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Q.1.A Objectives of a firm wishing to maximize profit?
To get the most profit, a company must have at least four main objectives:
1. Provide best customer service.
2. Provide lowest production costs.
3. Provide lowest inventory investment.
4. Provide lowest distribution costs.
These objectives create conflicts among the marketing, production, and finance departments because each has different responsibilities in these areas.
Marketing’s objective is to maintain and increase revenue; therefore, it must provide the best customer service possible. There are several ways of doing this:
Maintain high inventories so goods are always available for customers.
Interrupt production runs so that a non inventoried item can be manufactured quickly.
Create an extensive and costly distribution system so goods can be shipped. To the customer rapidly.
Finance must keep investment and costs low. This can be done in the following ways:
Reduce inventory so inventory investment is at a minimum.
Decrease the number of plants and wherehouses.
Produce large quantities using long production runs.
Manufacture only to customer order.
Production must keep its operating costs as low as possible. This can be done in the following ways:
Make long production runs of relatively few products. Fewer changeovers will be needed and specialized equipment can be used, thus reducing the cost of making the product.
Maintain high inventories of raw materials and work-in-process so production is not disrupted by shortages.
Q.1.B. Primary manufacturing strategies & the effects on delivery lead time
A highly market-oriented company will focus on meeting or exceeding customer expectations and on order winners. In such a company all functions must contribute toward a winning strategy. Thus, operations must have a strategy that allows it to supply the need of the marketplace and provide fast on-time delivery.
There are four basic primary manufacturing strategies: engineer-to-order, made-to-order, assemble-to-order, and make-to-stock. Customer involvement in the product design, delivery time, and inventory state are influenced by each strategy.
Engineer-to-order means that the customer’s specifications require unique engineering design or significant customization. Usually the customer is highly involved in the product design. Inventory will not normally be purchased until needed by manufacturing. Delivery lead time is long because it includes not only purchase lead time, but design lead time as well.
Make-to-order means that the manufacturer does not start to make the product until a customer’s order is received. The final product is usually made from standard items but many include custom-designed components as well/ delivery lead time is reduced because there is little design time required and inventory is held as raw material.
Assemble-to-order means that the product is made from standard components that the manufacturer can inventory and assemble according to a customer order. Delivery lead time is reduced further because there is no design time needed. And inventory is held ready for assembly. Customer involvement in the design of the product is limited to selecting the component part options needed.
Make-to-stock means that the supplier manufactures the goods and sells from finished goods inventory. Delivery time is shortest. The customer has little direct involvement in the product design
Q.1.C. Difference between make-to-order & assemble-to-order.
Make-to-order (MTO) sales model is a phenomenal success since the late 1990s. In this, the seller promises to deliver to the buyer at some future date a configuration the buyer desires. MTO sales model could help firms deal with both demand uncertainty and product cannibalization issues. First, MTO allows firms to produce a lower quantity while retaining the option to fulfill the demand if the demand happens to be high leading to reduction in inventory costs. Second, since MTO gives consumers an option to obtain the product that meets their preference, it helps firms to deal with product cannibalization problem more effectively. Interestingly, we find that with the MTO option, firms are more likely to lower the quality of the high-quality product, while the low-quality product is produced at a higher quality level than when there is no MTO option available.
The MTO model is widely observed in the marketplace today. It includes manufacturers such as Apple, Hewlett-Packard, Cisco, Sun, Levis, Sports Obermeyer, Lutron, etc. as well as retailers such as J. C. Penney, Home Depot, Best Buy, Virgin, etc. across categories ranging from information technology, consumer electronics, durables, music, apparel, fashion and home interiors. The conventional wisdom on popularity of the MTO model derives from the benefits it generates for the consumers as well as the channel. Consumers get what they want, albeit with a time lag. For the channel, MTO reduces the amount of inventory in the channel (which reduces capital costs considerably) and enables better segmentation and pricing.
We define an Assemble-to-order supply chain as a system consisting of push and a pull parts. In
the push part, undifferentiated components and subassemblies are manufactured to forecasts
whereas in the pull part, end products are assembled according to customer specifications. This
latter part is customer driven and largely determines how long customers wait between order
placement and delivery of final products.
Thus assemble-to-order supply chains trigger longer delivery times than traditional supply chains, in which products are directly picked out from the shelf. However, customers generally accept this delay because they highly value customized products which naturally require a specific time for assembly and shipment after order placement. It is worth noting that though customers would accept a certain delivery time; they would not agree with any delay. Dell is a good example of successful assemble-to-order supply chains in the computer industry. As the company was founded by 1984, other computer manufacturers were characterized by a high level of vertical integration with massive structures. The idea of Dell was to implement lean structures, while producing on customer demand and bypassing the retail through an innovative use of information technology. Due to a close relationship with suppliers, Dell optimized its inventories of components and operated its assembly system with nearly no work-in-process inventory. The assemble-to-order supply chain model enables Dell to reduce uncertainty while minimizing inventory costs in an industry that is characterized by the volatility of customer demand and rapid progress of technology (Magretta 1998).
Q.1.D. Three basic strategies used in developing a production plan
There are three different types of philosophies for coming up with a production plan — the match or chase strategy, the level strategy, and the combination.
• Demand matching (chase strategy): Produce the amounts that are demanded at any time.
• Level production: Continuously produce an amount equal to the average demand.
• In addition to the above pure strategies, a combination (hybrid) strategy may be used.
Chase (demand matching) strategy:
What happens at McDonald’s when two bus loads of Boy Scouts come in and order 40 cheeseburgers all at one time? Think about that. When you go to McDonald’s, those Boy Scouts don’t wait a long time. Ten or 12 minutes of waiting and they’ll go across the street and buy a pizza or something else. The manager is standing there. The manager has one person carrying out the garbage, another person cleaning up, somebody else doing something else; the manager says, “Quit all that — get up here, wash your hands, and cook hamburgers.”
So they shift their resources immediately. Even the manager goes back there and starts flipping hamburgers. If you’re going to follow that kind of a strategy, you have to be able to shift your resources quickly, which means that everybody has to be cross-trained to do the jobs that need to be done.
This strategy also has its disadvantages:
• As production increases, workers must be hired and trained. Extra shifts may be needed and overtime may be necessary. These requirements all increase cost.
• As production decreases, people are laid off and morale suffers.
• When production starts to increase again, the best workers may have other jobs and their skills will not be available.
• Manufacturing must have enough plant capacity to produce at the highest capacity needed.
You have the cost of layoffs because you cannot keep all your people on board once sales start dropping. So if you don’t have something else for them to do, you have to lay them off temporarily. This is where a lot of temporary labor is coming in. You bring people in, they work the job, then you let them go. They’re temporaries, not permanent, full time employees. As companies go into this kind of strategy, they start to use temporary labor. If they didn’t, it would have a serious impact on employee morale when they started laying people off.
Level Production Strategy:
The above figure shows a level production strategy. As before, sales are the solid line. Sales go along flat for while, and then they ramp up for awhile, and then begin to drop off again. Our production, however, stays level the entire time. The production control manager loves this. What about the financial people? They hate it; they’ll argue, “You’re building up inventory; you’re costing us money.”
The disadvantage of a level strategy is that, in lean sales periods, we’re building up inventory which we have to store until we need it; the advantage is we have a smooth, level production that avoids the cost of continuously matching demand.
Combination Strategy:
The third production strategy is a combination strategy, shown in the above figure. Companies that produce frozen orange juice can labels follow such a strategy. When you think about it, a frozen juice can is not really a can; rather it’s a rolled-up label which forms a can. They simply put a top and a bottom on it.
The orange juice market lasts only a few months. Oranges come in, they’re squeezed, the producer gets as many fresh out as he can, and what’s left over becomes frozen concentrate. So for a very brief period of two or three months, they’ve got to package all this frozen concentrate because they can’t do anything else with it. If they don’t freeze it, they lose it. So several companies in central Florida make these labels year round. Twelve months a year they’re cranking out these labels and storing them everywhere so that when the orange juice companies need these labels, they can bring them in and package the juice.
Now every year they run out of labels. Juice goes to waste because they’ve run out of places to put it. You see there’s a practical limit to their production because they can only store so many. Therefore, for three months out of the year, they’re working round the clock trying to keep up with the demand and the demand outpaces them every year.
For the combination strategy, we produce at close to or at full capacity for some part of the cycle, and we produce at a lower rate or don’t produce at all for the rest of the cycle. This makes use of our available capacity, and while we still get some inventory build-up and some inventory carrying costs, it’s not as much as with a level strategy. In effect, we’re trying to track our sales, but not as closely. The combination is what most companies usually wind up with.
