Inventory Management Corporate Finance Part 2 Section B Episode 22 CMA USA

Welcome back to another episode of CMA USA Exam Coach. In this video, we continue our journey through the topic of working capital management. And today, our focus is on inventory management. Now, what exactly is inventory? In simple terms, inventory refers to the goods and materials that a company holds for the purpose of resale or production. It includes raw materials, work in progress, and finished goods. But why is inventory such a critical component in financial management? Because inventory is a major asset on a company's balance sheet. It ties up cash, cash that could otherwise be used in other areas of the business. If a company holds too much inventory, it faces higher storage costs and the risk of obsolescence. But if it holds too little, it risks stockouts, delayed sales, and unhappy customers. So, managing inventory is about finding the right balance. Enough to meet demand, but not so much that it hurts cash flow or increases costs unnecessarily. In this episode, we'll break down the different types of inventory, explore key inventory control techniques like economic order, quantity, EOQ, economic lot size, and much more. We'll also look at how inventory levels impact working capital and the overall financial health of a business. Let's get started. Let's understand the different types of inventory because inventory doesn't mean the same thing for every kind of business. We can broadly classify inventory based on the nature of the business, whether it's a trading company or a manufacturing company. Let's look at each one in detail. First, trader's inventory. Trading businesses, like wholesalers, retailers, or resellers, don't manufacture products. They simply buy goods and sell them. So, their inventory consists only of finished goods. These are ready-to-sell products that were purchased from a supplier or manufacturer and are waiting to be sold to customers. For example, a supermarket's inventory is made up of finished products like canned food, beverages, or toiletries, products that are ready for immediate sale. Since traders don't have production activities, they don't hold raw materials or work in process. Their inventory management is focused on controlling stock levels of finished goods to avoid overstocking or running out of fast-moving items. Now, let's move to manufacturing inventory. In manufacturing businesses, the inventory is more complex. It includes three major components. One, raw materials. These are the basic inputs or resources used to produce goods. For example, for a furniture manufacturer, raw materials might include wood, nails, glue, and paint. Managing raw material inventory ensures that production doesn't stop due to a shortage of essential inputs. Two, work in process WIP. These are partly finished goods that are still in the production process. They have started the manufacturing cycle but are not yet complete. For example, a half-assembled chair in a furniture factory would be considered WIP. This category is important because it represents both material and labour costs that are in progress but not yet generating revenue. Three, finished goods. These are completed products that are ready to be sold to customers or transferred to distributors. Finished goods are similar to what traders hold, but in a manufacturing setting, they represent the final output of the production cycle. Too much finished goods inventory may lead to excess storage costs, while too little could result in missed sales opportunities. So, in summary, trading companies hold only finished goods, while manufacturing companies maintain three types of inventory. Raw materials, work in process and finished goods. Now that we know what inventory is and the different types, let's move on to an important topic, the different costs associated with inventory. Understanding these costs is crucial because effective inventory management is all about balancing these costs to optimise profitability and working capital. There are five key inventory-related costs that every CMA student should know. One, purchase cost. This is the cost of buying inventory, all costs related with purchasing the inventory and making the inventory available. In-company warehouse includes cash paid to supplier, transportation, loading and unloading, insurance, duties and taxes. Let's say a company purchases 1,000 units of a product at $10 per unit. That means the purchase cost is 1,000 units multiplied by $10 equals $10,000. Purchase cost is often the largest part of total inventory investment, especially for trading companies. While this cost is usually fixed per unit, discounts can be offered for bulk purchases. We'll see how this ties in with economic order quantity later. Two, carrying cost, also called holding cost. Carrying cost refers to the cost of holding or storing inventory over time. This includes storage space, insurance, depreciation, obsolescence and opportunity cost of tied-up capital. Let's say the company holds an average of 500 units in inventory over the year and the carrying cost per unit per year is $2. So, carrying cost equals 500 units times $2 equals $1,000 per year. This cost increases if you hold more inventory, so businesses must find the sweet spot, enough inventory to meet demand, but not so much that storage