INVENTORY MANAGEMENT AND                                        Y How to determine how much to orderCONTROL*              ...
Be sure those to whom you delegate                       The most profitable inventory turnover ratioresponsibility know e...
space, labor for handling, utilities, insurance,          Inventory service costs. These includetaxes on land and building...
Obsolescence cost based on the                                          Comparing these percentages with thevalue of the a...
he would not have a 100-percent stock                  Inventory holding                  Decrease inposition at all times...
Determining How Much and How Often                        represent the lowest cost because the totalto Order2            ...
Table 1.--Results of Successive Inventory Cuts                                         Inventory     Decrease in Decrease ...
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  1. 1. INVENTORY MANAGEMENT AND Y How to determine how much to orderCONTROL* and how often to order.INVENTORY MANAGEMENT AND Controlling InventoriesCONTROL concerns most managers ofagricultural marketing and supply businesses, Purchase systematically. Place orders forwhether they are retail, wholesale, or service materials long enough beforehand so thereoriented. will not be a shortage between ordering and delivery.The value of a manager to an agriculturalmarketing and supply business depends on Let the inventory become relatively lowhis ability to manage inventories effectively. before reordering but keep enough on handThe total cost of maintaining the desired to meet current needs. There are costsinventory level must be held down to a associated with keeping large inventories.reasonable figure, but the inventory must also Likewise, there are costs if you deplete yourbe large enough to permit the company to stock.effectively merchandise the products andservices it sells. If the manager doesnt Dont hold “dead” lines or items.control his inventories to accomplish both ofthese objectives, the business may not be Keep track of inventories. When stock isable to prosper or even to survive against received, be sure that what was ordered wascompetition. delivered. Make sure that the amount received is added to the inventory.The information in this circular suggests tothe manager ways on how best to do four Physical inventories should be takenthings: frequently to find out which items are not selling so you can discontinue them as Y How to control inventories. quickly as possible, to spot shortages in Y How to visualize the inventory costs to merchandise that may be due to theft, to note be included in determining how much deterioration that may occur, and to decide inventories are costing the company. when to reorder. Y How to determine the level of Make someone responsible for checking inventory that is most profitable. the inventory. Delegate the responsibility for specific parts of the total inventory effort to* By B.L. Brooks, Extension Economist, University of the persons in the organization who are bestIllinois; reprint of Extension Circular 1063, October qualified to do the job.1972, with the kind permission of the author and theCooperative Extension Service, University of Illinois,Urbana, Illinois. WASHINGTON STATE UNIVERSITY & U.S. DEPARTMENT OF AGRICULTURE COOPERATING 1
  2. 2. Be sure those to whom you delegate The most profitable inventory turnover ratioresponsibility know exactly what they are varies with each commodity. Generally, highsupposed to do. inventory is needed for rapidly moving commodities if the merchandising effort isUse storage facilities efficiently. Assign going to be efficient and effective. Goodspace to each item in stock. Arrange the examples of this are feed and grain. Otherstorage area to permit the handling of stock commodities move more slowly but requirewith the least amount of effort and in such a that a small stock be on hand at all times.way that stock can be easily found, the Farm machinery is a good example of this.quantity determined and recorded, and the The demand for some items, such as seed, isstock removed if necessary. seasonal and requires large inventories at certain times of the year.Arrange the warehouse and sales area so theitems that sell rapidly can be most easily Increase selling efforts or reduce the averagepicked up by the customer or restocked in the stock of slow-moving items. If an item can’tdisplay area readily by the employees. be sold, discontinue stocking it immediately. Dead items are real losers.Use mechanical means to handle and movesupplies whenever the volume warrants it. Know the costs of inventories. BecauseThis will reduce the amount of labor used in costs of inventories are very closely related tohandling stock. size of inventories, the manager should keep his inventory as small as possible consistentPlan to use space interchangeably with with a good merchandising program.seasonal items and thus reduce the cost ofstorage space. The costs of carrying inventories can be a large percentage of the sale value of theBe aware of inventory turnovers. Know inventory. The costs are often 20 to 25what the turnover of each commodity is and if percent or more of the total value of thepossible compare this with the turnover of the inventory. The manager should know thesame items by other similar firms. costs of holding an inventory and then try to reduce the price of an item to the inventoryInventory turnover ratio is determined by