Miller-Orr Model of cash management, Inventory management, Inventory costs, Economic order quantity, Reorder level, Discounts and EOQ

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Corporate Finance FIN 622

Lesson 29

INVENTORY MANAGEMENT

The following topics will be discussed in this lecture.

Miller-Orr Model of cash management

Inventory management

Inventory costs

Economic order quantity

Reorder level

Discounts and EOQ

Miller-Orr Model for Cash Management:

Most firms maintain a minimum amount of cash on hand to meet daily obligations or as a requirement from

the firm's bank. A maximum amount may also be specified to reflect the tradeoff between the transaction

cost of investing in liquid assets (e.g. Money Market Funds) and the cost of lost interest if the cash is not

invested. The Miller-Orr model computes the spread between the minimum and maximum cash balance

limits as

Spread = 3(0.75 x transaction cost x variance of daily cash flows / daily interest rate) ^(1/3)

(where a^b is used to denote "a to the power b").

The maximum cash balance is the spread plus the minimum cash balance, which is assumed to be known.

The "return point" is defined as the minimum cash balance plus spread/3.

Whenever the cash balance hits (or exceeds) the maximum, the firm should invest the difference between

the amount available and the return point; if the minimum is reached, sufficient securities should be sold to

bring it up to the return point.

· MILLER-ORR MODEL:

CASH

UPPER LIMIT

RETURN POINT

LOWER LIMIT

TIME

Graph Explanation:

When cash balance reaches point `A', the upper limit, company will invest the surplus to bring down the

cash balance to return point.

When cash balance touches down point `B', the lower limit, the company would liquidate some of its

securities to increase the balance back to return point.

Upper and lower limits are determined as explained above.

These limits depend upon variance of cash flow, transaction cost and interest rate.

If variability of cash flow is high and transaction cost is high too, then the limits will be wide apart,

otherwise narrow would suffice.

If interest rates are high then the narrow limits would be set.

Corporate Finance FIN 622

To keep interest cost as low as possible, the return point is set 1/3 of the spread between the lower and

upper limit.

Inventory Management:

Inventory management is the active control program which allows the management of sales, purchases

and payments.

Inventory management software helps create invoices, purchase orders, receiving lists, payment receipts

and can print bar coded labels. An inventory management software system configured to your warehouse,

retail or product line will help to create revenue for your company. The Inventory Management will

control operating costs and provide better understanding. We are your source for inventory management

information, inventory management software and tools.

A complete Inventory Management Control system contains the following components:

· Inventory Management Definition

· Inventory Management Terms

· Inventory Management Purposes

· Definition and Objectives for Inventory Management

· Organizational Hierarchy of Inventory Management

· Inventory Management Planning

· Inventory Management Controls for Inventory

· Determining Inventory Management Stock Levels

1. Inventory costs

Inventory costs depend on the amount of space required, and how much that space costs. If the assumption

is made that every part spends an equal amount of time located in inventory, then the cost of inventory can

be shared equally amongst all parts. This simplification leads to equation 3.4.1 as an expression for the

inventory costs:

Carrying cost:

Cost of holding an item in inventory.

Ordering cost:

Cost of replenishing inventory

Shortage Cost:

Temporary or permanent loss of sales when demand customers don't find the product in the market and

switch over to substitute products.

2. Economic order quantity

EOQ The amount of orders that minimizes total variable costs required to order and hold inventory.

Re-order quantity is the quantity for which order is placed when the stock reached re-orders level. By fixing

this quantity the purchaser has not to be to re-calculate the quantity to be purchased each time he orders for

material.

Re-order quantity is known as economic order quantity because it is the quantity which is most economical

to order. In other words, economic order quantity is that size of quantity of the order which gives

maximum economy in purchasing any material and ultimately contributes towards maintaining the material

at the optimum level and minimum cost.

While setting economic order quantity, two types of cost should be taken into account:

1. Ordering Cost: This is the cost of placing an order with the supplier. Because of so many factors

involved, it is quite difficult to quantify this cost. It mainly includes the cost of stationary, salaries of

those engaged in receiving and inspection, salaries of those engaged in placing an order, etc.

2. Cost of Carrying Stock: This is the cost of holding the stock in storage.

It includes the following:

(a) cost of operating the stores,(salaries, rent, stationary)

(b) the incidence of insurance cost;

(d) Deterioration and wastage of material.

Corporate Finance FIN 622

A graph illustrating the relationship amongst the Ordering Costs curve, the Holding Costs curve, the Total

Costs curve and the Economic ordering quantity

The single item EOQ formula can be seen as the minimum point of the following cost function:

Total cost = purchase cost + order cost + holding cost, which corresponds to:

Taking the derivative of both sides of the equation and setting equal to zero, one obtains

The result of this differentiation is:

Solving for Q:

3. Reorder level

This is that level of material at which purchase requisition is initiated for fresh supplies. This is fixed some

where between minimum level and maximum level. This is fixed in such a way that by re-ordering when

material falls to this level, then in the normal course of events, new supplies will be received just before the

minimum level is reached. Its formula is:

Re-order Level = Maximum consumption * Maximum re-order period

The following factors are considered in fixing this level:

Corporate Finance FIN 622

1. Rate of consumption of the material

2. Minimum level

3. Delivery time; i.e., the time normally taken from the time of initiating a purchase requisition, to the

receipts of material

4. Variation in delivery time.

4. Discounts and EOQ

Discounts are reductions to a basic price. They could modify either the manufacturer's list price

(determined by the manufacturer and often printed on the package), the retail price (set by the retailer and

often attached to the product with a sticker), or the list price (which is quoted to a potential buyer, usually in

written form). The market price (also called effective price) is the amount actually paid. The purpose of

discounts is to increase short-term sales, move out-of-date stock, reward valuable customers, or encourage

distribution channel members to perform a function. Some discounts and allowances are forms of sales

promotion.

EOQ The amount of orders that minimizes total variable costs required to order and hold inventory.

Re-order quantity is the quantity for which order is placed when the stock reached re-orders level. By fixing

this quantity the purchaser has not to be to re-calculate the quantity to be purchased each time he orders for

material.

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