Inventory Management

Learning Objectives:
1. Understand the concept of inventory management
2. Discuss inventory management: differing views, common techniques and international concerns
3. Explain the concept of economic order quantity
4. Understand the concept of Just In Time (JIT) inventory system

Introduction
- The purpose of inventory management is to ensure availability of materials in sufficient quantity as and when required
and also to minimize investment in inventories.
- A proper planning of purchasing, handling, storing and accounting should form a part of inventory management.
- An efficient system of inventory management will determine the following:
a. What to purchase?
b. How much to purchase?
c. From where to purchase?
d. Where to purchase?

There are conflicting interests and viewpoints of different division heads over the issue of inventory. Below scenario is for
a manufacturing setup.
1. Financial Manager – his disposition toward inventory levels is to keep them low, to ensure that the firm’s money is not
being unwisely invested in excess resources
2. Marketing Manager – would like to have large inventories of the firm’s finished products
3. Production Manager – his responsibility is to implement the production plan so that it results in the desired amount of
finished goods of acceptable quality available on time at a low cost
4. Purchasing Manager – concerned solely with the raw materials inventories

Inventory Management
- The development and administration of inventory policies, systems, and procedures necessary to efficiently and
satisfactorily meet inventory requirement at the minimum cost possible.
- It requires the coordination of both purchasing and financing functions to effectively manage inventory.

Objectives of Inventory Management

1. To reduce inventories while maintaining customer service levels and quality. The firm can free needed cash to finance
both internal and external growth. It involves a delicate balance between ordering costs, carrying or holding costs and
shortage costs.

2. To establish production and inventory control.

The following must be noted in inventory management:
a. Control
- Proper control system must be set up
- Stock cards and other records for inventory physical movements, though with the advancement of technology, most
inventory controls are through computers

b. Information
- Information on inventory level must be properly communicated on time to avoid stock out

c. Inventory value
- Stored items have value and this value must be reflected in the appropriate statements about inventory

Cost of carrying inventories:

- Desired rate of return on inventory investment (foregone interest on working capital tied up in inventory)
- Risk of obsolescence, spoilage, theft and deterioration)
- Storage space costs (warehouse, depreciation or rental, security)
- Property taxes
- Insurance

Cost of ordering or set up costs:

- Preparing purchase or production orders
1. Time spent in finding suppliers and expediting orders
2. Clerical costs of preparing purchase order
- Receiving (unloading, unpacking, inspecting)
1. Transportation costs
2. Receiving costs

- Processing all related documents

- Mailing and stationery costs
- Other costs like telephoning and typing orders

Shortage costs:
- Disrupted production when raw materials are unavailable
1. Idle workers
2. Extra machine setup

- Lost sales resulting in dissatisfied customers

- Loss of quantity discounts on purchases

Economic Order Quantity (EOQ)

- The order size or the appropriate number of units that must be ordered at the least cost
- The optimal number of units to be ordered to maintain the minimum cost

Formula

EOQ = √ 2 x D x O
C

D = demand annually for the product or use for raw materials

O = order cost per order placed or set up cost for production
C = carrying cost annually of one unit in inventory

Basic Assumptions in Using EOQ

1. Supply of goods is stable
2. Demand occurs at a constant rate throughout the year
3. Lead time on the receipt of the orders is constant
4. The entire quantity ordered is received at one time
5. The unit costs of the items ordered are constant, thus there can be no quantity discounts
6. There are no limitations on the size of the inventory

Total Carrying Cost

= percentage cost of carrying inventory x price of inventory per unit x average number of unit held

Total Ordering Cost

= fixed cost of placing an order x number of orders placed per year

Number of Orders
= total demand per year / order size

Stockout Costs
- Include lost sales and lost customer goodwill
- These costs are normally avoided by carrying safety stocks

Reorder Point
- Represents the level of inventory where the order must be placed for the quantity size as predetermined in the EOQ

Lead Time
- The time interval between placing an order and receiving delivery

Safety Stock
- Inventory carried over and above the quantity determined by the EOQ formula to meet unanticipated demand or delays
= (maximum lead time – normal lead time) x daily demand
= (maximum daily demand – normal daily demand) x lead time
Weaknesses of EOQ Model
a. Assumes that demand is constant and uniformly occurred throughout the year. If demand is unstable, say it varies from
day to day, the model should be modified to include safety stock.
b. Assumes a constant unit price. Adjustments must also be made if quantity discounts are being offered.
c. Assumes a constant carrying cost. The unit carrying cost will vary as the level of inventory changes. The higher the
average inventory level, the higher the carrying cost.
d. Assumes constant ordering costs, if not, EOQ cannot be used.
e. Assumes instantaneous delivery, that is, expected lead time is achieved, and if not, safety stock will have to be added
into the model.
f. Orders are assumed to be independent. It means that the firm does not combine orders to save on costs.

