Inventory Management, EOQ And Variance Analysis For Optimal Business Operations

Inventory Management and Optimal Operations

Inventory management is major part for logistic operations as the decisions made with regard to storage area, stock levels and order quantity that has considerable impact on cost of inventory and risk of being out of the stock. Further, it is associated with timely replenishment of operations, availability of shelf and relationship with the customers. Optimal method of inventory management controls the company’s inventory irrespective of the fact that the inventories are kept for resale or internal use. It manages fully fledged profile for inventories that includes all aspects like re-order level, re-order quantity, product specification, product information and lead time (Agrawal and Smith 2013). It manages multi-store, multi currency, multi-level and multi location inventory structure. Drill down facilities, reporting and inquiries capabilities are controlled in best way for company’s inventories.  Optimal management of inventory assist is achieving 3 major aims of the company. Optimal inventory management is beneficial for – (i) estimating exact requirement of inventory on-hand. It will help in preventing the shortages of product and will allow keeping sufficient inventory without storing high level of inventory in the warehouse (ii) it will support in maintaining organized warehouse. Companies prefer to optimize the warehouse through storing highest selling items together to make it easily accessible. This assists in speeding up the process of order fulfilments and keeping the customers happy (iii) optimal management of inventory helps to save money as well as time. Through keeping the track of on-hand orders seller can save the effort in recounting the inventories to assure that the records are accurate. It also helps in saving money as the money is not wasted in slow moving products (Raviv and Kolka 2013).

Economic order quantity (EOQ) is the production formula that is used for determining most efficient amount for goods that shall be purchased on the basis of carrying and ordering costs. To be more specific, it indicates the optimal inventory quantity that shall be ordered by the company each time for minimizing the cost related to holding and ordering the inventories. EOQ assumes that the demand is constant and inventory will be depleted at fixed rate until it is reached to zero. At this point particular number of items is arrived for returning the inventory to beginning level. Hence, inventory cost under EOQ model involves trade-off among order cost and costs of inventory holding. Ordering large amount of product at once will increase the holding cost of the business (Chen, Cárdenas-Barrón and Teng 2014). On the contrary, more frequent orders for small number of items will decrease the cost of holding however it will increase the ordering cost. Therefore, the EOQ shall find the quality at which these costs are minimized. Controls required to put for best action of EOQ are as follows –

• Demand – number of the units sold by the company over particular period of time, generally a year shall be taken into consideration while computing the EOQ
• Relevant cost of order – ordering cost for each purchase order shall be determined. It includes transportation cost. Staffs cost and other costs related to placing of order.
• Relevant carrying cost – it is assumed that the items are in stock for entire time period and per unit carrying cost shall be interpreted accordingly.

Once the above mentioned data are collected the EOQ shall be computed through using the formula –  

Variance analysis is quantitative investigation to determine the difference among planned and actual behaviour. Variance analysis is used for maintaining control over the business. It is especially effective while the variance is reviewed based on the trend line so that any sudden change under variance level will be more apparent from month to month. It also involves the investigation of differences so that the outcome will indicate the reason of variance from expectation.

Economic Order Quantity

Advantages of variance analysis –

1. Performance measurement – less sophisticate executives and other accounting information users will consider the favourable variance as good and unfavourable variance as bad. Though it is an useful tool to evaluate the performance of managers or executives care shall be taken while using variance analysis for making accurate assumptions.
2. Responsibility accounting – this term is used for stating the way in which managers are considered accountable for their activities. Generally, companies are segregated into segments based on their divisions or functions and held as accountable for the resources allocated by them. As the variance analysis is performed on departmental or item basis it makes easy for the divisions, departments or managers to be held as accountable for any kind of material deviation from the planned activity (Špa?ková and Straub 2015).
3. Management through exemption – material or significant variance will draw management’s attention to the areas where the planned activities vary from the actual outcome.

For instance, if material price variance = $ 10,000 and material usage variance is – $ 7,000, it indicates that material purchased were less than the standard material purchase quantity and material used were more as compared to to standard use. Therefore, the management may take steps to find the reason why material is used in more quantity.

Disadvantages of variance analysis –

1. As the activity the variance analysis is based on the financial result that is issued much later of quarterly closing. However, this leads to time gap that may impact the remedial action to certain limit. Further, all the sources for variance analysis are not available under accounting data that makes working out on variances difficult.
2. If budgeting is not made not considering detailed analysis of every factor, budgeting may be done loosely that is bound to vary from actual numbers. After that the variance analysis may not be considered as useful activity (Klychova, Faskhutdinova and Sadrieva 2014).

If the above mentioned example is taken into consideration it can be stated that it is not always possible to find out the reason why material has been used more as compared to the standard quantity.