costs rise unnecessarily. Three, stock-out cost. Stock-out cost is the cost of running out of inventory. This includes lost sales, customer dissatisfaction, or even the cost of emergency restocking. For example, imagine a store runs out of a popular product and loses 50 sales, each worth $20 profit. That's 50 multiplied by $20 equals $1,000 lost in profit. Additionally, customers might go to a competitor and never return. That long-term impact can be much higher than just one lost sale. So, while holding too much inventory is costly, having too little can also hurt the business. Four, ordering cost. This is the cost of placing and processing an order for inventory. It includes administrative work, shipping charges and inspection. Let's say the ordering cost per order is $100 and the company places 12 orders a year. That gives us 12 orders multiplied by $100 equals $1,200 per year in ordering cost. This cost decreases if you order in large quantities less frequently. But remember, larger orders mean higher carrying costs. So again, it's a trade-off. Five, set-up cost for manufacturers. In manufacturing, there's an extra category called set-up cost, which is the cost to prepare machines and processes for a production run. Let's say each time the factory changes over to a different product batch, it costs $500. If they do this 10 times a year, 10 set-ups times $500 equals $5,000 per year in set-up costs. This is similar in nature to ordering cost, but specific to internal production. To summarize, purchase cost is what you pay per unit. Carrying cost is cost of holding inventory. Stock-out cost is the cost of running out of stock. Ordering cost is cost of placing inventory orders. Set-up cost is the cost to prepare manufacturing equipment. Each of these costs affects the decision on how much inventory to order and when. Now let's understand some key terms that are essential for managing inventory efficiently. These terms help us decide when to order and how much to keep in stock to avoid stock-outs and delays. We'll cover three important concepts. One, inventory lead time. Lead time is the time delay between placing an order and actually receiving the goods. For example, let's say a company places an order with a supplier on June 1st and the goods arrive on June 10th. In this case, the lead time is nine days. Lead time is important because during this period, the company continues to sell or use inventory. If we don't account for lead time, the stock might run out before the new inventory arrives, causing delays or lost sales. Some businesses also include internal lead time, like inspection or unpacking time after delivery. Two, reorder point. The reorder point is the inventory level at which a new order should be placed to replenish stock before it runs out. The formula is reorder point equals daily usage times lead time. Let's look at a simple example. If a company uses 100 units per day and the lead time is five days, then reorder point equals 100 multiplied by five equals 500 units. This means that when the inventory level drops to 500 units, the company should place a new order so that the new stock arrives just in time before running out. If the company waits too long and orders after it hits zero, it will face stock out costs. Three, safety stock or buffer stock. Safety stock is the extra inventory kept on hand to protect against unexpected spikes in demand or delays in supply. Let's say the company usually sells 100 units per day, but occasionally demand spikes to 130 units, or the supplier sometimes delivers a few days late. To avoid stock outs in such situations, the company adds a safety stock, let's say of 200 units. So now, instead of placing the order at exactly 500 units, as per our earlier example, the reorder point becomes Reorder point equals daily usage multiply lead time plus safety stock equals 100 multiply by five plus 200 equals 700 units. This means the company will place a new order when inventory reaches 700 units, giving them enough buffer to absorb unexpected situations. Safety stock is especially important for critical items, seasonal fluctuations, or when supply chains are not reliable. Let's summarize. Inventory lead, the time gap between ordering and receiving inventory. Reorder point, the inventory level at which a new order is placed. Safety stock, the extra stock kept as a cushion for uncertainties. Now let me also mention how we can express the reorder point in the form of an equation. The reorder point tells us the inventory level at which we should place a new order, so that we don't run out of stock before the new inventory arrives. We can calculate it using this simple formula. Reorder point equals safety stock plus lead time multiplied by average daily sales. Let me repeat that again slowly. Reorder point equals safety stock plus lead time multiplied by average daily sales. This formula helps companies make sure that even during the time they are waiting for a new order to arrive, they will still have enough inventory to meet customer demand. And the safety stock adds a cushion to protect against any unexpected delays or sudden increase in demand. It's a simple but powerful formula that helps prevent stock outs and keeps operations running smoothly. All right students, let's now begin our discussion on inventory management models. And the first model we