holding cost to dispose of the items instead ofdividing the volume of sales of merchandise holding them in the level of inventory at a point in time,such as the first of each month. For example, Avoid holding lines of merchandise thatthe sales of fertilizer in May amounted to compete with one another. Stocking too$143,000 and the fertilizer inventory at the many lines is asking for inventory problems.end of May was $16,300. The inventory Choose the lines of merchandise carefullyturnover ratio for May thus was and then vigorously sell a limited number of$143,000/$16,300, or 8.8 to 1. That is, there lines. Duplication of items that occurs whenwas an $8.80 turnover of fertilizer for every the company carries multiple lines can moredollar’s worth in stock at the end of the period easily result in larger inventories andin question. increased inventory holding costs.A zero inventory, which would give you a ratio Determining Inventory Costsof infinity, would not be desirable because theobjective of management is to maintain the Inventory costs are real but they are alsolevel of inventory at a level that will permit the difficult to determine because they cannot bemost effective merchandising. taken directly from accounting records. Inventory costs for individual items make it necessary to prorate costs of equipment, WASHINGTON STATE UNIVERSITY & U.S. DEPARTMENT OF AGRICULTURE COOPERATING 2
  3. 3. space, labor for handling, utilities, insurance, Inventory service costs. These includetaxes on land and buildings, depreciation on taxes on inventory; labor costs ofbuildings and handling equipment, clerical handling and maintaining stock clericalhelp, unemployment insurance for certain costs for inventory records; contribution topersonnel, social security for all “space,” Social Security by employer based on“handling,” and “inventory service” personnel, prorated time devoted to inventories byand a proportionate share of administrative employees; unemployment compensationoverhead. The cost of holding inventories insurance based on prorated time ofmay make the payoff so great that the “inventory involved” personnel; employermanager can’t afford not to do it. Also, when contribution to pension plans, and groupinventory costs have been determined once, life, health, and accident insuranceit is a much simpler task to make the programs based on prorated time ofnecessary adjustments in each of the costs. “inventory involved” personnel; and an appropriate proportionate share forOne way to view the total annual cost of administrative overhead, including allcarrying inventory is as a percentage of total taxes, Social Security, pension, andinventory value. For example, if a company’s employer contributions to insuranceaverage inventory is $25,000 and the programs for administrative personnelaverage inventory carrying cost is 20 percent, who are will cost the company $5,000 per year tocarry an average inventory of $25,000. Capital costs. These include interest on money invested in inventory; interest onAn inventory holding cost that is 20 percent of money invested in inventory handling andthe average value of inventory is probably too control equipment; and interest on moneylow. Estimates of inventory holding costs for invested in land and buildings to storeagricultural supply businesses usually range inventory (if land and buildings arefrom 20 to 35 percent. owned).The costs that need to be included in the total Cost summary. The information aboutinventory carrying cost are: the hypothetical company that follows shows how a manager can develop a Storage space costs. These include better understanding of how he can use taxes on land and buildings; insurance on the knowledge he has about inventory buildings; depreciation on buildings and holding costs to make better management warehouses owned; rent (if paid); decisions. materials for repairs and maintenance on buildings; utilities; and janitor, watchman, The company management thinks they have and maintenance costs. a high cost of inventory holding but they dont know exactly what that cost is. Consequently Handling costs. These include they ask the manager to compute this cost. depreciation on equipment; fuel for The average inventory value in 1971 was equipment; maintenance and repair of $25,000. This figure is arrived at by adding equipment and insurance and taxes on the quarterly inventory values, which were equipment. $21,000 on March 31, $33,000 on June 30, $29,000 on September 30, and $18,000 on Risk costs on inventory. These include December 31, to get a total of $101,000. This insurance on inventory; obsolescence of results in a quarterly average of $25,250, inventory; physical deterioration of which is rounded to $25,000. The manager inventory; pilferage; and losses resulting computed the holding costs on the average from inventory price declines. inventory and found that they were as follows: WASHINGTON STATE UNIVERSITY & U.S. DEPARTMENT OF AGRICULTURE COOPERATING 3