Q.2.A. Purpose of a rough cut capacity plan
Rough-cut capacity planning checks whether critical resources are available to support the preliminary master schedule. A resource bill shows the time required for individual items on a critical resource. Once the preliminary MPSs are made, they must be checked against the available capacity. This process is called rough-cut capacity planning; its purpose is to check whether critical resources are available to support the master production schedule.
A key concern in our ability to meet the master schedule is the existence of bottlenecks. You may not know where your bottleneck work centers are, but you can be sure you have them. Suppose you have inventory piled up at each work center. Something is definitely wrong. At your bottleneck work center, you want to have a backlog of work so that it’s never out of material, but everything upstream of the bottleneck center shouldn’t have backlog; they should be running with excess capacity. It may be necessary to take work orders off the shop floor and remove WIP from the work centers.
If that’s the case, you need to do a rough-cut capacity check. Check those key work centers and check your resource bill. Make sure you can build what you need to. You’ll probably find that your demand and your resources are out of balance. Once you find out that they are out of balance, the next thing you’re going to have to do is change something.
You’re going to have to increase capacity if you need more capacity; you’re going to have to get more material if you need more material; you’re going to have to shift skills if that’s what you need. You may also have to change the master schedule. What? Change the master schedule? Of course! The master schedule is simply a tool.
Q.2.B. What is planned order and how is it created?
Planned orders are automatically scheduled and controlled by the computer. As gross requirement, projected available inventory, and scheduled receipts change, the computer recalculates the timing and quantities of planned order releases. The MRP program recommends to the planner the release of an order when the order enters the action bucket but does not release the order .
Releasing or launching a planned order is the responsibility of the planner. Whwen released, the order becomes an open order to the factory or to purchasing and appears on the MRP record as a scheduled receipt. It is then under the control of the planner, who may expedite, delay or even cancel the order.
Q.2.C. What are exception messages and what’s their purpose?
If the manufacturing process is under control and the material requirnments planning system is working properly, the system will work according to the plan. However, sometimes there are problems that need the attention of the planner. A good MRP system generates exception messagesto advise the planner when some events needs attention. Following are some examples of situations that will generate exception messages.
Components for which planned orders are in the action bcket and which should be considered for release.
Open orders for which the timing or quantity of scheduled receipts does not satisfy the plan. Perhaps a scheduled report is timed to arrive too early or late, and its due date should be revised.
Situations in which the standard lead times will result in late delivery of a zero-level part. This situation might call for expediting to reduce the standard lead times.
Q.2.D. Process of back scheduling
The usual process is to start with the due dat and, using the lead times, to work back to find the start date for each operation. This process is called back scheduling. To schedule, we need to know
The quantity and the due date.
Sequence of operations and work centers needed.
Setup and run times for each operation.
Queue, wait and move times.
Work center capacity available (rated or demonstrated).
The information needed is obtained from the following:
Order file – quantities and due dates.
Route file – sequence of operations, work centers needed, setup time, and run time.
Work center file – queue, move and wait times and work center capacity.
The process is as follows:
For each work order, calculate the capacity required (time) at each work center.
Starting with the due date, schedule back to get the completion and start dates for each operation.
Q.3. Process of back scheduling
The usual process is to start with the due dat and, using the lead times, to work back to find the start date for each operation. This process is called back scheduling. To schedule, we need to know
The quantity and the due date.
Sequence of operations and work centers needed.
Setup and run times for each operation.
Queue, wait and move times.
Work center capacity available (rated or demonstrated).
The information needed is obtained from the following:
Order file – quantities and due dates.
Route file – sequence of operations, work centers needed, setup time, and run time.
Work center file – queue, move and wait times and work center capacity.
The process is as follows:
For each work order, calculate the capacity required (time) at each work center.
Starting with the due date, schedule back to get the completion and start dates for each operation.
Q.3.A. Why is backward scheduling preferred?
Activities are scheduled back from the due date. Under backward scheduling, we know when the job has to be finished and, based on that, we work backwards to determine the latest point the job can start to meet that end date. Backward scheduling is common in the industry because it reduces inventory.
Q.3.B. Purpose of production reporting & why it is needed?
The first thing we need to know from the shop floor is the order status. This comes all the way back to your bill of material. When you construct your bill of material, your levels in the bill of material and in your routing, and your work steps within the routing, each of these should have their own run standard hours associated with them. Then, as you complete those operations, you can check them off as complete in the machine and your computer can then tell you what percent of the work has been completed. It’s not real time, but it’s near real time.
Production reporting provides feedback on what is actually happening by work center.
Order status
Exception reports
Inventory status
Labor reports
Machine performance
We also want exception reports from the shop floor. “The machine broke down again, so we’re running late and we’ve got to get it fixed.” We want to know that right away, not two days later when the job is late.
We also want to know inventory status, both material coming from the stockroom to go to the shop floor from our pick list especially if it’s short and material that’s finished and is going back to the stockroom. Finally, we want labor reports and machine performance reports. We want to track all of these to see whether there are any problems.
Q.3.C. Functions & purpose of different inventories:
A. Anticipation Inventory
Oftentimes, firms will purchase and hold inventory that is in excess of their current need in anticipation of a possible future event. Such events may include a price increase, a seasonal increase in demand, or even an impending labor strike. This tactic is commonly used by retailers, who routinely build up inventory months before the demand for their products will be unusually high (i.e., at Halloween, Christmas, or the back-to-school season). For manufacturers, anticipation inventory allows them to build up inventory when demand is low (also keeping workers busy during slack times) so that when demand picks up the increased inventory will be slowly depleted and the firm does not have to react by increasing production time (along with the subsequent increase in hiring, training, and other associated labor costs). Therefore, the firm has avoided both excessive overtime due to increased demand and hiring costs due to increased demand. It also has avoided layoff costs associated with production cut-backs, or worse, the idling or shutting down of facilities. This process is sometimes called "smoothing" because it smoothes the peaks and valleys in demand, allowing the firm to maintain a constant level of output and a stable workforce.
B. Fluctuation inventory (commonly called safety stock)
Fluctuation inventory is held to cover random unpredictable fluctuations in supply and demand or lead time. If demand or lead time is greater than forecast, a stockout will occur.
Safety stock is carried to protect against this possibility. Its purpose is to prevent disruptionms in manufacturing or deliveries to customers. Safety stock is also called buffer stock or reserve stock.
Inventory is sometimes used to protect against the uncertainties of supply and demand, as well as unpredictable events such as poor delivery reliability or poor quality of a supplier's products. These inventory cushions are often referred to as safety stock. Safety stock or buffer inventory is any amount held on hand that is over and above that currently needed to meet demand. Generally, the higher the level of buffer inventory, the better the firm's customer service. This occurs because the firm suffers fewer "stock-outs" (when a customer's order cannot be immediately filled from existing inventory) and has less need to backorder the item, make the customer wait until the next order cycle, or even worse, cause the customer to leave empty-handed to find another supplier. Obviously, the better the customer service the greater the likelihood of customer satisfaction.
C. Lot-size inventory
As per the concept of economic order quantity (EOQ) its know that the EOQ is an attempt to balance inventory holding or carrying costs with the costs incurred from ordering or setting up machinery. When large quantities are ordered or produced, inventory holding costs are increased, but ordering/setup costs decrease. Conversely, when lot sizes decrease, inventory holding/carrying costs decrease, but the cost of ordering/setup increases since more orders/setups are required to meet demand. When the two costs are equal (holding/carrying costs and ordering/setup costs) the total cost (the sum of the two costs) is minimized. Lot-size inventories, sometimes called cycle stock, result from this process. Usually, excess material is ordered and, consequently, held in inventory in an effort to reach this minimization point. Hence, cycle inventory results from ordering in batches or lot sizes rather than ordering material strictly as needed.
D. Transportation inventory
Transit inventories result from the need to transport items or material from one location to another, and from the fact that there is some transportation time involved in getting from one location to another. Sometimes this is referred to as pipeline inventory. Merchandise shipped by truck or rail can sometimes take days or even weeks to go from a regional warehouse to a retail facility. Some large firms, such as automobile manufacturers, employ freight consolidators to pool their transit inventories coming from various locations into one shipping source in order to take advantage of economies of scale. Of course, this can greatly increase the transit time for these inventories, hence an increase in the size of the inventory in transit.