Just In Time (JIT) System

- A system of inventory control in which a manufacturer coordinate with suppliers so that raw materials or components
parts will be received just in time they are needed in the production process.
- Completion of products will be made just in time they are to be delivered to the customers

Objective of JIT
- The primary concern of the JIT system is to reduce carrying costs particularly cost of investment in inventory on hand
itself and other related control costs
- With a coordinated production schedule, the supplier may also benefit:
1. By having able to schedule production runs better
2. By having to carry lower finished goods inventory safety stock

Computerized Systems for Resource Control

1. Materials Requirement Planning System
- An inventory management technique that applies EOQ concepts and a computer to compare production needs to
available inventory balances and determine when orders should be placed for various items on a product’s bill of materials

2. Manufacturing Resource Planning

- A sophisticated computerized system that integrates data from numerous areas such as finance, accounting, marketing,
engineering and manufacturing and generates production plans as well as numerous financial and management reports

3. Enterprise Resource Planning

- A computerized system that electronically integrates external information about the firm’s suppliers and customers with
the firm’s departmental data so that information on all available resources, human and material, can be instantly obtained
in a fashion that eliminates production delays and controls costs.
Short Term Financing Management

Learning Objectives:
1. Review accounts payable, the key components of credit terms, and the procedures for analyzing those terms
2. Understand the effects of stretching accounts payable on their cost and the use of accruals
3. Describe interest rates and the basic types of unsecured bank sources of short-term loans
4. Know the advantages and disadvantages of short-term credit
5. Discuss the basic features of commercial paper and the key aspects of international short-term loans
6. Explain the characteristics of secured short-term loans and the use of accounts receivable as short-term loan collateral
7. Describe the various ways in which inventory can be used as short-term loan collateral

Introduction
- A firm’s current assets need to be financed.
- Many firms finance their short-term assets with short-term financing sources.
- Using short-term funds to finance both current and fixed assets is a high-risk, high potential return strategy.
- The use of long-term funds to finance both current and fixed assets is a low-risk potential strategy.
- Common short-term financing sources available to firms are trade credit (accounts payable) and bank loans.
- Short-term financing options are tied directly to immediate sales. They are relatively easy to qualify for as long as the
business has a positive cash flow or outstanding invoices to use as collateral.

Spontaneous Liabilities
- Financing that arises from the normal course of business
- These are obligations of a company that are accumulated automatically as a result of the firm’s day to day business
- An increase in spontaneous liabilities is normally tied to an increase in cost of goods sold which in turn depends on sales
of goods or services
- These liabilities are called spontaneous because they arise from changes in sales activity which are not directly
controlled by the firm

Sources of Spontaneous Liabilities

1. Accounts Payable
2. Accruals

Accounts Payable
- The major source of unsecured short-term financing for business firms
- They result from transactions in which merchandise is purchased but no formal note is signed to show the purchaser’s
liability to the seller

Two Parts of Average Payment Period

1. The time from the purchase of raw materials until the firm mails the payment
2. Payment float time (the time it takes after the firm mails its payment until the supplier has withdrawn spendable funds
from the firm’s account)

Accounts Payable Management

- Management by the firm of the time that elapses between its purchase of raw materials and its mailing payment to the
supplier

Short-term Credit or Financing

- Debt scheduled to be repaid within one year
- Three factors that should be considered in selecting a source of short-term financing:
1. The effective cost of the credit source
2. The availability of credit
3. The effect of the use of a particular source of credit on the cost and availability of other sources

Interest Computation (PRT)

Principal x Rate x Time

Assume a loan of 100,000 with 12% interest on January 1 is to be paid on December 31, how much is the interest?
Answer: 100,000 x 0.12 x 12/12 = 12,000

Assume a loan of 100,000 with 12% interest on January 1 is to be paid on June 30, how much is the interest?
Answer: 100,000 x 0.12 x 6/12 = 6,000
Accruals
- Liabilities for services received for which payment has yet to be made
- The most common items accrued by a firm are wages and taxes

