Inventory represents a significant cost for many companies and needs to be managed effectively. Inventory levels that are too low will result in loss of sales due to stock-outs, whereas a high inventory level means excess capital is tied up in inventory. The appropriate inventory balance depends on the type of product sold and the complexity of the production process i.e. how long it takes to make the final product.
Approaches to Managing Inventory Levels
There are two basic approaches for managing the level of inventory: economic order quantity and just-in-time.
Economic order quantity is the optimal amount of inventory to be ordered that minimizes total inventory costs. Reorder point refers to the level of inventory at which new inventory is ordered.
It is tricky to balance ordering costs and carrying costs. Ordering inventory several times can be inefficient as it would mean the company incurs transaction, communication and transportation costs every time it orders; at the same time setting aside a large sum for a large inventory order will decrease ordering costs but increase carrying costs. This is also inefficient as capital is tied up (opportunity cost of capital) that could have been used elsewhere. So, what is the optimal point at which inventory must be ordered so that the total inventory costs are minimized? This is determined by the EOQ method.
The diagram above illustrates how EOQ method works. Inventory level is plotted against time. The arrows show the reorder point, the level of inventory at which an order is placed. If the level of inventory goes below this point, then the company runs a risk of going out of stock. Economic order quantity in the diagram represents the order size that should be placed every time the inventory levels reach the reorder point.
Just-in-time inventory: Unlike economic order quantity, just-in-time involves placing smaller, more frequent inventory orders. It minimizes the inventory levels. It is a demand driven inventory system where materials are ordered only when current stocks of material reach a reorder point, which in turn, is determined by historical demand.
Just-in-time strategy strives to improve efficiency and reduce inventory carrying costs. Production planning and inventory management have to be integrated which is done using a manufacturing resource planning system.
Evaluating Inventory Management
The most common way to evaluate inventory management of a company is to calculate its inventory turnover ratio and number of days of inventory. A decrease in inventory turnover may mean:
A high inventory turnover ratio results in low days of inventory. This may indicate that a company’s products are being sold quickly, and it is maintaining a low inventory. However, to get the right picture, the changes in inventory turnover ratio and days of inventory should be compared over time and relative to the industry average.
Accounts payable is the amount a company has not yet paid to suppliers of goods and services. It represents an important source of funds and should be managed well. Companies take advantage of trade credit to delay the payment. For example, the terms may be such as 2/10 net 30, which means if the payment is made within 10 days, the company will get a 2 percent discount else the entire payment must be made within 30 days.
The Economics of Taking a Trade Discount
It is important for a company to evaluate when to pay its suppliers: within the discount period, or within the maximum time allowed. To make this decision, a company should calculate the cost of trade credit, which is the annualized cost of not availing a trade discount. If a company’s payment terms are 2/10, net 40, the cost of not availing the 2% discount and instead making the payment on day-40 can be calculated using the formula below:
where: n = 365 / number of days beyond discount period
This is further illustrated in the below example.
Compute the cost of trade credit if terms are 2/10, net 40 and the account is paid on the 40th day.
Assume the item is for $100. If payment is made by Day-10 we only pay $98. Hence we can say the actual price is $98. If payment is made on the 40th day, we pay $100. To hold our money for 30 days beyond the discount period we pay an extra $2 over the actual price of $98. The rate is 2/98 = 0.0204. To compute the cost of trade credit we need to annualize this number:
(1 + 0.0204)365/30 – 1 = 27.85%. In other words, the annualized cost of not taking the trade credit is 27.85%. If a company’s short-term borrowing cost is less than 27.85%, it should avail the trade credit and pay the supplier within 10 days.
The key point is that a company should avail discounts made available by suppliers if the cost of trade credit is higher than the company’s short-term borrowing cost.
The objectives of a short-term borrowing strategy for companies are to:
Short-term borrowing could be from banks or from non-bank sources. Large companies that are financially strong use lines of credit. Companies with weaker credit terms have to use collateral for bank borrowings. Smaller firms with poor credit terms may approach nonbank finance companies for short term borrowings. Large creditworthy companies may issue commercial paper.
Computing the Costs of Borrowing
One of the key tasks for a company is to decide which form of short-term borrowing will be the most cost-effective. For comparison purposes, the company must calculate the total cost of the form of borrowing and divide it by the total amount of loan borrowed. For example, costs for three forms of borrowing are given below:
For an all-inclusive interest rate where the amount borrowed includes interest (banker’s acceptance):
When amount borrowed includes dealer’s fee and a backup fee:
These costs are further illustrated in the below example.
You need to borrow $1 millio20n for one month and have three options shown below. Which one represents the lowest cost?
We begin by calculating the cost of borrowing for each option.
Loan amount = 1 million
Interest amount + commitment fee = [0.055 x 1 million x 1/12 + 0.005 x 1 million x 1/12] x 12
Cost of line of credit = [0.055 x 1 million x 1/12 + 0.005 x 1 million x 1/12] x 12 / 1 million = 6%
Therefore, we can conclude that commercial paper represents the lowest cost.