Q.3.E. Purpose of cash flow analysis
The inflow and outflow of cash in a business over a period of time is the cash flow. To survive, a business must have cash available to pay its bills even if it has to borrow money to do so.
Let’s look at this process:
When inventory is purchased as raw material, it is recorded as an asset. When it enters production, it is recorded as work-in-process. As it is processed, its value increases by the amount of direct labor applied to it and the overhead attributed to its processing. The material is said to absorb overhead.
When the goods are ready for sale, they do not become revenue until they are sold. However, the expenses incurred in producing the goods have had to be paid for all along. This is the problem of cash flow. Businesses must have the cash to pay their bills. Cash is generated by sales, and the flow of cash into a business must be sufficient to pay bills as they become due.
How does cash flow relate to inventory?
Raw material is a cash outflow. A supplier who gives us raw material wants to be paid for it. If we don’t pay right away, the second time we order material from them they’ll say, “We will be glad to ship it to you as soon as you pay your bill.”
Inventory State Effect on Cash Flow
Raw Material Cash outflow
Work-in-progress Cash outflow
Finished goods Cash outflow
Accounts receivable paid Cash inflow
Work-in-process (WIP) is a cash outflow because we’re paying the labor to work on this WIP. So we’re paying money out and not getting anything back for it; we’re just changing the shape of the widget.
Finished goods are also a cash outflow. There’s a carrying cost, overhead; you don’t want to have a whole lot of finished goods in stock if you can help it — you’d like the customer to come and pick it up.
Apple Computer Example:
When Apple Computer first designed the Macintosh computer, they were the first and (to date) the only fully automated factory in the country ever. They didn’t have any finished goods warehouse space. When the product reached the end of the assembly line, it went into a box, then onto a conveyor belt, and into a trailer truck. When the trailer was full, they hitched the cab to it and drove it away. That was their concept — keep the line running all the time and drive the product right to the store. I thought it was brilliant. They made a lot of money on the Macintosh. If we have finished goods just sitting around, it is cash outflow. We’re paying money just to have it sit there.
Lastly, accounts receivable paid is cash inflow. When we finally deliver the widget to the customer and it is paid for, we finally have cash inflow.
Q.4.A. What is the basic premise of ABC analysis? What are the three steps in making in ABC inventory analysis?
ABC classification is based on the premise that a small number of items represent the most critical values of the inventory. ABC inventory control separates the most significant items from the least important and it’s used to determine the degree and level of control for the inventory items. Rough cut, 20% of our items will represent 80% of our dollar value; that is, one in five parts or part numbers in our stockroom represent a huge majority of the cost of our inventory. Another 30% of our items represent another 15% of the total dollar value, which leaves 50% of the items in the stockroom that make up only about 5% of our inventory cost. From a value standpoint, fully half the parts out there just are not worth tracking. That’s not exactly true, because we do need to track the data but half the parts out there are very low cost and should be C parts.
A Items 20% of the items account for 80% of the total dollar usage
B Items 30% of the items account for 15% of the total dollar usage
C Items 50% of the items account for 5% of the total dollar usage
Steps in Making an ABC Analysis
1. Establish the item characteristics that influence the result of inventory management. This is usually annual dollar usage but may be other criteria, such as scarcity of material.
2. Classify items into groups based on the established criteria.
3. Apply a degree of control in proportion to the importance of the group.
There are several factors that would cause us to classify something as an A item. One, of course, is our annual dollar usage. The items we spend the most money on become A items. Another factor is scarcity of material. There are some items that are not high in cost but are difficult to obtain; so we promote them to A items. Quality problems can also determine the need for an A classification. Perhaps because of the nature of the item, it’s hard to maintain quality or maybe the vendor you’re getting the item from has had quality problems in the past but you don’t have another choice.
Q.4.B. Differences between FIFO & LIFO?
FIFO and LIFO are two different ways to account for the cost of inventory. FIFO stands for First In First Out, while LIFO stands for Last In First Out. It is important to understand the differences between the two because the COGS (cost of goods sold) line item on an income statement is affected by your choice of LIFO vs. FIFO accounting as is the valuation of inventory on the balance sheet. As a result, a company can impact both its earnings and current assets simply through its choice of inventory cost accounting measures.
It's worth noting that there are other methods of inventory accounting beside LIFO and FIFO, such as the specific identification method, but those are outside the scope of this article.
DEFINITION OF LIFO:
LIFO means that the inventory that you bought in the past is the last inventory to be sold and likewise that the inventory you purchased most recently is the inventory you sell most recently. Think about a giant pile of coal. The coal on the bottom of the pile was the first coal to be placed there, whereas the coal on the top of the pile was the most recent (or last) coal placed there. Now, when you go to sell the coal, obviously you are going to sell the coal on the top of the pile first - you aren't going to sell the coal buried on the bottom of the pile. In fact, you may never sell the coal on the bottom of the pile.
DEFINITION OF FIFO:
FIFO, on the other hand means the exact opposite. Namely, that the inventory you purchased in the past will be the first inventory that you sell, whereas the inventory that you purchased most recently will be the inventory you sell later. As an example, think about the milk in your grocer's refrigerator. As the grocer buys the milk (i.e. the inventory) he pushes it to the front of the frig and replaces newer milk behind it. In other words, the cartons of milk with the most recent dates are always the first cartons to be sold and the cartons with the later dates are only sold after the newer milk has already been sold.
INFLATION AND ITS IMPACT ON ACCOUNTING FOR INVENTORY:
Why is this seemingly meaningless difference in accounting methods important? Well, if you turnover your inventory very quickly (as is the case with milk) it is probably not that big of a deal. However, if your inventory turns over very slowly it can have a major impact. Consider again the pile of coal. Who knows how long those first pieces of coal on the bottom of the pile have been sitting there? The reason we care about that question is because of inflation. Inflation causes prices to rise over time. Therefore, the price a company paid for the coal on the bottom of its pile is much different than the price the company paid for the coal on the top of its pile.
LIFO VS. FIFO AND ITS IMPACT ON THE FINANCIAL STATEMENTS:
Bringing these examples back to accounting we can see how this choice of LIFO vs. FIFO affects both the cost of inventory (COGS) on the income statement and the value of inventory on the balance sheet. In an environment of rising prices (which is usually the environment in most developed economies) if you choose the LIFO method of accounting then the inventory that you sell costs more than the inventory that you have remaining. Again, think about the pile of coal. The coal on the top of the pile is the coal you sell and it costs more than the coal on the bottom of the pile (which may have been purchased years ago). Therefore, choosing LIFO will result in lower inventory values on your balance sheet vs. FIFO and higher COGS on the income statement than FIFO.
Choosing the FIFO method of accounting will have the opposite affect. Namely, the inventory that you sell costs you less than the inventory that you have remaining (assuming rises prices which is generally the case). Therefore, the choice of FIFO accounting results in lower COGS on the income statement vs. LIFO and a higher inventory valuation on your balance sheet vs. LIFO.
LIFO VS. FIFO AND ITS IMPACT ON TAXES:
Now here's where it gets really complicated. Because FIFO results in lower COGS on the income statement, it also results in higher earnings. But when earnings are higher taxes are also higher. And when taxes are higher, after-tax earnings become lower. On the other hand, LIFO results in lower pre-tax earnings (since COGS are higher) and therefore lower taxes and therefore higher after-tax earnings. The interplay between pre-tax earnings, taxes and after-tax earnings is a complicated one and proper analysis must be used to choose the best accounting method for any given company.
THE CHOICE BETWEEN LIFO AND FIFO:
As a result of all of the above, the choice between LIFO and FIFO accounting allows a company to manipulate the cost of its inventory by choosing its method even if it is counterintuitive to the reality of their inventory purchasing situation. In other words, just because you actually sell the most recent pieces of coal that you bought does not mean that you have to choose the LIFO method of accounting for those purchases. You can choose FIFO if you wish and in fact most companies choose whichever method has the most favorable impact on their after-tax earnings.
It should be noted however that switching back and forth between the two methods from year to year is not a common practice. To switch from one method to another is a major hassle. And more importantly, if you continuously switch back and forth then investors will view that decision quite negatively.
It should also be noted that in accounting, companies often keep two separate sets of data. One for tax purposes and one for book purposes. This can be quite confusing when dealing with LIFO vs. FIFO because in some cases you can have two different inventory accounting methods, one for tax purposes and one for book purposes. However, in order to avoid situations where companies can get the best of both worlds by using FIFO for their books and LIFO for tax purposes, the IRS now requires that companies who choose LIFO for tax purposes must also choose LIFO for book purposes. Note however that this still allows a company to choose FIFO for tax purposes and LIFO for book purposes.