Generally, an entity produces report that contains information suitable for the the purpose of public consumption. The external reports can be used for disseminating the information that will assist in achieving the strategic objective. Characteristic of the externally reported information are as follows –

• A means to the end – financial reporting is known to be the “means to the end and it is not the end in and of itself”.
• Historical by nature – the financial reporting of the company deals with the past as well as historical data till present date (Wahlen, Baginski and Bradshaw 2014)
• Financial statements – financial reporting of the company includes the financial statements.
• Usefulness is enhanced through explanation – it is believed under accounting profession that when the accounting treatment is disclosed through notes it will add value to the financial statement.
• Assumption related to general purpose – Financial reporting is general purpose accounting information which deals with the external users to provide them the information included in financial statement.
• Approximate and in-exact measures – financial report is prepared on the basis of estimates, judgements and assumptions (Khan 2015).

Manufacturing costs are the costs incurred for producing a product that is made for selling to the customer. It involves direct labour, direct material and the manufacturing overheads. Details of the manufacturing costs are as follows –

• Direct material – this includes the purchase cost of raw material those are directly used for manufacturing the product.
• Direct labour – this includes the wages, insurance and benefits those are paid to the employees who are involved directly for producing and manufacturing the products (Mellor, Hao and Zhang 2014).
• Manufacturing overhead – these are the overhead cost those are indirectly related to the factory cost and incurred for producing the product. It includes – (i) indirect material – these are not directly traceable to production process but are used in production process (ii) indirect labour – this is the labour those are not involved in production process directly. For instance, supervisors, quality assurances and payment to the security guards will be charged as indirect labour (iii) other costs – it includes the costs like lease, insurance and factory utilities (Khataie and Bulgak 2013).

Example – Saudi Modern Factory will produce 1000 tables. It will require wood amounting to $ 12,000, wages to the carpenters will be $ 2,000, $ 500 will be paid for the security guard wages, $ 100 will be paid to purchase a bag of nails and $ 500 for will be paid as factory rent. Therefore, total manufacturing cost will be (12000 + 2000 + 100 + 500+ 500) = $ 15,100. Hence, the company incurred $ 15,100 for manufacturing 1000 tables or it incurred $ 15,100/100 = $ 15.10 per table (SMF 2018).

For assuring that the budget serves the effective technique for making managerial decision certain principles needs to be followed. These are – (i) management support – cooperation and support from top management is required for implementing the budget successfully. They shall not only take interest in setting up the targets and finishing up the budget it shall further be monitored continuously (ii) employee involvement – participation from the employees will assist in developing the budget in accordance with their preference and will motivate them to achieve the budget (iii) Flexibility – if basic assumption regarding the budget changes during the year the budget shall be restated accordingly (iv) sound system of accounting – company must have good system of accounting for generating reliable, precise, prompt and accurate information required for successful budget implementation.

Out of various budgeting principle methodologies top-down approach is most inspiring as it backed down from upper management to lower positioned people. Under this method the department estimates costs of higher level tasks and using those estimates constrains for the lower level tasks are calculated. This method helps the employees to understand their goal in better way (Vasu, Stewart and Garson 2017).

Capital budgeting techniques	Project X	Project Y
Payback period	3.73 Years	4.89 Years
Accounting rate of return	1.09	1.04
Net present value	$ 9,153	$ 4,247
Profitability index	1.09	1.04

As the net present values of both the projects are positive and the payback period of both the projects are less than their useful life, both the projects are acceptable. However, if the projects are mutually exclusive and only one project is to be selected, Project X shall be selected. The reasons are as follows –

• Payback period of Project X is 3.73 years whereas the payback period for Project Y is 4.89 years.
• Accounting rate of return for project X is more than project Y. The ARR of Project X is 1.09 whereas the ARR of Project Y is 1.04.
• Through the initial investment for both the project is same, net present value of project is more than Project Y. The NPV of Project X is $ 9,153 whereas the NPV of Project Y is 4,247.
• Profitability index of project X is more than project Y. The PI of Project X is 1.09 whereas the PI of Project Y is 1.04.

Variance Analysis for Control over Business

Therefore, Project X shall be chosen over Project Y.

4.