  4. 4. Obsolescence cost based on the Comparing these percentages with thevalue of the average inventory ......... $1,500.00 industry-wide wide averages, the managerCost of capital on the average discovered that most of his costs were on theinventory ........................................... $2,500.00 high side, compared to those of the industry.Deterioration of average inventory or For example, his cost for handling andits prevention .................................... $1,250.00 distribution was 8 percent of the averageHandling and distribution costs of value of his inventory while the industryaverage inventory ............................. $2,000.00 standard for handling and distribution ofTransportation................................... $250.00 average inventory was 2 to 3 percent of the average inventory value.Taxes on average inventory ............. $187.50Insurance of average inventory… $125.00 The manager then decided to summarizeStorage facilities cost on average each of his costs and compare them with theinventory ........................................... $500.00 industry standards to get a clear pictureTOTAL .............................................. $8,312.50 regarding which of his individual inventory costs were higher than the industryThe manager also had available the average standards. He would then know which of hisindustry-wide inventory holding costs listed costs should receive his attention. Hebelow: prepared a summary of the percentage his costs were of the total average value of hisObsolescence ................................ 4 to 7% inventory and compared each of the costsCost of capital ................................ 8 to 12% with the inventory standards as shown below:Deterioration or its prevention ....... 4 to 5%Handling and distribution ............... 2 to 3% PercentTransportation................................ .5 to 1% above or Computed belowTaxes ............................................. .5 to .75% Range for cost for maximumInsurance ....................................... 0.25% industry company industryStorage facilities ............................ .25 to .75% (percent) (percent) costTOTAL ...........................................19.5 to 29.75% Obsolescence 4 to 7 6 -1 Cost of capital 8 to 12 10 -2The manager now compared his company’s Deterioration 4 to 5 5 ...costs with these percentages by computing Handling andthe percentages that each of the company’s distribution 2 to 3 8 +5average inventory holding costs were of his Transportation .5 to 1 1 …total inventory costs. These computations Taxes .5 to .75 0.75 …yielded the following information: Insurance 0.25 0.5 +0.25 Storage facilities .25 to .75 2 +1.25Obsolescence ....... $1,500 is 6% of $25,000 TOTAL Difference ................................ +3.5Cost of capital ....... 2,500 is 10% of 25,000Deterioration or its These figures indicated to the manager thatprevention ............. 1,250 is 5% of 25,000 he should reduce inventory handling andHandling and distribution costs and the costs of the storagedistribution ............ 2,000 is 8% of 25,000 space being used for the inventory beingTransportation....... 250 is 1% of 25,000 carried by the company. The manager nowTaxes .................... 187.50 is .75% of 25,000 wondered whether he should also reduce hisInsurance .............. 125 is .5% of 25,000 average inventory which would consequentlyStorage facilities ... 500 is 2% of 25,000 reduce the cost of holding the inventory. He knew that he would loose some sales andTOTAL .......... $8,312.50 is 33.25% of $25,000 possibly some customers if he did because WASHINGTON STATE UNIVERSITY & U.S. DEPARTMENT OF AGRICULTURE COOPERATING 4
  5. 5. he would not have a 100-percent stock Inventory holding Decrease inposition at all times. So he decided that he decrease units sold 1would try to determine what would be his 4,400 units 600most profitable level of inventory. 4,400 units 1,800 4,400 units 3,600Determining the Most Profitable Level 4,400 units 6,800of Inventory 4,400 units 7,200There is another cost associated with By reducing the inventory by 20,000 units, theinventory management in addition to those company will lose $23,000 (20,000 X $1.15)discussed previously. This cost results when in sales. This is far more than the $8,312.50an item is not available or your inventory for in inventory holding costs.the item is zero. This kind of situation resultsin the loss of sale immediately and might At what point should the manager stop cuttingpermanently lose a customer. Although a his inventory, given the above decrease inbusiness doesn’t want to lose sales nor sales with each successive cut in inventorycustomers permanently, should it maintain a he makes? Table 1 gives the results of the100-percent in-stock condition, with manager’s computations.associated high inventory costs, to forestallthese situations? Or would it he more It is obvious from Table 1 that the averageprofitable to have a 95-percent in-stock inventory holding costs are reduced as aposition? Any inventory management system result of each cut. But sales are also reduced,must weigh these alternatives and the so what is gained is partially, or totally lost bymanager must decide whether to maintain a decreased sales. The manager decides to cut100-percent in-stock position and pay his average inventory by about 10,000 units,additional inventory costs or to carry a less thus reducing his average inventory holdingthan 100-percent in-stock position and lower costs by about $3,775. His sales will behis inventory costs while risking possible loss reduced by a similar amount. Any furtherof sales and customers. How can the reduction in inventory would not reduce themanager make this decision? average inventory holding costs as much as the reduction in sales and would result in aLet’s go hack to the hypothetical company. reduction of gross income.The manager knows that for the $25,000avenge value inventory he carries, it costs A manager cannot reduce