Q.4.C. What is SKU?
A SKU or Stock Keeping Unit is an identifier that is used by merchants to permit the systematic tracking of products and services offered to customers. Usage of the SKU system is rooted in the drill down method, pertaining to data management. SKUs are assigned and serialized at the merchant level. Each SKU is attached to an item, variant, product line, bundle, service, fee or attachment.
SKUs are not always associated with actual physical items, but are more appropriately billable entities. Extended warranties, delivery fees, and installation fees are not physical, but have SKUs because they are billable. All merchants using the SKU method will have their own personal approach to assigning the numbers based on regional or national corporate data storage and retrieval policies. SKU tracking varies from other product tracking methods which are controlled by a wider body of regulations stemming from manufacturers or possibly third-party regulations.
Consider this: a ball has a part number of 1234, it is packed 20 to a box, and the box is marked with the same part number 1234. The box is then placed in the warehouse. The box of balls is the stock keeping unit (SKU), because it is the stocked item. Even though the part numbers are interchangeable to mean either a ball or a box of balls, the box of balls is the stocked unit. There may be three different colors of balls; each of these colours will be a separate SKU. When the product is shipped, there may be 50 boxes of the blue balls, 100 boxes of the red balls, and 70 boxes of the yellow balls shipped. That shipment would be said to have been a shipment of 220 boxes, across three SKUs.
Successful inventory management systems assign a unique SKU for each product and also for its variants. For example, different flavors or models of product, or different bundled packages including a number of related products, have independent SKUs. This allows merchants to track, for instance, whether blue shirts are selling better than green shirts.
The acronym SKU is used almost exclusively when talking about merchant tracking, although there are other uses of this term.
Q.4.D.
A. Annual Ordering Cost
Annual ordering cost = number of orders * cost of ordering
Annual ordering cost can be defined as the Total expenses incurred in placing and order.
B. Annual Carrying Cost
Annual carrying cost = average inventory * cost of holding
Carrying cost refers to the total cost of holding inventory. This includes warehousing costs such as rent, utilities and salaries, financial costs such as opportunity cost, and inventory costs related to perishibility, shrinkage and insurance.
C. Total Annual Cost
Total annual cost = annual ordering cost + annual carrying cost
Example Problem
The annual demand is 10,000 units, the ordering cost $30 per order, the carrying cost 20%, and the unit cost $15. The order quantity is 600 units. Find
a) Annual ordering cost
b) Annual carrying cost
c) Total annual cost
Answer:
A= 10,000 units
S= $30
I= 0.20
C= $15
Q=600 units
a) Annual ordering cost=
Q.5. What is period-order quantity?
A. How is it established? When can it be used?
The economic-order quantity attempts to minimize the total cost of ordering and carrying inventory and is based on the assumption that demand is uniform. Often demand is not uniform, particularily in material requirements planning, and using the EOD does not produce a minimum cost.
The period-order quantity lot-size is based on the same theory as the economic-order quantity. It uses the EOQ formula to calculate an economic time between orders. This is calculated by dividing the EOQ by the demand rate. This produces a time interval for which orders are placed. Instead of ordering the same quantity (EOQ), orders are placed to satisfy requirements for the calculated time interval. The number of orders placed in a year is the same as for an economic-order quantity, but the amount ordered each time varies. Thus, the ordering cost is the same but, because the order quantities are determined by actual demand, the carrying cost is reduced.
Period-order quantity= EDQ
Average weekly usage
Q.5.B. Four characteristics of the order point system. Why is safety stock carried?
The Order Point Point (OP) is equal to Demand During Lead Time (DDLT) plus Safety Stock (SS) or
OP = DDLT + SS
(Eq. 6-2)
The above shows such a system. The order point formula (Eq. 6-2) tells us when to place an order. The Order Point, OP, equals DDLT, which is the demand during lead time plus SS, which is the safety stock. Lead time is how long it takes us to place the order and get it in. Demand during lead time is the quantity we’re going to use during that period of time. If our lead time to get the parts in is one week and we’re consuming 100 a week, then the demand during lead time would be 100. Add to that the safety stock.
Safety stock is a buffer against variances in demand. Sometimes we may use more than 100 during a week — we may use 102 or 103. Also, suppose the new order does not come in after five working days. It may be the morning of the sixth day before it comes in. For these kinds of reasons we use safety stock.
When the quantity on hand of an item falls to a predetermined level, called the order point, an order is placed. An order must be placed while there is enough stock on hand to satisfy demand during the lead time.
To reiterate then, an order point system would ask how long does it take to get the order in, how much are we going to use during that period of time, and how much safety stock do we need to carry just in case; the sum of those two quantities establishes our order point. All we have to do is monitor the inventory and when it gets down to that level, we place an order.
The figure below shows another example. Here demand is 100 units per week, lead time is 4 weeks, and safety stock is 100 units, so our order point is (100x4)+100 = 500. We have a bucket of widgets out there and when the bucket gets down to only 500 widgets left, it’s time to reorder.
An Order Point Example
Demand = 100 units per week
Lead time = 4 weeks
Safety stock = 100 units
OP = DDLT + SS
= 100(4) + 100
= 500
Place an order when 500 units are on hand.
That’s not telling us how much to order. We’ve already established how much to order; this just tells us when to place the order. Now “when” sounds kind of strange because “when” usually means a period of time, but we’re talking about when in relation to the number of units. With order point, quantities are usually fixed. How many we are going to order has usually been worked out with the vendor so we don’t have to think about that at this time.
The order point system should be automated because we are probably not going to have somebody going through the stockroom every day to see if we have reached the order point. If we have an MRP system that is tracking every part that comes in and goes out from our stockroom, then it can be preset to look at this item number and when it falls to 500, it’s time to launch an order. Having the computer do this is the only thing that makes sense.
Safety stock is used to prevent a stock out. The amount of safety stock we carry will depend on the variability of demand during lead time, the frequency of ordering, our desired service level, the length of lead time, and our ability to forecast and control the lead time
Safety stock, also called buffer stock and fluctuation stock, is used to prevent a stock out. The amount of safety stock carried depends on:
• Variability of ordering
• Frequency of ordering
• Desired service level
• Length of the lead time
• Ability to forecast and control lead times
We always have to balance the cost of a stock out against the cost of back orders, the cost of lost sales, and the cost of lost customers; once again these are qualitative not quantitative. It’s a management decision.
Q.5. C. Describe distribution requirement planning.
DRP is a system that forecasts when the various demands will be made by the system on central supply. This gives central supply and the factory the opportunity to plan for the goods that will actually be needed and when. It is able both to respond to customer demand and co-ordinate planning and control.
Distribution requirements planning or DRP is very similar to MRP. Referring to the figure below, At distribution center A, in week one we expect to release an order for 200 units, and an order for another 200 units in week 3. This is based on our internal forecast of customer demand. Distribution center B plans to release an order for 100 units in week 2. Both of these plans are communicated to the factory so that it can look three weeks ahead and say, “This is probably what’s going to happen (or very close to it).” The requirements of the distribution center become the gross requirements of Central Supply, so we have a gross requirement for 200 in week 1, 100 in week 2, and 200 in week 3.
Now we have 400 on hand at the factory prior to week 1. We know that we’re going to ship 200 in week 1 to meet the demand of distribution center A. Since it takes two weeks to build some more of these and we build them in lot sizes of 500, then, also in week 1, we had better plan to release a work order to build 500 more of these and have them available. If we in the factory have the information from the distribution centers, we can plan out our work in advance, that’s DRP, Distribution Requirements Planning, and any MRP system can be tweaked to do this as well because it uses the same logic.
Q.5.D. Name & describe the three functions in the flow of materials from supplier to consumer.
Elements that form each flow:
The materials flow includes the physical flow of products through the chain, from suppliers to customers, and the flow of reverse activities through returns, service, recycling and product elimination.
The information flow includes the transmission of orders and delivery status.
The financial flow includes credit conditions, payment programs and consignment and property title agreements.
Differences between physical supply & physical distribution
Physical supply is the movement and storage of goods from suppliers to manufacturing. Depending on the conditions of sale, the cost may be paid by either the supplier or the customer, but it is ultimately passed on to the consumer.
Physical Distribution, on the other hand, is the movement and storage of finished goods from the end of production to the consumer. The particular path in which the goods move - through distribution centers, wholesalers and retailers is called the channel of distribution.