will study is called economic order quantity or simply EOQ. EOQ helps a business calculate the optimum quantity of inventory it should order each time it places an order. This is a critical decision because ordering either too little or too much can increase the company's total inventory related costs. Let me explain. When a company places orders in very small quantities, it has to place orders more frequently. And every time an order is placed, it involves administrative work, shipping arrangements, paperwork, invoice processing, and coordination with suppliers. All of these are part of what we call the ordering cost. So if the company places many small orders, the total ordering cost becomes very high. Now imagine the other extreme. What if the company decides to place one large order to cover the entire year's demand? This might reduce the number of orders and bring down the ordering cost. But now the company will have a large quantity of inventory sitting in its warehouse. That means higher storage costs, higher insurance, a greater risk of spoilage or obsolescence, and also the opportunity cost of capital tied up in unsold goods. This is what we call the carrying cost. So you can see the trade-off. If we order too little, we spend more on ordering costs. If we order too much, we spend more on carrying costs. What we want is a balance, a quantity that minimizes the total cost. This is exactly what EOQ helps us calculate. EOQ is the order quantity at which the combined total of ordering cost and carrying cost is at its minimum. It tells us the most efficient quantity to order considering both cost factors. Now let's look at the formula used to calculate EOQ. EOQ is equal to the square root of 2 multiplied by A times D divided by K. In this formula, A represents the ordering cost per order, D represents the annual demand or the total number of units required in a year, and K represents the carrying cost per unit per year. So again, EOQ is equal to the square root of 2 multiplied by A multiplied by D and then divided by K. This simple formula gives us the exact number of units we should order each time to minimize our total inventory costs. It helps businesses avoid both frequent ordering and excessive holding of inventory. If you've already studied cash management, you might find this formula familiar. That's because the same logic is used in the Baumol model, which we use to manage cash and marketable securities. In both cases, the idea is to find an optimal level by balancing two opposing costs. In EOQ, it is ordering cost and carrying cost. In the Baumol model, it is transaction cost and opportunity cost. So to summarize, EOQ is an essential inventory management tool. It helps companies avoid the cost of frequent ordering, as well as the cost of holding too much inventory. In the next slide, we will go step by step through a numerical example so you can learn exactly how to apply this formula in real-life situations and in your CMA exam. Now that we've understood the concept and formula for economic order quantity, let's apply it to a sample question. Here's the question. ABC company makes footballs using leather. The company requires 12,000 square meters of leather during the next year. The average carrying cost is $3 per unit, and the average ordering cost is $450 per order. Based on this information, we are asked to calculate the EOQ. Let's break this down slowly and understand what is being given. First, the company is planning its inventory for leather, which is a raw material used to make footballs. They're expecting to use 12,000 square meters of leather over the next year. This is their annual demand, the total quantity of inventory they will need across the year. Next, we are told that the average carrying cost is $3 per unit per year. This means for every one square meter of leather held in inventory, the company incurs a cost of $3 each year. This includes storage, insurance, and other related expenses. We are also given the ordering cost, which is $450 per order. This is the cost the company incurs every time it places a purchase order, regardless of how many units are ordered in that batch. So, what are we asked to find? We are asked to calculate the economic order quantity, that is, how many square meters of leather the company should order each time it places an order, so that it minimizes the total cost of ordering and carrying inventory. Now we are going to use the EOQ formula to calculate how many square meters of leather the company should order each time. The EOQ formula is EOQ equals the square root of open parenthesis, two times A times D, divided by K, close parenthesis, where A is the ordering cost per order, which is $450. D is the annual demand, which is 12,000 square meters. K is the carrying cost per unit per year, which is $3. Let's plug in the values. EOQ equals the square root of 2 times 450 times 12,000, divided by 3. First, we multiply 2 times 450, which gives us 900. Then we multiply 900 by 12,000. That gives us 10,800,000. Now we divide 10,800,000 by 3. Which gives us 3,600,000. Finally, we take the square root of 3,600,000. That gives us an EOQ of approximately 1,897 units. So, the company should order approximately 1,897 square meters of leather each time it places an order. Now let's calculate how many times the company needs to place orders during the year. We already know the company needs 12,000 square meters of leather over the entire year. If they order 1,897 units at a time, we divide 12,000 by 1,897. 