Sources of Short-Term Credits

1. Unsecured Credit
- Consists of all those sources that have as their security only the lenders’ trust and confidence on the ability of the
borrower to repay the funds when due
2. Secured Funds
- Include additional security in the form of assets that are pledged as collateral in the event the borrower defaults in
payment of principal and interest

Sources of Unsecured Short-Term Credit

1. Trade credit
2. Unsecured bank loans
3. Commercial paper

Trade Credit
- Provides one of the most flexible sources of financing available to the firm
- The firm just places an order with one of its suppliers.
- The supplier then makes some credit investigation and if the credit is good, the supplier sends the goods or renders
services

Example: If 2/10, net 30 is the term of payment

The buyer has 10 days to pay to avail of the 2% discount. If discount is not taken, the full price must be paid within 30
days.

Commercial Bank Loans

a. Lines of Credit
- An informal agreement or understanding between the borrower and the bank as to the maximum amount of credit that
the bank will provide the borrower at any one time
b. Transaction Loans (Notes Payable)
- Made for a specific purpose (a transaction)

Prime Interest Rate

- The rate charged by commercial banks to their best (the largest and financially strongest) business customers

Cost of Bank Loan

a. Simple Interest
- Based on the borrowed amount and is paid at the end of the loan term
b. Discounted Interest
- Based on the borrowed amount but is paid in advance
c. Add-on Interest
- Relates to installment loan and is equal to the interest divided by the average balance

Commercial Paper
- Consists of short-term, unsecured, notes payable issued in large denominations by large companies with high credit
ratings to other companies and institutional investors, such as pension funds, banks and insurance companies.
- Maturity date is normally less than 270 days (9 months)
- Traded in money markets and thus is highly liquid
- Only the largest and most creditworthy companies are able to use commercial paper, which consists of unsecured
promissory notes sold in the money market

Advantages of Using Commercial Paper:

1. Interest rates are generally lower than rates on bank loans and comparable sources of short-term financing. It is usually
issued at below the prime rate.
2. No minimum balance requirements like compensating balances
3. It offers the firm with very large credit needs from a single source for all its short-term financing needs
Secured Short-Term Credit
- Secured sources of short-term credit have certain assets of the firm, such as accounts receivable or inventories, pledged
as collateral to secure a loan
- Two main current assets which are used as collateral for short-term credits are the accounts receivables and inventories.

For Accounts Receivables:

1. Pledging
- The amount of the loan is stated as a percentage of the face value of the receivables pledged
2. Factoring
- The sale of accounts receivable to a factor

For Inventories:
1. Floating Lien Agreement
- The borrower gives the lender a lien against all its inventories
2. Chattel Mortgage Agreement
- It involves having specific items of inventory identified in the security agreement
3. Field Warehouse Financing Agreement
- The inventories used as collateral are physically separated from the firm’s other inventories and are placed under the
control of a third party field warehousing firm

Stretching Accounts Payable

- Paying bills as late as possible without damaging the firm’s credit rating

Terms in Working Capital Management and Short-term Financing

1. Inventory Conversion Period
- The average length of time required to convert raw materials into finished goods and then to sell them

2. Receivables Conversion Period

- The average length of time required to convert the firm’s receivables into cash and it is equal to the days sales
outstanding

3. Payable Deferral Period

- The average length of time between the purchase of raw materials and labor and paying for them

4. Cash Conversion Cycle

- The length of time between paying for raw materials purchase and receiving cash from the sale of finished goods

Cash = Inventory + Receivables - Payables

Conversion Cycle Conversion Period Conversion Period Deferral Period

Cash Conversion Cycle =

+ Inventory Conversion Period
+ Receivables Conversion Period
- Payables Deferral Period

Advantages of Short-Term Credit

1. Speed with which short-term loans can be arranged
2. Increased flexibility
3. Interest rates on short-term loans are generally lower than long-term rates

Disadvantages of Short-Term Credit

- The extra risk that the borrower must bear because
1. the lender can demand payment on short notice
2. the cost of loan will increase if interest rates increase
Financial Planning

Learning Objectives:
1. Understand what is financial planning
2. Understand what is financial control
3. List and explain purposes of budgeting systems
4. Identify the components of a master budget
5. Identify the components of an operating budget
6. Define budgeting and describe the concept of budgetary systems
7. Enumerate the major advantages of budgeting
8. Know the behavioral implications of budgetary systems
9. Know the role of the budget committee
10. Learn the contents of the budget manual
11. Know the basic factors to consider in preparing the budget
12. Know the factors to consider in a sales forecast
13. Understand the basic limitations of budgeting