To get the most profit, a company must have at least four main objectives:
1. Provide best customer service.
2. Provide lowest production costs.
3. Provide lowest inventory investment.
4. Provide lowest distribution costs.
These objectives create conflicts among the marketing, production, and finance departments because each has different responsibilities in these areas.
Marketing’s objective is to maintain and increase revenue; therefore, it must provide the best customer service possible. There are several ways of doing this:
Maintain high inventories so goods are always available for customers.
Interrupt production runs so that a non inventoried item can be manufactured quickly.
Create an extensive and costly distribution system so goods can be shipped. To the customer rapidly.
Finance must keep investment and costs low. This can be done in the following ways:
Reduce inventory so inventory investment is at a minimum.
Decrease the number of plants and wherehouses.
Produce large quantities using long production runs.
Manufacture only to customer order.
Production must keep its operating costs as low as possible. This can be done in the following ways:
Make long production runs of relatively few products. Fewer changeovers will be needed and specialized equipment can be used, thus reducing the cost of making the product.
Maintain high inventories of raw materials and work-in-process so production is not disrupted by shortages.
Q.1.B. Primary manufacturing strategies & the effects on delivery lead time
A highly market-oriented company will focus on meeting or exceeding customer expectations and on order winners. In such a company all functions must contribute toward a winning strategy. Thus, operations must have a strategy that allows it to supply the need of the marketplace and provide fast on-time delivery.
There are four basic primary manufacturing strategies: engineer-to-order, made-to-order, assemble-to-order, and make-to-stock. Customer involvement in the product design, delivery time, and inventory state are influenced by each strategy.
Engineer-to-order means that the customer’s specifications require unique engineering design or significant customization. Usually the customer is highly involved in the product design. Inventory will not normally be purchased until needed by manufacturing. Delivery lead time is long because it includes not only purchase lead time, but design lead time as well.
Make-to-order means that the manufacturer does not start to make the product until a customer’s order is received. The final product is usually made from standard items but many include custom-designed components as well/ delivery lead time is reduced because there is little design time required and inventory is held as raw material.
Assemble-to-order means that the product is made from standard components that the manufacturer can inventory and assemble according to a customer order. Delivery lead time is reduced further because there is no design time needed. And inventory is held ready for assembly. Customer involvement in the design of the product is limited to selecting the component part options needed.
Make-to-stock means that the supplier manufactures the goods and sells from finished goods inventory. Delivery time is shortest. The customer has little direct involvement in the product design
Q.1.C. Difference between make-to-order & assemble-to-order.
Make-to-order (MTO) sales model is a phenomenal success since the late 1990s. In this, the seller promises to deliver to the buyer at some future date a configuration the buyer desires. MTO sales model could help firms deal with both demand uncertainty and product cannibalization issues. First, MTO allows firms to produce a lower quantity while retaining the option to fulfill the demand if the demand happens to be high leading to reduction in inventory costs. Second, since MTO gives consumers an option to obtain the product that meets their preference, it helps firms to deal with product cannibalization problem more effectively. Interestingly, we find that with the MTO option, firms are more likely to lower the quality of the high-quality product, while the low-quality product is produced at a higher quality level than when there is no MTO option available.
The MTO model is widely observed in the marketplace today. It includes manufacturers such as Apple, Hewlett-Packard, Cisco, Sun, Levis, Sports Obermeyer, Lutron, etc. as well as retailers such as J. C. Penney, Home Depot, Best Buy, Virgin, etc. across categories ranging from information technology, consumer electronics, durables, music, apparel, fashion and home interiors. The conventional wisdom on popularity of the MTO model derives from the benefits it generates for the consumers as well as the channel. Consumers get what they want, albeit with a time lag. For the channel, MTO reduces the amount of inventory in the channel (which reduces capital costs considerably) and enables better segmentation and pricing.
We define an Assemble-to-order supply chain as a system consisting of push and a pull parts. In
the push part, undifferentiated components and subassemblies are manufactured to forecasts
whereas in the pull part, end products are assembled according to customer specifications. This
latter part is customer driven and largely determines how long customers wait between order
placement and delivery of final products.
Thus assemble-to-order supply chains trigger longer delivery times than traditional supply chains, in which products are directly picked out from the shelf. However, customers generally accept this delay because they highly value customized products which naturally require a specific time for assembly and shipment after order placement. It is worth noting that though customers would accept a certain delivery time; they would not agree with any delay. Dell is a good example of successful assemble-to-order supply chains in the computer industry. As the company was founded by 1984, other computer manufacturers were characterized by a high level of vertical integration with massive structures. The idea of Dell was to implement lean structures, while producing on customer demand and bypassing the retail through an innovative use of information technology. Due to a close relationship with suppliers, Dell optimized its inventories of components and operated its assembly system with nearly no work-in-process inventory. The assemble-to-order supply chain model enables Dell to reduce uncertainty while minimizing inventory costs in an industry that is characterized by the volatility of customer demand and rapid progress of technology (Magretta 1998).
Q.1.D. Three basic strategies used in developing a production plan
There are three different types of philosophies for coming up with a production plan — the match or chase strategy, the level strategy, and the combination.
• Demand matching (chase strategy): Produce the amounts that are demanded at any time.
• Level production: Continuously produce an amount equal to the average demand.
• In addition to the above pure strategies, a combination (hybrid) strategy may be used.
Chase (demand matching) strategy:
What happens at McDonald’s when two bus loads of Boy Scouts come in and order 40 cheeseburgers all at one time? Think about that. When you go to McDonald’s, those Boy Scouts don’t wait a long time. Ten or 12 minutes of waiting and they’ll go across the street and buy a pizza or something else. The manager is standing there. The manager has one person carrying out the garbage, another person cleaning up, somebody else doing something else; the manager says, “Quit all that — get up here, wash your hands, and cook hamburgers.”
So they shift their resources immediately. Even the manager goes back there and starts flipping hamburgers. If you’re going to follow that kind of a strategy, you have to be able to shift your resources quickly, which means that everybody has to be cross-trained to do the jobs that need to be done.
This strategy also has its disadvantages:
• As production increases, workers must be hired and trained. Extra shifts may be needed and overtime may be necessary. These requirements all increase cost.
• As production decreases, people are laid off and morale suffers.
• When production starts to increase again, the best workers may have other jobs and their skills will not be available.
• Manufacturing must have enough plant capacity to produce at the highest capacity needed.
You have the cost of layoffs because you cannot keep all your people on board once sales start dropping. So if you don’t have something else for them to do, you have to lay them off temporarily. This is where a lot of temporary labor is coming in. You bring people in, they work the job, then you let them go. They’re temporaries, not permanent, full time employees. As companies go into this kind of strategy, they start to use temporary labor. If they didn’t, it would have a serious impact on employee morale when they started laying people off.
Level Production Strategy:
The above figure shows a level production strategy. As before, sales are the solid line. Sales go along flat for while, and then they ramp up for awhile, and then begin to drop off again. Our production, however, stays level the entire time. The production control manager loves this. What about the financial people? They hate it; they’ll argue, “You’re building up inventory; you’re costing us money.”
The disadvantage of a level strategy is that, in lean sales periods, we’re building up inventory which we have to store until we need it; the advantage is we have a smooth, level production that avoids the cost of continuously matching demand.
Combination Strategy:
The third production strategy is a combination strategy, shown in the above figure. Companies that produce frozen orange juice can labels follow such a strategy. When you think about it, a frozen juice can is not really a can; rather it’s a rolled-up label which forms a can. They simply put a top and a bottom on it.
The orange juice market lasts only a few months. Oranges come in, they’re squeezed, the producer gets as many fresh out as he can, and what’s left over becomes frozen concentrate. So for a very brief period of two or three months, they’ve got to package all this frozen concentrate because they can’t do anything else with it. If they don’t freeze it, they lose it. So several companies in central Florida make these labels year round. Twelve months a year they’re cranking out these labels and storing them everywhere so that when the orange juice companies need these labels, they can bring them in and package the juice.
Now every year they run out of labels. Juice goes to waste because they’ve run out of places to put it. You see there’s a practical limit to their production because they can only store so many. Therefore, for three months out of the year, they’re working round the clock trying to keep up with the demand and the demand outpaces them every year.
For the combination strategy, we produce at close to or at full capacity for some part of the cycle, and we produce at a lower rate or don’t produce at all for the rest of the cycle. This makes use of our available capacity, and while we still get some inventory build-up and some inventory carrying costs, it’s not as much as with a level strategy. In effect, we’re trying to track our sales, but not as closely. The combination is what most companies usually wind up with.
