistent over time
Planning

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Conclusion (continued)

Lot-sizing answers the question of how much to order at one time. There are a variety of
methods and variations of some methods. Each method tries to balance the costs of
ordering with the costs of carrying inventory. No single method is best for all situations or
for all items in a given situation, but the economic order quantity (EOQ) is frequently
chosen.

The overall goal of the EOQ model is to minimize total inventory costs, which are made
up of carrying and ordering costs. The EOQ model is based on several assumptions:

Demand rate is constant, recurring, and known.


Ordering cost is independent of the quantity ordered.
Lead time is constant and known, and new orders arrive exactly when the
inventory level reaches zero.
Formula can handle only one type of item at a time.
Orders arrive in a single batch.

In order to utilize the EOQ model with quantity discounts, annual dollar usage rather than
annual usage will be used in the numerator with the carrying rate as the denominator.
Other commonly used lot-sizing methods include:

Lot-for-lot which generates planned orders in quantities equal to the net


requirements in each period.
Fixed quantity which is based on usage of a set amount of stock.
Fixed period quantity which sets the order quantity to the demand for a given
number of periods.
Period order quantity where the lot size is equal to the net requirements for a
given number of periods.

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Conclusion (continued)

Safety stock is maintained to compensate for variability in supply or demand. It is not


planned to be used. Reducing the variability of supply or demand, the level of service
desired, or the time covered are the only ways to reduce the level of safety stock. Three
commonly used techniques are statistical quantity, fixed quantity, and time period
quantity.

The techniques can be compared as follows:

The most commonly used statistical technique is the constant safety factor technique. It
is the level required to achieve a level of service defined by the number of periods without
a stockout. It does not directly consider the number of exposures to stockout or the
magnitude of the stockout.

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Conclusion (continued)

Inventory is typically one of the larger assets of a firm. The method of determining
inventory value affects the total assets and reported profits of the firm. A physical
inventory can satisfy owners and auditors that the financial value of inventory is properly
stated. Six methods typically used to value inventory are actual cost; average cost; first-
in, first-out; last-in, first-out; replacement; and standard cost.

Cycle counting taking inventories on a sample of specific items at regular intervals


avoids a costly shutdown of production facilities and high labor costs and overtime
premiums. Counts are scheduled so that each item is counted on a predetermined
schedule. Important items may be counted every day or shift, while the least important
items may only be counted once a year.

The categories of inventory are:

Operating is the level of inventory for which there is a high level of confidence
that it will be used in the near future.

Excess is the inventory level which is greater than the operating inventory target
and any other discretionary balances, but still with a reasonable likelihood of
being used within the planning time frame.

Surplus is inventory that exceeds the targets for operating and excess inventory
and has some possibility of being used within the cumulative lead-time of
products.

Inactive is inventory in excess of the demand for the planning period and not
likely to be used in the foreseeable future.

Obsolete is inventory that is no longer used by the firm.

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