Introduction
- Financial planning is making projections of sales or revenues, expenditures based on alternative production and
marketing strategies, as well as asset acquisition necessary to achieve those strategies and then deciding how to meet the
forecasted financial requirements.
- Such plans must be stated in quantitative terms known as budget so as to be able to institute control systems.
- Budget is a detailed plan defining or outlining the sourcing and uses of financial and other resources of the company in a
given period of time.
- Every organization or individual has to budget their scarce resources to make the best use of such resources (time,
money, and energy)
- In this chapter, the focus is in cash budget or cash planning. A cash budget is a schedule showing projected cash inflows
and outflows over a specified period.

Objectives of Financial Planning or Budgeting

- Many companies consider budgeting as one of the most important function of management.
- Budgeting is the best approach to planning, controlling, as well as cost reduction program of the company.
- Failure of the management to draw up, monitor, and adjust budgets to changing conditions is one of the primary reasons
behind the collapse of many businesses.
- Budgeting process involves the participation of every member of the organization.

The objectives of budgeting could be summarized as follows:

- It compels or forces managers to plan.
- It provides information that can be used to improve its decision making functions.
- It helps to set a benchmark that can be used for performance evaluation.
- It improves communication and coordination.

Definition and Components of a Master Budget

Master Budget
- A network which is composed of operating budgets and financial budgets

Operating Budget
- The detailed schedule for each item in the operation of the business (sales, production, purchases, and operating
expenses)

Sales Budget or Sales Forecast

- The starting point of all operating budget
- It is a detailed schedule showing the expected sales for the coming year

Production Budget
- Applicable for manufacturing firms only
- After the sales target has been established, the production requirements will be prepared
- It would show the sufficient goods to be produced for the period, and the required beginning and ending inventories of
finished goods
Purchases Budget
- Prepared for both manufacturing and merchandising firms
- It will show the direct materials purchases for manufacturing and goods for sale for merchandising firms

Cost of Goods Sold Budget

- Shows the total number of units sold and its average unit prices

Operating Expenses Budget

- Shows all the expenses for the period
- This is prepared for each kind of expense
- This includes direct labor and manufacturing overhead budgets for a manufacturing firm which are related to production
budget

Budgeted Income Statement

- Prepared based on the detailed operating budgets and will show how profitable operations is in the period

Financial Budget
- Composed of the budgeted balance sheet, cash budget and in some cases includes capital acquisition budget

Budgeted Balance Sheet

- Show the pro-forma presentation of the financial condition of the company
- It is prepared beginning with the current balance sheet and adjusted by the amounts from the operating budgets

Cash Budget
- Show the cash balance at the end of the period
- It will outline the beginning cash balance and adjusted by the total cash receipts and cash disbursements during the year
whether from operating, investing or financing activities of the firm
- This will reflect also if the company will require some borrowings in a given period or can avail of any investment
opportunities in case of excess cash

Major Benefits of Budgeting

1. Planning
- Budgeting compels managers to thin ahead by formalizing their responsibilities in business operations

2. Evaluation Performance
- Budgeting provides definite expectations that serve as the best framework for judging subsequent performance

3. Coordinating and Control

- Budgeting aids managers in coordinating their efforts, so that the objectives of the organization as a whole match the
objectives of its parts

4. Motivation and Positive Behavior

- People who are involve in the preparation of the budget must develop a sense of commitments to the achievement of the
budget they made
- Likewise, promotions, incentives and rewards are based on job performance, which certainly the achievement of their
targets

Behavioral Implications of the Budgetary System

- Budgeting necessarily involves people, and their behavior.
- Behavioral problems arise when manager has conflicts with what the other members of the organization wanted
- In most cases, budgeting systems promote and improve teamwork among the people in the organization; they will be
more involved in improving targets and greater goal congruence.
- Goal congruence is a condition in which the major objectives of every department in an organization are in harmony.