1. Risk – return trade – off– Generally higher return is associated with the greater probability of involving higher risk and lower return is associated with the greater probability of involving lower risk. The trade off that is faced by an investor between return and risk while considering any decision regarding investment is known as risk return trade off (Adrian, Crump and Vogt 2015).
2. Time value of money– this is important concept under financial management. It states that the value of money expected to be received in future is lower as compared to the value of the money in hand today. The reason behind this is that the money in hand today can be invested to generate income from that. It is used for comparing the alternatives available for investments and taking decisions regarding loans, leases, mortgages, annuities and savings (Lucko 2013).  
3. Cash is king– it is a phrase used to indicate that cash or money is more valuable as compared to other form of the investment tool. It is typically used while the prices under securities market are higher and the investors prefer to save the cash for the time when the prices will be cheaper. From the cash flow or balance sheet aspect higher amount of cash on hand indicates positive situation. Further, it allows the company to be more flexible with regard to potential investment as well as business decision (Bhandari and Iyer 2013).
4. Incremental cash flows– it is the additional cash flows generated by a company from taking any new project. It is used for measuring the changes in cash outflows and cash inflow those are particularly attributed to the management decision. If the incremental cash flow is positive it indicates that the cash flow of the company will be positive if the project is accepted (Ball et al. 2016).
5. The agency problem– it is the conflict arises when the people are engaged for looking after interests of others uses the power or authority for own benefit. Agency problem is pervasive problem and practically exists in every organization irrespective of business (Donadelli, Fasan and Magnanelli 2014).
6. Taxes bias business decisions– as cash is regarded as king of all business the business must consider the after tax cash flow from any business. Tax consequence of the business decision will have an effect on the cash flows as it will reduce the cash flows. Managers generally take their decisions without taking into consideration the tax effect. It is considered as biggest mistake. Therefore, investment related decisions shall be taken after considering the tax effect (Giroud and Rauh 2015).   
7. All risk is not equal– some of the risks are diversifiable and some of the risks are not diversifiable. Diversification process can decrease the risk and owing to this the measuring of the asset or project’s risk can be very difficult. Further, all the monies shall not be invested into one project and the investment shall be diversified to minimize the risks (Brunnermeier and Oehmke 2013).
8. Ethical dilemmas are everywhere in finance– ethical dilemmas are the issues related to finance. Ethical behaviour states doing right thing. However the issues arise while it is attempted to define the right thing. Each of us has our own values based on which the personal judgements are formed regarding right thing. However, the unethical behaviour removes results, trusts and loss of the public confidence. When the trust is lost it is considered as unethical (Skorin-Kapov 2019).  

Phrase meaning –

Axiom is defined as universally recognized or self evident truth. Above mentioned 10 axioms associated with personal finance delivers a foundation through which the individual irrespective of their status in any level of financial cycle, can measure direction and soundness of personal financial lifestyle and planning (Danthine and Donaldson 2014). Keeping it mind the fact that at first glance these axioms may seemed to be simple or trivial, they provide the driving forces behind all those are followed. Further, these axioms weave together the techniques and concepts which in turn, allows to focus on underlying logic for practising financial management.

References

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Agrawal, N. and Smith, S.A., 2013. Optimal inventory management for a retail chain with diverse store demands. European Journal of Operational Research, 225(3), pp.393-403.

Ball, R., Gerakos, J., Linnainmaa, J.T. and Nikolaev, V., 2016. Accruals, cash flows, and operating profitability in the cross section of stock returns. Journal of Financial Economics, 121(1), pp.28-45.

Bhandari, S.B. and Iyer, R., 2013. Predicting business failure using cash flow statement based measures. Managerial Finance, 39(7), pp.667-676.

Brunnermeier, M.K. and Oehmke, M., 2013. Bubbles, financial crises, and systemic risk. In Handbook of the Economics of Finance (Vol. 2, pp. 1221-1288). Elsevier.

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Klychova, G.S., Faskhutdinova, ?.S. and Sadrieva, E.R., 2014. Budget efficiency for cost control purposes in management accounting system. Mediterranean journal of social sciences, 5(24), p.79.

Lucko, G., 2013. Supporting financial decision-making based on time value of money with singularity functions in cash flow models. Construction Management and Economics, 31(3), pp.238-253.

Mellor, S., Hao, L. and Zhang, D., 2014. Additive manufacturing: A framework for implementation. International Journal of Production Economics, 149, pp.194-201.

Raviv, T. and Kolka, O., 2013. Optimal inventory management of a bike-sharing station. IIE Transactions, 45(10), pp.1077-1093.

Skorin-Kapov, J., 2019. Financial Machinations and Ethical Perspectives. In Professional and Business Ethics Through Film (pp. 91-138). Palgrave Macmillan, Cham.

SMF., 2018. Wooden Furniture Manufacturing Company | Steel Furniture Manufacturers in Saudi Arabia – Saudi Modern Factory. [online] Available at: https://smf.com.sa/ [Accessed 25 Aug. 2018].

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Vasu, M.L., Stewart, D.W. and Garson, G.D. eds., 2017. Organizational Behavior and Public Management, Revised and Expanded. Routledge.

Wahlen, J., Baginski, S. and Bradshaw, M., 2014. Financial reporting, financial statement analysis and valuation. Nelson Education.

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