12,000 divided by 1,897 equals approximately 6.3. This means the company will place around 6.3 orders in a year. Since we can't place a fraction of an order in real life, this means they will likely place around 7 orders per year. Now, let's take this one step further. If the company places around 7 orders per year, and there are 365 days in a year, we divide 365 by 7. 365 divided by 7 is approximately 52 days. So what does this mean? It means that the company should place an order roughly once every 52 days in order to maintain an optimum inventory level, minimize total costs, and avoid overstocking or stockouts. This is the power of the EOQ model. It gives clear, data-driven answers that help the company plan inventory purchases efficiently, reduce unnecessary expenses, and improve working capital management. Let's look at another important area related to inventory management, how to calculate the carrying cost of inventory. In this question, we are going to break down each component that makes up the total carrying cost so you understand how to apply it in the real world and in your CMA exam. Let's begin by reading and understanding the scenario. We are told that a company purchases inventory at a total cost of $380. In addition, they incur a transportation charge of $20. So the total cost of acquiring the inventory becomes 380 plus 20, which is $400. This total cost of $400 is now the value of one unit of inventory, fully delivered and ready to be stored. Now, we are told that the company applies a 9% annual opportunity cost on the capital invested in inventory. That means the business expects to earn 9% per year if that money were invested elsewhere. So, holding inventory has an opportunity cost. We are losing the chance to earn that return. Let's calculate that now. 9% of $400 is $36 per year. That's the annual opportunity cost of holding one unit of this inventory. Now, we are asked to calculate this on a monthly basis. So, we divide $36 by 12 months, which gives us $3 per month. This is the monthly opportunity cost of holding that unit in stock. In addition to this, we are told there are other carrying expenses, such as storage and insurance, which total $15 per month. So, now let's calculate the total monthly carrying cost. We add the monthly opportunity cost of $3 and the other carrying expenses of $15. This gives us a total carrying cost of $18 per unit per month. The unloading cost, or the cost of placing an order, may choose not to include them in the per unit carrying cost calculation. Why is that? Because these types of costs are usually fixed per order, not per unit. That means the cost remains the same no matter how many units we order. Whether we order 10 units or 1,000 units, the cost of unloading or the administrative cost of placing the order will be the same. Since carrying cost is calculated per unit, we only include those expenses that actually vary with the number of units held in inventory, like storage cost, insurance, or opportunity cost. However, if any of these costs are given on a per unit basis, then yes, we must include them in the carrying cost calculation. So remember, only include costs in the per unit carrying cost if they apply per unit. If they apply per order, they are treated separately as ordering costs in the EOQ formula. Let me repeat that clearly. The total cost to carry one unit of this inventory for one month is $18. This includes both the opportunity cost of the capital tied up in the inventory and the physical costs of storing and protecting the item. This type of calculation is extremely important in inventory planning, especially when comparing suppliers, evaluating purchase discounts, or applying the EOQ formula. Always remember, carrying cost is not just storage, it includes everything related to holding the inventory, including lost investment opportunities. Let's review another important question related to inventory management. Calculating average inventory when safety stock is involved. Here's the question. ABC Manufacturing Corporation uses the standard economic order quantity model. For product X, the economic order quantity is 200 units. In addition, ABC maintains a safety stock of 50 units for this product. The question asks, what is the average inventory of product X? Let's understand what is given and what is being asked. We know that the economic order quantity, or EOQ, is 200 units. This means that ABC orders 200 units of product X every time they replenish their stock. We also know that there is a safety stock of 50 units. Safety stock is extra inventory held to protect against unexpected demand or supply delays. It acts as a buffer. Now, to calculate average inventory, we need to understand the minimum and maximum inventory levels. The minimum inventory is the safety stock itself, which is 50 units. This is the lowest amount of inventory ABC wants to keep at any time. The maximum inventory is the safety stock plus the EOQ. So, that would be 50 plus 200, which equals 250 units. This is the highest inventory level right after a new order arrives. Average inventory is calculated as the average of the minimum and maximum inventory. In other words, we add the minimum and maximum inventory and then divide by 2. So, average inventory equals 50 plus 250 divided by 2. 