Page 187 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes necessary to complete the order. These requirements can then be extended mechanically to find
the amount of each material or item needed to fill the overall requirement.

Past-usage Methods

The other method used for determining production requirements relies on past usage, rather
than on the sales forecast. If a certain item, was used at a rate of 100 units per month during the
past year – or during some other representative period – it is likely to be used at the same rate
in future. If the production rate is expected to be higher or lower than in the past period, the past
usage figure may be altered accordingly by an application of a factor that represents the
anticipated percentage of change.
In general, the past-usage method is not as accurate as the explosion method. Changes in product
mix or product design may adversely affect the results of the past usage method. In addition, it
does not sufficient account of shifting production levels.

Value-volume Analysis

Many firms use the value-volume analysis to determine which inventory accounts should be
controlled by the explosion method and which should be controlled by the past-usage method.
In value-volume analysis the number of each item used in the past year is multiplied by its unit
to find the find the annual activity for the item. In most cases, the volume analysis reveals that
a relatively small percentage of the items in inventory accounts for a large percentage of annual
activity. Typically, most of the cost of inventory is concentrated in a few high activity inventory
accounts.
This is an important concept, because those items with a high level of activity must be more
closely controlled than the ones with relatively low activity levels. Their requirements must be
determined by the more accurate explosion process while requirements for the low activity
items can be determined by the less accurate and less costly past-usage method. The high activity
items are generally few in number but they represent most of the activity; they are the ones,
therefore, that most directly affect inventory values. These items should be ordered and to
increase the turnover rate. Since expediting expense, if necessary, is usually justified, lead times
should be controlled by the most effective recording systems.

ABC Approach

One of the most widely recognized concepts of inventory management is refereed to as ABC
inventory control. The traditional allocation of large indirect and overhead costs became less
accurate as the difference in the consumption of resources by products and services increased.
The ABC approach rather than allocating costs to individual units, identifies the activities that
consume resources, matching costs to the level of such activities. The central aspect of the
approach is the model development that to represent the logical and quantifiable relationship
between the utilization of resources, the performance of activities, and the products or services
they provide.
Previously, the companies could afford to make mistakes since their global profitability would
hide the impact of the incorrect cost allocations. But under the current business scenario, the
margin of error is much slimmer, making the knowledge of the real cost of the product and the
costs of serving specific channels and customer to be the key company survival.

Example: An item having inventory cost of ` 10,000 has a much greater potential for
saving of expenses related to maintaining inventories than an item, into these classes “A”, “B”

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