Coverdrive Ltd Case Study Working Capital Management Inventory Control Since joining Coverdrive, John Thistle the

e management accountant, has been implementing various systems linked to short-term planning and reporting. He has recently focused on a revie of the stock holding of ra materials, consumables and maintenance spares and having conducted a full physical stock take and valuation at !uarter ended "# $arch he is concerned at the lack of control that e%ists in ordering issue and control of some stock items. &t a recent management meeting John had agreed ith Steve &mbrose, the $', that one of his short-term objectives as management accountant ould be a full revie of orking capital re!uirements and its control. He reports his concerns e%pressed regarding the control of stocks and Steve asks him to prepare a presentation on the issues of inventory control for the ne%t management meeting, to hich he plans to invite both the production and stores managers. (reliminary notes prepared by John in advance of the meeting )n manufacturing and distributive trades, inventories *or stocks+ constitute a substantial portion of total assets employed. )nventory control comprises accounting and the physical control of materials, ork-in-progress and finished goods. &ccounting control is effected by the use of a series of control accounts for each category listed above and stores ledger accounts relating to !uantities and values of stock on hand. (hysical control comprises strategy for buying, handling, storing, issuing, supervising the stores function and taking stock. )nherent in any system of inventory control is the concept of stock levels, hich are normally e%pressed in physical units but may also be in money terms. The objective of establishing control levels is to ensure that e%cessive stocks are not carried and orking capital is not sacrificed, thereby avoiding the likelihood of being out of stock of any material. ,hat are the factors to be considered hen establishing control levels-

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These include8 i ii iii iv v vi vii viii ,orking capital available and the cost of capital. &verage consumption or production re!uirements. The re-order period 9 the period bet een placing the order and receiving delivery. Storage space available. $arket conditions. 4conomic order !uantity. (ossibility of loss through deterioration or obsolescence. Costs of ordering, receiving, inspecting and accounting.

The stock levels used in inventory control systems for both accounting and physical measures are minimum stock, ma%imum stock, re-order level and the re-order !uantity or economic order !uantity: and ) suggest that e implement such controls across our range of stock. $inimum stock level8 ;The lo est level to hich stocks should normally be allo ed to fall, and is held as a buffer stock to be made available in situations of non-delivery by a supplier<. )t takes into account the re-order level and average consumption in the average delivery period. $a%imum stock level8 ;The highest level to hich stock should normally be allo ed to rise, other ise too much orking capital is tied up, thus sacrificing li!uidity, and there is a risk of loss through deterioration and obsolescence<. )t takes account of the re-order level, the re-order !uantity and the minimum consumption in the minimum delivery period. /e-order level8 ;This is the level at hich an order ould normally be raised<. )t takes into account the ma%imum usage in the ma%imum delivery period. /e-order !uantity or economic order !uantity8 ;This is the !uantity hich is most economical to order as it minimises the costs of ordering and the carrying costs such as storage, insurance and interest on capital<. .nce the re-order !uantity has been determined, the other control levels can be determined by the follo ing formulae8 $inimum stock level = /e-order level 9 *average usage in average delivery period+.

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$a%imum stock level = /e-order level > re-order !uantity 9 *minimum usage in minimum delivery period+. /e-order level = ma%imum usage % ma%imum delivery period. 4%ample8 The follo ing relates to stock item C.? @, calculate8 re-order level ma%imum stock level minimum stock level #677 units ma%imum B77 units minimum ma%imum C months minimum 6 months "777 units

Asage per month8 4stimated delivery period8 /e-order !uantity8

/e-order level = C % #677 = CD77 units $a%imum level = CD77 > "777 - *B77 % 6+ = E777 units $inimum level = CC77 - *#7@7 % "+ = #6@7 units The tabulation belo sho s a typical cycle of events for this stock item. This is a monthly summary and assumes that stock as received on the last day of month 6 and @. /e-order levels ould have been reached at the start of month #, prior to the end of month " and to ards the latter part of month E. This summary is based on monthly receipts and issues. Ho ever the status of stock ould be reported daily. Stock Item COV 5 (Units /e-order and usage profile8 $onth # F F $onth 6 F F $onth " $onth C $onth @ F F $onth E .pening balance )ssues )ssues /eceipt of order )ssues )ssues )ssues /eceipt of order )ssues !uantity #677 ##77 "777 #677 #677 ##77 "777 ##77 "alance @777 "D77 6G77 @G77 C@77 ""77 6677 @677 C#77

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,hen graphed this profile sho s8

E777 @777 C777 A1)TS "777 6777 $)1)$A$ 34?43 #777 /4-./'4/ 34?43 $&H)$A$ 34?43

" $.1THS

The graph sho s the movement of stock and the levels kept levels of control.

ithin the predetermined

)n the model illustrated so far, the re-order !uantity is given. Ho ever, consideration must no be given to the determination of the economic order !uantity. ,hen an order is placed ith a supplier, certain start-up costs such as administration are incurred. )f this as the only factor for consideration, e ould make the order as large as possible, thus benefiting from ma%imum discounts. Iut, as previously mentioned, e must consider the holding costs. The economic order !uantity is that !uantity hich minimises the total of the starting and carrying costs. There are t o methods of determining this. .ne is the tabular method, the other by mathematical model.

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*i+ ,here

$athematical formula J & ( S J = = = = = 4conomic order !uantity &nnual demand in units Cost of placing an order Cost of holding one unit in stock for one year 6&( S

&ssume that in case of a further stock item C.? E, E777 units are re!uired annually and that e%penses relating to start up costs are K6@ per order and carrying costs are K7.67 per unit per annum. .rders could be arranged in lots of E77, #677, 6777, "777 or E777. Then8 J J = = 6 % E777 % 6@ 7.67 #66@ units or @ orders per annum

#a$ular Met%od *#+ *6+ *"+ *C+ *@+ .rder siLe Mre!uency of orders &verage stock *#N6 batch siLe+ Starting costs *no. of orders % K6@+ Carrying costs *average stock % K7.67+ E77 #7 "77 & 6@7 E7 "#7 #677 @ E77 & #6@ #67 6C@ 6777 " #777 & G@ 677 6G@ "777 6 #@77 & @7 "77 "@7 E777 # "777 & 6@ E77 E6@

#otal Cost

Mrom this tabulation it appears that the 4.J is #677 units as this minimises the total costs.

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'resented (rap%ically KE77 K@77 KC77 K"77 K677 K#77 7 # 6 " .rder siLe C @ E 777<s units Cost Total cost 4conomic order !uantity #677 Carrying cost

Conclusion ) intend to apply these controls and this model to a sample of stock items over the ne%t fe months to determine the possible savings in terms of investment in orking capital.

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