Q.2.A. Purpose of a rough cut capacity plan
Rough-cut capacity planning checks whether critical resources are available to support the preliminary master schedule. A resource bill shows the time required for individual items on a critical resource. Once the preliminary MPSs are made, they must be checked against the available capacity. This process is called rough-cut capacity planning; its purpose is to check whether critical resources are available to support the master production schedule.
A key concern in our ability to meet the master schedule is the existence of bottlenecks. You may not know where your bottleneck work centers are, but you can be sure you have them. Suppose you have inventory piled up at each work center. Something is definitely wrong. At your bottleneck work center, you want to have a backlog of work so that it’s never out of material, but everything upstream of the bottleneck center shouldn’t have backlog; they should be running with excess capacity. It may be necessary to take work orders off the shop floor and remove WIP from the work centers.
If that’s the case, you need to do a rough-cut capacity check. Check those key work centers and check your resource bill. Make sure you can build what you need to. You’ll probably find that your demand and your resources are out of balance. Once you find out that they are out of balance, the next thing you’re going to have to do is change something.
You’re going to have to increase capacity if you need more capacity; you’re going to have to get more material if you need more material; you’re going to have to shift skills if that’s what you need. You may also have to change the master schedule. What? Change the master schedule? Of course! The master schedule is simply a tool.
Q.2.B. What is planned order and how is it created?
Planned orders are automatically scheduled and controlled by the computer. As gross requirement, projected available inventory, and scheduled receipts change, the computer recalculates the timing and quantities of planned order releases. The MRP program recommends to the planner the release of an order when the order enters the action bucket but does not release the order .
Releasing or launching a planned order is the responsibility of the planner. Whwen released, the order becomes an open order to the factory or to purchasing and appears on the MRP record as a scheduled receipt. It is then under the control of the planner, who may expedite, delay or even cancel the order.
Q.2.C. What are exception messages and what’s their purpose?
If the manufacturing process is under control and the material requirnments planning system is working properly, the system will work according to the plan. However, sometimes there are problems that need the attention of the planner. A good MRP system generates exception messagesto advise the planner when some events needs attention. Following are some examples of situations that will generate exception messages.
Components for which planned orders are in the action bcket and which should be considered for release.
Open orders for which the timing or quantity of scheduled receipts does not satisfy the plan. Perhaps a scheduled report is timed to arrive too early or late, and its due date should be revised.
Situations in which the standard lead times will result in late delivery of a zero-level part. This situation might call for expediting to reduce the standard lead times.
Q.2.D. Process of back scheduling
The usual process is to start with the due dat and, using the lead times, to work back to find the start date for each operation. This process is called back scheduling. To schedule, we need to know
The quantity and the due date.
Sequence of operations and work centers needed.
Setup and run times for each operation.
Queue, wait and move times.
Work center capacity available (rated or demonstrated).
The information needed is obtained from the following:
Order file – quantities and due dates.
Route file – sequence of operations, work centers needed, setup time, and run time.
Work center file – queue, move and wait times and work center capacity.
The process is as follows:
For each work order, calculate the capacity required (time) at each work center.
Starting with the due date, schedule back to get the completion and start dates for each operation.
Q.3. Process of back scheduling
The usual process is to start with the due dat and, using the lead times, to work back to find the start date for each operation. This process is called back scheduling. To schedule, we need to know
The quantity and the due date.
Sequence of operations and work centers needed.
Setup and run times for each operation.
Queue, wait and move times.
Work center capacity available (rated or demonstrated).
The information needed is obtained from the following:
Order file – quantities and due dates.
Route file – sequence of operations, work centers needed, setup time, and run time.
Work center file – queue, move and wait times and work center capacity.
The process is as follows:
For each work order, calculate the capacity required (time) at each work center.
Starting with the due date, schedule back to get the completion and start dates for each operation.
Q.3.A. Why is backward scheduling preferred?
Activities are scheduled back from the due date. Under backward scheduling, we know when the job has to be finished and, based on that, we work backwards to determine the latest point the job can start to meet that end date. Backward scheduling is common in the industry because it reduces inventory.
Q.3.B. Purpose of production reporting & why it is needed?
The first thing we need to know from the shop floor is the order status. This comes all the way back to your bill of material. When you construct your bill of material, your levels in the bill of material and in your routing, and your work steps within the routing, each of these should have their own run standard hours associated with them. Then, as you complete those operations, you can check them off as complete in the machine and your computer can then tell you what percent of the work has been completed. It’s not real time, but it’s near real time.
Production reporting provides feedback on what is actually happening by work center.
Order status
Exception reports
Inventory status
Labor reports
Machine performance
We also want exception reports from the shop floor. “The machine broke down again, so we’re running late and we’ve got to get it fixed.” We want to know that right away, not two days later when the job is late.
We also want to know inventory status, both material coming from the stockroom to go to the shop floor from our pick list especially if it’s short and material that’s finished and is going back to the stockroom. Finally, we want labor reports and machine performance reports. We want to track all of these to see whether there are any problems.
Q.3.C. Functions & purpose of different inventories:
A. Anticipation Inventory
Oftentimes, firms will purchase and hold inventory that is in excess of their current need in anticipation of a possible future event. Such events may include a price increase, a seasonal increase in demand, or even an impending labor strike. This tactic is commonly used by retailers, who routinely build up inventory months before the demand for their products will be unusually high (i.e., at Halloween, Christmas, or the back-to-school season). For manufacturers, anticipation inventory allows them to build up inventory when demand is low (also keeping workers busy during slack times) so that when demand picks up the increased inventory will be slowly depleted and the firm does not have to react by increasing production time (along with the subsequent increase in hiring, training, and other associated labor costs). Therefore, the firm has avoided both excessive overtime due to increased demand and hiring costs due to increased demand. It also has avoided layoff costs associated with production cut-backs, or worse, the idling or shutting down of facilities. This process is sometimes called "smoothing" because it smoothes the peaks and valleys in demand, allowing the firm to maintain a constant level of output and a stable workforce.
B. Fluctuation inventory (commonly called safety stock)
Fluctuation inventory is held to cover random unpredictable fluctuations in supply and demand or lead time. If demand or lead time is greater than forecast, a stockout will occur.
Safety stock is carried to protect against this possibility. Its purpose is to prevent disruptionms in manufacturing or deliveries to customers. Safety stock is also called buffer stock or reserve stock.
Inventory is sometimes used to protect against the uncertainties of supply and demand, as well as unpredictable events such as poor delivery reliability or poor quality of a supplier's products. These inventory cushions are often referred to as safety stock. Safety stock or buffer inventory is any amount held on hand that is over and above that currently needed to meet demand. Generally, the higher the level of buffer inventory, the better the firm's customer service. This occurs because the firm suffers fewer "stock-outs" (when a customer's order cannot be immediately filled from existing inventory) and has less need to backorder the item, make the customer wait until the next order cycle, or even worse, cause the customer to leave empty-handed to find another supplier. Obviously, the better the customer service the greater the likelihood of customer satisfaction.
C. Lot-size inventory
As per the concept of economic order quantity (EOQ) its know that the EOQ is an attempt to balance inventory holding or carrying costs with the costs incurred from ordering or setting up machinery. When large quantities are ordered or produced, inventory holding costs are increased, but ordering/setup costs decrease. Conversely, when lot sizes decrease, inventory holding/carrying costs decrease, but the cost of ordering/setup increases since more orders/setups are required to meet demand. When the two costs are equal (holding/carrying costs and ordering/setup costs) the total cost (the sum of the two costs) is minimized. Lot-size inventories, sometimes called cycle stock, result from this process. Usually, excess material is ordered and, consequently, held in inventory in an effort to reach this minimization point. Hence, cycle inventory results from ordering in batches or lot sizes rather than ordering material strictly as needed.
D. Transportation inventory
Transit inventories result from the need to transport items or material from one location to another, and from the fact that there is some transportation time involved in getting from one location to another. Sometimes this is referred to as pipeline inventory. Merchandise shipped by truck or rail can sometimes take days or even weeks to go from a regional warehouse to a retail facility. Some large firms, such as automobile manufacturers, employ freight consolidators to pool their transit inventories coming from various locations into one shipping source in order to take advantage of economies of scale. Of course, this can greatly increase the transit time for these inventories, hence an increase in the size of the inventory in transit.