50 plus 250 equals 300, and 300 divided by 2 gives us 150 units. Therefore, the average inventory of product X is 150 units. This average inventory value is important for calculating carrying costs, planning warehouse space, and managing working capital. Remember, whenever safety stock is involved, always include it when calculating minimum and maximum inventory levels, and then find the average. All right students, now that we've covered economic order quantity, let's move on to our second important inventory management model called economic lot size. This model is mainly used by manufacturers to decide how many units they should produce in each production run. Think about a factory that makes products using machines. Every time the factory starts a new production run, it has to spend time and money setting up the machines. This setup cost can be significant. At the same time, if the factory produces too many units in one run, it will have to store a large amount of finished goods, which increases the carrying cost. On the other hand, if the factory produces very small lots frequently, it will have to pay the setup cost many times, increasing the total setup cost. The economic lot size model helps manufacturers find the optimal number of units to produce in each run, so that the total cost of machine setup and carrying inventory is minimized. In simple words, economic lot size balances the cost of setting up the machines and the cost of holding inventory, just like EOQ balances ordering and carrying costs. This model is very useful because it helps manufacturers improve efficiency, reduce unnecessary expenses, and keep production and inventory in balance. Before we close this episode, let's quickly review a key inventory management ratio that we have actually discussed in one of our earlier sessions. You'll find it under the topic of financial ratios or activity ratios. The ratio we're talking about is the inventory turnover ratio, often abbreviated as ITR. This ratio helps us understand how efficiently a company is managing its inventory. More specifically, it tells us how many times the inventory is sold or replaced over a given period, usually one year. The formula for inventory turnover ratio is Inventory turnover equals cost of goods sold divided by average inventory. Let me explain this in simple terms. The numerator, which is the cost of goods sold, represents the total cost of the products that were sold during the year. The denominator, average inventory, tells us the average value of inventory held by the company during that year. So, by dividing the cost of goods sold by average inventory, we get a number that shows how many times the inventory has turned over, or in other words, how many times it has been completely used up and replaced. A higher inventory turnover ratio generally means the company is selling products quickly and managing inventory well. It indicates that inventory is moving efficiently, which is usually a good sign. On the other hand, a lower ratio could suggest that inventory is moving slowly, which may lead to higher carrying costs or even inventory obsolescence. This ratio is especially important when analyzing inventory performance across different time periods or when comparing different companies in the same industry. If you want a more detailed explanation with examples and interpretations, I recommend revisiting the episode where we discussed activity ratios. That's where we went deeper into inventory turnover and how to use it in financial analysis. In summary, inventory turnover ratio is a powerful tool that connects financial data with an inventory management, and it gives valuable insights about a company's operational efficiency. Before we wind up, let's take a quick moment to summarize what we've covered in this episode on inventory management. First, we introduced the concept of inventory management and why it plays a crucial role in working capital planning. Then, we discussed the different types of inventory, including raw materials, work in process, and finished goods for manufacturers, and finished goods inventory for trading businesses. Next, we looked at the different costs associated with inventory, such as purchase cost, ordering cost, carrying cost, and stock-out cost. We explained each of these in detail, so you understand their impact on business decisions. After that, we went through some key inventory-related terms, including lead time, reorder point, and safety stock. We then moved into the heart of this lesson, exploring inventory management models. We studied the economic order quantity model, solved a complete example, and then briefly introduced the economic lot size model used in manufacturing settings. And finally, we revisited an important ratio we discussed in a previous episode, the inventory turnover ratio, which helps assess how efficiently a company manages and replaces its inventory. Thank you so much for watching this episode. I hope the concepts are now clear and easy to remember. As always, I encourage you to review your notes, practice-related questions, and make sure to go through the CMA material thoroughly so you're confident in the exam. All the best in your preparation, and I'll see you in the next episode.