Inventory

Outline

Inventory overview
Cost of inventory
Inventory turns
The role of safety inventory in a supply chain
Inventory policies
Determining the appropriate level of safety inventory

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 Inventory Overview

Inventory is the raw materials, work in

process and the finished products within a
supply chain

Provides good service to the customer

Helps to take advantages of economies of

scale in production and distribution

It incur cost
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Components of Inventory cost

Inventory holding cost
Purchasing order cost
Shortage cost
Inventory control cost

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 Inventory Carrying Cost

The cost of holding goods in stock.

Components
• capital or opportunity cost (cost of money)
• deterioration
• pilferage
• obsolescence
• taxes
• insurance
• storage cost (warehouse)
• handling cost
Holdling cost per year = Irc
• I is the average inventory (unit)
• c is the unit value cost ($/unit)
• r is the carrying cost rate ( $/$/year) 5

The Truth About Carrying Inventory

Studies of industries about inventory carrying

costs reveal the
following . . . .
• Over 65% of most companies do not compute inventory
carrying costs, they use rough estimates
• Leading logistics experts place the cost of carrying inventory
between 18% per year and 75% per year depending on the
type of products and business
• The standard “rule of thumb” for inventory carrying cost is
25% of inventory value on hand
• The cost of capital is the leading factor in determining the
percentage of carrying cost

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How to computing the inventory
carrying cost rate
Cost of inventory per year
= inventory capital cost + inventory service cost +
inventory risk cost + inventory storage cost

Inventory service cost inventory storage cost

• insurance cost • cost of space which includes
• physical handling cost cost to rent, lease, or
• taxes finance the storage facility
that is used to store
Inventory risk cost inventory.
• obsolescence, • The inventory storage cost
• damage, may also include extra cost
• shrink, to handle, store, and
• deterioration, and r maintain hazardous,
• relocation cost perishable, or sensitive 7
inventories.

Inventory capital cost

Expected financial return that capital could be expected to earn in
an alternative investment of equivalent risk
Weighted average cost of capital (WACC)

• E = Market value of firms equity

• D = Market value of the firm's debt
• V = E + D = Total market value
• Re = Cost of equity
• Rd = Cost of debt
• Tc = Corporate tax rate
inventory capital cost = WACC*Inventory value
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 Inventory capital cost
For cost of equity, capital asset pricing model (CAPM) is used
• CAPM = risk free rate + *(expected market rate – risk free
rate)
• For example, in USA, US Treasury Bond can be used as risk
free rate and a 5 year stock index average return, such as the
5-year S&P 500 average return can be used for the expected
market rate.
• Systematic risk () is the sensitivity of the expected excess
asset returns to the expected market returns

Example
1. Add up your annual 3. Suppose
Inventory Costs: 9% = WACC
Example: 4% = Insurance
$800k = Storage 6% = Taxes
$400k = Handling Total = 19%
$600k = Obsolescence 4. Add percentages:
$800k = Damage
$600k = Administrative 10% + 19% = 29%
$200k = Loss (pilferage etc)
$3,400k Total The inventory carrying rate =
2. Annual inventory value = 29%
$34,000k 
$3,400k / $34,000k = 10% 10
 Purchase Order Cost
Independent of the size of replenishment
Order forms Purchase order follow-
Postage up time
Telecommunications Purchasing
Authorization management
Purchase order Office space
planning Office supplies
Purchase order entry
time Purchase order entry
systems
Purchase order
processing time Tracking and expediting
Purchase order
inspection time 11

Stockouts
Inventory carrying cost for not being out of stock is
infinite.
Responses to unsatisfied demand
• Backordering
• Substitution
• Lost sales
Stockouts can be reflected in the shortage factor, an
index applied to the selling price to reflect the
magnitude of the damage of the lost sale.

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 Inventory Control Cost
Operation of selected decision system
Cost of data acquisition, data storage, maintenance
and computation
Human interpretation of results, training

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Inventory Turns

An indicator for comparing current to past

performances of inventory.
Inventory turns =
Annual sales or usage/Average inventory in $
Indication of how fast a particular sku is flowing
through the warehouse/productivity of inventory
Cash flow
Useful for benchmarking

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 Example

The excerpt from the financial statements of Coca-

Cola in 2000 show that cost of goods sold is
$6,204,000,000. The average inventory value in 2000
is $1,071,000,000
What is the inventory turns?
Is it good?

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Return on invested capital figures for select companies in the

computing industry.

Source: Business Week

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