Q.3.E. Purpose of cash flow analysis
The inflow and outflow of cash in a business over a period of time is the cash flow. To survive, a business must have cash available to pay its bills even if it has to borrow money to do so.
Let’s look at this process:
When inventory is purchased as raw material, it is recorded as an asset. When it enters production, it is recorded as work-in-process. As it is processed, its value increases by the amount of direct labor applied to it and the overhead attributed to its processing. The material is said to absorb overhead.
When the goods are ready for sale, they do not become revenue until they are sold. However, the expenses incurred in producing the goods have had to be paid for all along. This is the problem of cash flow. Businesses must have the cash to pay their bills. Cash is generated by sales, and the flow of cash into a business must be sufficient to pay bills as they become due.
How does cash flow relate to inventory?
Raw material is a cash outflow. A supplier who gives us raw material wants to be paid for it. If we don’t pay right away, the second time we order material from them they’ll say, “We will be glad to ship it to you as soon as you pay your bill.”
Inventory State Effect on Cash Flow
Raw Material Cash outflow
Work-in-progress Cash outflow
Finished goods Cash outflow
Accounts receivable paid Cash inflow
Work-in-process (WIP) is a cash outflow because we’re paying the labor to work on this WIP. So we’re paying money out and not getting anything back for it; we’re just changing the shape of the widget.
Finished goods are also a cash outflow. There’s a carrying cost, overhead; you don’t want to have a whole lot of finished goods in stock if you can help it — you’d like the customer to come and pick it up.
Apple Computer Example:
When Apple Computer first designed the Macintosh computer, they were the first and (to date) the only fully automated factory in the country ever. They didn’t have any finished goods warehouse space. When the product reached the end of the assembly line, it went into a box, then onto a conveyor belt, and into a trailer truck. When the trailer was full, they hitched the cab to it and drove it away. That was their concept — keep the line running all the time and drive the product right to the store. I thought it was brilliant. They made a lot of money on the Macintosh. If we have finished goods just sitting around, it is cash outflow. We’re paying money just to have it sit there.
Lastly, accounts receivable paid is cash inflow. When we finally deliver the widget to the customer and it is paid for, we finally have cash inflow.
Q.4.A. What is the basic premise of ABC analysis? What are the three steps in making in ABC inventory analysis?
ABC classification is based on the premise that a small number of items represent the most critical values of the inventory. ABC inventory control separates the most significant items from the least important and it’s used to determine the degree and level of control for the inventory items. Rough cut, 20% of our items will represent 80% of our dollar value; that is, one in five parts or part numbers in our stockroom represent a huge majority of the cost of our inventory. Another 30% of our items represent another 15% of the total dollar value, which leaves 50% of the items in the stockroom that make up only about 5% of our inventory cost. From a value standpoint, fully half the parts out there just are not worth tracking. That’s not exactly true, because we do need to track the data but half the parts out there are very low cost and should be C parts.
A Items 20% of the items account for 80% of the total dollar usage
B Items 30% of the items account for 15% of the total dollar usage
C Items 50% of the items account for 5% of the total dollar usage
Steps in Making an ABC Analysis
1. Establish the item characteristics that influence the result of inventory management. This is usually annual dollar usage but may be other criteria, such as scarcity of material.
2. Classify items into groups based on the established criteria.
3. Apply a degree of control in proportion to the importance of the group.
There are several factors that would cause us to classify something as an A item. One, of course, is our annual dollar usage. The items we spend the most money on become A items. Another factor is scarcity of material. There are some items that are not high in cost but are difficult to obtain; so we promote them to A items. Quality problems can also determine the need for an A classification. Perhaps because of the nature of the item, it’s hard to maintain quality or maybe the vendor you’re getting the item from has had quality problems in the past but you don’t have another choice.
Q.4.B. Differences between FIFO & LIFO?
FIFO and LIFO are two different ways to account for the cost of inventory. FIFO stands for First In First Out, while LIFO stands for Last In First Out. It is important to understand the differences between the two because the COGS (cost of goods sold) line item on an income statement is affected by your choice of LIFO vs. FIFO accounting as is the valuation of inventory on the balance sheet. As a result, a company can impact both its earnings and current assets simply through its choice of inventory cost accounting measures.
It's worth noting that there are other methods of inventory accounting beside LIFO and FIFO, such as the specific identification method, but those are outside the scope of this article.
DEFINITION OF LIFO:
LIFO means that the inventory that you bought in the past is the last inventory to be sold and likewise that the inventory you purchased most recently is the inventory you sell most recently. Think about a giant pile of coal. The coal on the bottom of the pile was the first coal to be placed there, whereas the coal on the top of the pile was the most recent (or last) coal placed there. Now, when you go to sell the coal, obviously you are going to sell the coal on the top of the pile first - you aren't going to sell the coal buried on the bottom of the pile. In fact, you may never sell the coal on the bottom of the pile.
DEFINITION OF FIFO:
FIFO, on the other hand means the exact opposite. Namely, that the inventory you purchased in the past will be the first inventory that you sell, whereas the inventory that you purchased most recently will be the inventory you sell later. As an example, think about the milk in your grocer's refrigerator. As the grocer buys the milk (i.e. the inventory) he pushes it to the front of the frig and replaces newer milk behind it. In other words, the cartons of milk with the most recent dates are always the first cartons to be sold and the cartons with the later dates are only sold after the newer milk has already been sold.
INFLATION AND ITS IMPACT ON ACCOUNTING FOR INVENTORY:
Why is this seemingly meaningless difference in accounting methods important? Well, if you turnover your inventory very quickly (as is the case with milk) it is probably not that big of a deal. However, if your inventory turns over very slowly it can have a major impact. Consider again the pile of coal. Who knows how long those first pieces of coal on the bottom of the pile have been sitting there? The reason we care about that question is because of inflation. Inflation causes prices to rise over time. Therefore, the price a company paid for the coal on the bottom of its pile is much different than the price the company paid for the coal on the top of its pile.
LIFO VS. FIFO AND ITS IMPACT ON THE FINANCIAL STATEMENTS:
Bringing these examples back to accounting we can see how this choice of LIFO vs. FIFO affects both the cost of inventory (COGS) on the income statement and the value of inventory on the balance sheet. In an environment of rising prices (which is usually the environment in most developed economies) if you choose the LIFO method of accounting then the inventory that you sell costs more than the inventory that you have remaining. Again, think about the pile of coal. The coal on the top of the pile is the coal you sell and it costs more than the coal on the bottom of the pile (which may have been purchased years ago). Therefore, choosing LIFO will result in lower inventory values on your balance sheet vs. FIFO and higher COGS on the income statement than FIFO.
Choosing the FIFO method of accounting will have the opposite affect. Namely, the inventory that you sell costs you less than the inventory that you have remaining (assuming rises prices which is generally the case). Therefore, the choice of FIFO accounting results in lower COGS on the income statement vs. LIFO and a higher inventory valuation on your balance sheet vs. LIFO.
LIFO VS. FIFO AND ITS IMPACT ON TAXES:
Now here's where it gets really complicated. Because FIFO results in lower COGS on the income statement, it also results in higher earnings. But when earnings are higher taxes are also higher. And when taxes are higher, after-tax earnings become lower. On the other hand, LIFO results in lower pre-tax earnings (since COGS are higher) and therefore lower taxes and therefore higher after-tax earnings. The interplay between pre-tax earnings, taxes and after-tax earnings is a complicated one and proper analysis must be used to choose the best accounting method for any given company.
THE CHOICE BETWEEN LIFO AND FIFO:
As a result of all of the above, the choice between LIFO and FIFO accounting allows a company to manipulate the cost of its inventory by choosing its method even if it is counterintuitive to the reality of their inventory purchasing situation. In other words, just because you actually sell the most recent pieces of coal that you bought does not mean that you have to choose the LIFO method of accounting for those purchases. You can choose FIFO if you wish and in fact most companies choose whichever method has the most favorable impact on their after-tax earnings.
It should be noted however that switching back and forth between the two methods from year to year is not a common practice. To switch from one method to another is a major hassle. And more importantly, if you continuously switch back and forth then investors will view that decision quite negatively.
It should also be noted that in accounting, companies often keep two separate sets of data. One for tax purposes and one for book purposes. This can be quite confusing when dealing with LIFO vs. FIFO because in some cases you can have two different inventory accounting methods, one for tax purposes and one for book purposes. However, in order to avoid situations where companies can get the best of both worlds by using FIFO for their books and LIFO for tax purposes, the IRS now requires that companies who choose LIFO for tax purposes must also choose LIFO for book purposes. Note however that this still allows a company to choose FIFO for tax purposes and LIFO for book purposes.