Budget Committee
- Responsible for the overall policy matters related to budgeting process
- Responsible for making the budget program and in coordination with the preparation of the budget itself
- This is usually composed of the president, vice presidents in charge of the various functions, such as finance, marketing,
production, personnel, and purchasing.
- Tasked to prepare the budget manual
- Budget manual is the handbook where all rules, procedures, and policies are outlined.
Contents of Budget Manual
- Objectives and policies of the enterprise
- Definition of line of authority and responsibility
- Functions and responsibilities of the budget committee and the budget officer
- Time schedules for budget preparation
- Instructions and forms to be used
- Program for preparation of budgets
- Procedures for obtaining approval
- Forms, nature and responsibility for the preparation of the budget
- Procedures for budgetary control and account codes in use

Some Basic Factors to Consider in Preparing the Budget

- Nature of demand for the product - Need for control of operations
- Length of trade cycle - The accounting period
- Length of production cycle - Functional area covered
- Time interval necessary for financing production well in advance of actual results

Basic Factors to Consider in Preparing a Sales Forecast

Sales forecast is broader than sales budget. It generally encompasses the potential sales demand of the entire industry. The
sales budget is prepared from that sales forecast. In forecasting sales, the following factors must be considered:
- Past experience or sales trend in terms of volume
- Anticipated changes in prices or pricing policies
- General economic conditions
- Industry economic conditions
- Industry competitions
- Company’s market share
- Company’s advertising and product promotion policies
- Movements of the economic indicators such as gross national product, inflation, employment rates, prices, and disposal
income of individuals
- Market researches
- Consumers’ behavioral changes

Some Limitations of Budgeting

1. Accuracy of estimates
- As budgets are prepared for the future, data are purely based on estimates and those estimates are the product of different
bases on hand at present which may lead to some errors

2. Adverse reactions from employees

- People preparing the budget must consider the reasonable degree of achievability, otherwise, it may demoralize the
concerns

3. Amount of work used in developing good budget

- As the budget has to be completed at a specified period, the time used may not be enough to come up with good
estimates

Some Basic Terms and Procedures to Remember in Budgeting:

Forecasting
- The process of making predictions about changing conditions and future events that may significantly affect the
activities of an organization
- It is used in areas such as production planning, budgeting, strategic planning, sales analysis, inventory control, marketing
planning, logistics planning, purchasing, material requirements planning and product planning
- It could be quantitative, technological, or qualitative and judgmental

Quantitative Forecasting
- A type of forecasting that relies heavily on numerical data and mathematical models to predict future conditions

Technological or Qualitative Forecasting

- Used or aimed primarily at predicting long-term trends in technology and other important aspects of environment
- Particular emphasis is placed on technology, since the ability of organization to innovate and remain competitive is often
related to being able to take advantage of opportunities evolving from technological changes
Judgmental Forecasting
- A method which relies mainly on individuals or group agreements regarding future conditions

Long Range Planning

- Produce forecasted financial statements for five or ten year periods

Strategic Plan
- Sets the overall goals and objectives of the organization
- Some business analysts do not call a strategic plan a budget because it covers no specific period and does not produce
forecasted financial statements

Capital Budget
- Details the planned expenditures for facilities, equipment, new products, and other long-term investments

Master Budget (pro forma statements)

- A budget that summarizes the planned activities of all sub-units of an organization – sales, production, distribution, and
finance
- The master budget quantifies targets for sales, cost-driver activity, purchases, production, net income, cash position, and
other objective that management specifies

Continuous Budget (rolling budget)

- A common form of master budget that adds a month in the future as the month just ended is dropped
- Continuous budgets compel managers to think specifically about the forthcoming 12 months and thus maintain a stable-
planning horizon

Operational Goals
- Targets or future end results set by lower management that address specific measurable outcomes required from the
lower level

Operational Plans
- Devised to support implementation of tactical plans and achievements of operational goals

Operational Control
- A control type that involves overseeing the implementation of operating plans, monitoring day-to-day results, and taking
corrective action when required

Operating Budget
- A major part of a master budget that focuses on the income statement and reporting schedules
- This statement presents the financial plan for each responsibility center during the budget period and reflects operating
activities involving revenues and expenses

Financial Budget
- The part of a master budget that focuses on the effects that the operating budget and other loans (such as capital budgets
and repayments of debt) will have on cash

Fixed Budget
- Based on one level of activity

Flexible Budget
- Based on different levels of activity
- It is an extremely useful tool for comparing actual cost incurred to the cost allowable for the activity level achieved

Static Budget
- A budget for a particular level of activity
- It shows the planned results at the original budgeted activity level

Zero Based Budgeting

- Treats all activities in the organizations to start to zero level
- Zero based budgeting approach forces management to rethink each phase of an organization’s operations before
allocating resources