inventory to zerohim $8,312.50. He also knows that he carries without losing sales volume. He can,about 22,000 items in his average inventory however, reduce inventory as well as thewith an average value of $1.15 per item. The costs of holding inventory to a certain point,average inventory holding cost per item is which can be determined, that will be anthus about 37 3/4 cents ($8,312.50 ¸ optimum point for holding inventory from a cost versus loss-of-sales standpoint. A22,000). Now, suppose he decides to manager can do this only if he knows hisdecrease his average inventory in five inventory holding costs and can then estimatesuccessive steps, which will reduce his within a reasonable degree of accuracy whatinventory holding cost to zero. But he also will happen to his sales when he cuts hisknows he will lose sales because he will be inventory.out of stock in some items when hiscustomers ask for them. He estimates thatthe decrease in sales with each successive 120-percent decrease in inventory holding cost Decrease in sales is cumulative. That is, the first cutwill be as follows: in inventory results in a decrease of 600 in the number of items sold, the next one in 1,800 plus the previous 600, or 2,400, and so forth. WASHINGTON STATE UNIVERSITY & U.S. DEPARTMENT OF AGRICULTURE COOPERATING 5
  6. 6. Determining How Much and How Often represent the lowest cost because the totalto Order2 cost for four units or for six units is not known. A mathematical formula can be used toThe order cycle is the period of time that determine the EOQ.elapses between the order of the goods andthe receipt of the order. For example, if the The components of the EOQ formula are:company has sales of $700,000, the average a = ordering cost per order,daily inventory must he at least $2,000 s = annual sales rate,($700,000 ¸ 365 days). The longer the order i = ineterest cost per unit per year.cycle, the larger the inventory requirements.Thus, if the order cycle is 15 days, the The formula is:average inventory must be at least $30,000. Ifthe order cycle is shortened to 10 days, thenthe average inventory requirement is at least 2as EOQ =$20,000. iThere is a technique that can be used to Given the data in the previous example:determine how much should be ordered. This a = $15technique is called the Economic OrderQuantity (EOQ). To determine the EOQ, a s = 5,200 unitsbusinessman must trade off two costs -- i = $0.15 per unitordering costs and inventory carrying costs.Ordering costs are the expenses involved in then:placing a single order times the frequencyorders are made. The smaller the quantity 2(15)(5,200) EOQ =ordered per order, the greater the ordering .15costs because more orders are placed with 156,000suppliers. The fewer the orders placed, the EOQ =lower the ordering costs but the higher the .15average inventory and higher inventory EOQ = 1,040,000holding costs. EOQ = 1,019 unitsTable 2 below shows how a least-costsolution for EOQ determination can be made. Thus, for lowest total cost, 1,019 units shouldIn this example, assume that the business be ordered about five times a year.has determined (1) carrying costs equal to 15percent of average inventory value (if the unitcost is $1, carrying costs are 15 cents), (2)order costs are $15 per order, (3) averageinventory holding costs are one-half of theorder quantity, and (4) total sales are 5,200units per year.The lowest total cost in Table 2 is found atfive orders per year. This is $153. However,there is no assurance that five orders2 Adapted from unpublished material prepared byRichard Fenwick, Extension Economist, AgriculturalBusiness Management, University Extension Division,University of Missouri-Columbia. WASHINGTON STATE UNIVERSITY & U.S. DEPARTMENT OF AGRICULTURE COOPERATING 6
  7. 7. Table 1.--Results of Successive Inventory Cuts Inventory Decrease in Decrease in Net gain orInventory holding units sold with inventory Decrease loss fromcut number decrease in each cut in holding in sales inventory units a inventoryb costc volume d decrease e1 .................................. 4,400 600 $1,661 $ 690 $ 971 gain2 .................................. 4,400 2,400 3,322 2,760 562 gain3 .................................. 4,400 6,000 4,983 6,900 1,917 loss4 .................................. 4,400 12,800 6,644 14,720 8,076 loss5 .................................. 4,400 20,000 8,305 23,000 14,695 lossa Total inventory is 22,000 units and the manager plant to cut 20 percent in five successive cuts, or .20 x 22,000 = 4,400 units.b Decrease in units sold is 600 for first cut, 600 plus 1,800 for second cut, 600 plus 3,600 for the third cut, etc., until the fifth cut when sales are reduced a total of 20,000 units by reducing the inventory to zero.c Inventory holding costs are decreased about $1,661 each time (37 ¾ cents x 4,400 unity).d Decrease in dollar sales volume is the decrease in units sold with each cut time $1.15 per unit.e Net gain or loss is the amount saved by reducing inventory cost minus the decrease in dollar volume as a result of reduced sales. Table 2--Economic Order Quantity (EOQ) Formulation Number of Orders 1 2 5 10 15 20 25Size of order (units) 5,200 2,600 1,040 520 347 250 208Average inventory (units) 2,600 1,300 520 260 173 125 104Carrying cost $390 $195 $78 $39 $26 $19 $16Order cost 15 30 75 150 225 300 375TOTAL COST $405 $225 $153 $189 $251 $319 $391 Sincerely, Ken D. Duft Extension Economist WASHINGTON STATE UNIVERSITY & U.S. DEPARTMENT OF AGRICULTURE COOPERATING 7