Q.4.C. What is SKU?
A SKU or Stock Keeping Unit is an identifier that is used by merchants to permit the systematic tracking of products and services offered to customers. Usage of the SKU system is rooted in the drill down method, pertaining to data management. SKUs are assigned and serialized at the merchant level. Each SKU is attached to an item, variant, product line, bundle, service, fee or attachment.
SKUs are not always associated with actual physical items, but are more appropriately billable entities. Extended warranties, delivery fees, and installation fees are not physical, but have SKUs because they are billable. All merchants using the SKU method will have their own personal approach to assigning the numbers based on regional or national corporate data storage and retrieval policies. SKU tracking varies from other product tracking methods which are controlled by a wider body of regulations stemming from manufacturers or possibly third-party regulations.
Consider this: a ball has a part number of 1234, it is packed 20 to a box, and the box is marked with the same part number 1234. The box is then placed in the warehouse. The box of balls is the stock keeping unit (SKU), because it is the stocked item. Even though the part numbers are interchangeable to mean either a ball or a box of balls, the box of balls is the stocked unit. There may be three different colors of balls; each of these colours will be a separate SKU. When the product is shipped, there may be 50 boxes of the blue balls, 100 boxes of the red balls, and 70 boxes of the yellow balls shipped. That shipment would be said to have been a shipment of 220 boxes, across three SKUs.
Successful inventory management systems assign a unique SKU for each product and also for its variants. For example, different flavors or models of product, or different bundled packages including a number of related products, have independent SKUs. This allows merchants to track, for instance, whether blue shirts are selling better than green shirts.
The acronym SKU is used almost exclusively when talking about merchant tracking, although there are other uses of this term.
Q.4.D.
A. Annual Ordering Cost
Annual ordering cost = number of orders * cost of ordering
Annual ordering cost can be defined as the Total expenses incurred in placing and order.
B. Annual Carrying Cost
Annual carrying cost = average inventory * cost of holding
Carrying cost refers to the total cost of holding inventory. This includes warehousing costs such as rent, utilities and salaries, financial costs such as opportunity cost, and inventory costs related to perishibility, shrinkage and insurance.
C. Total Annual Cost
Total annual cost = annual ordering cost + annual carrying cost
Example Problem
The annual demand is 10,000 units, the ordering cost $30 per order, the carrying cost 20%, and the unit cost $15. The order quantity is 600 units. Find
a) Annual ordering cost
b) Annual carrying cost
c) Total annual cost
Answer:
A= 10,000 units
S= $30
I= 0.20
C= $15
Q=600 units
a) Annual ordering cost=
Q.5. What is period-order quantity?
A. How is it established? When can it be used?
The economic-order quantity attempts to minimize the total cost of ordering and carrying inventory and is based on the assumption that demand is uniform. Often demand is not uniform, particularily in material requirements planning, and using the EOD does not produce a minimum cost.
The period-order quantity lot-size is based on the same theory as the economic-order quantity. It uses the EOQ formula to calculate an economic time between orders. This is calculated by dividing the EOQ by the demand rate. This produces a time interval for which orders are placed. Instead of ordering the same quantity (EOQ), orders are placed to satisfy requirements for the calculated time interval. The number of orders placed in a year is the same as for an economic-order quantity, but the amount ordered each time varies. Thus, the ordering cost is the same but, because the order quantities are determined by actual demand, the carrying cost is reduced.
Period-order quantity= EDQ
Average weekly usage
Q.5.B. Four characteristics of the order point system. Why is safety stock carried?
The Order Point Point (OP) is equal to Demand During Lead Time (DDLT) plus Safety Stock (SS) or
OP = DDLT + SS
(Eq. 6-2)
The above shows such a system. The order point formula (Eq. 6-2) tells us when to place an order. The Order Point, OP, equals DDLT, which is the demand during lead time plus SS, which is the safety stock. Lead time is how long it takes us to place the order and get it in. Demand during lead time is the quantity we’re going to use during that period of time. If our lead time to get the parts in is one week and we’re consuming 100 a week, then the demand during lead time would be 100. Add to that the safety stock.
Safety stock is a buffer against variances in demand. Sometimes we may use more than 100 during a week — we may use 102 or 103. Also, suppose the new order does not come in after five working days. It may be the morning of the sixth day before it comes in. For these kinds of reasons we use safety stock.
When the quantity on hand of an item falls to a predetermined level, called the order point, an order is placed. An order must be placed while there is enough stock on hand to satisfy demand during the lead time.
To reiterate then, an order point system would ask how long does it take to get the order in, how much are we going to use during that period of time, and how much safety stock do we need to carry just in case; the sum of those two quantities establishes our order point. All we have to do is monitor the inventory and when it gets down to that level, we place an order.
The figure below shows another example. Here demand is 100 units per week, lead time is 4 weeks, and safety stock is 100 units, so our order point is (100x4)+100 = 500. We have a bucket of widgets out there and when the bucket gets down to only 500 widgets left, it’s time to reorder.
An Order Point Example
Demand = 100 units per week
Lead time = 4 weeks
Safety stock = 100 units
OP = DDLT + SS
= 100(4) + 100
= 500
Place an order when 500 units are on hand.
That’s not telling us how much to order. We’ve already established how much to order; this just tells us when to place the order. Now “when” sounds kind of strange because “when” usually means a period of time, but we’re talking about when in relation to the number of units. With order point, quantities are usually fixed. How many we are going to order has usually been worked out with the vendor so we don’t have to think about that at this time.
The order point system should be automated because we are probably not going to have somebody going through the stockroom every day to see if we have reached the order point. If we have an MRP system that is tracking every part that comes in and goes out from our stockroom, then it can be preset to look at this item number and when it falls to 500, it’s time to launch an order. Having the computer do this is the only thing that makes sense.
Safety stock is used to prevent a stock out. The amount of safety stock we carry will depend on the variability of demand during lead time, the frequency of ordering, our desired service level, the length of lead time, and our ability to forecast and control the lead time
Safety stock, also called buffer stock and fluctuation stock, is used to prevent a stock out. The amount of safety stock carried depends on:
• Variability of ordering
• Frequency of ordering
• Desired service level
• Length of the lead time
• Ability to forecast and control lead times
We always have to balance the cost of a stock out against the cost of back orders, the cost of lost sales, and the cost of lost customers; once again these are qualitative not quantitative. It’s a management decision.
Q.5. C. Describe distribution requirement planning.
DRP is a system that forecasts when the various demands will be made by the system on central supply. This gives central supply and the factory the opportunity to plan for the goods that will actually be needed and when. It is able both to respond to customer demand and co-ordinate planning and control.
Distribution requirements planning or DRP is very similar to MRP. Referring to the figure below, At distribution center A, in week one we expect to release an order for 200 units, and an order for another 200 units in week 3. This is based on our internal forecast of customer demand. Distribution center B plans to release an order for 100 units in week 2. Both of these plans are communicated to the factory so that it can look three weeks ahead and say, “This is probably what’s going to happen (or very close to it).” The requirements of the distribution center become the gross requirements of Central Supply, so we have a gross requirement for 200 in week 1, 100 in week 2, and 200 in week 3.
Now we have 400 on hand at the factory prior to week 1. We know that we’re going to ship 200 in week 1 to meet the demand of distribution center A. Since it takes two weeks to build some more of these and we build them in lot sizes of 500, then, also in week 1, we had better plan to release a work order to build 500 more of these and have them available. If we in the factory have the information from the distribution centers, we can plan out our work in advance, that’s DRP, Distribution Requirements Planning, and any MRP system can be tweaked to do this as well because it uses the same logic.
Q.5.D. Name & describe the three functions in the flow of materials from supplier to consumer.
Elements that form each flow:
The materials flow includes the physical flow of products through the chain, from suppliers to customers, and the flow of reverse activities through returns, service, recycling and product elimination.
The information flow includes the transmission of orders and delivery status.
The financial flow includes credit conditions, payment programs and consignment and property title agreements.
Differences between physical supply & physical distribution
Physical supply is the movement and storage of goods from suppliers to manufacturing. Depending on the conditions of sale, the cost may be paid by either the supplier or the customer, but it is ultimately passed on to the consumer.
Physical Distribution, on the other hand, is the movement and storage of finished goods from the end of production to the consumer. The particular path in which the goods move - through distribution centers, wholesalers and retailers is called the channel of distribution.