Page 201 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes these assumptions may not be strictly correct. Typically, demand fluctuates over time due to
seasonal, cyclical, and “random” influences, and imprecise forecasts of future demands often are
all that can be made. Similarly, lead times are subject to uncertainty because of such factors as
transportation delays, strikes, and natural disasters. Under these conditions, the possibility of
stock outs exists. To minimize the possibility of stock outs and the associated stock out costs,
most companies use a standard approach of adding a safety stock to their inventory. A safety
stock is maintained to meet unexpectedly high demand during the lead, unanticipated delays in
the lead time, or both.
Figure 12.3 shows the inventory pattern characterized by these more realistic assumptions.
During the first inventory cycle (0 – T ), an order to replenish the inventory is placed at T , when
2 1
the inventory level reaches the predetermined order point. The order then is received at T . The
2
second (T – T ) is similar to the first, except that demand exceeds the normal inventory of the
2 4
item, and part of the safety stock is consumed during the lead time prior to receipt of the order
at T . During cycle 3(T – T ), demand exceeds the normal inventory plus the safety and, as a
4 4 6
result, a stock out occurs during the lead time prior to receipt of the order at T .
6
Determining the optimal safety stock and order quantities under these more realistic conditions
is a fairly complex process. However, the factors that have to be considered in this type of
analyzing can be identified briefly. All other things being equal, the optimal safety stock increases
as the uncertainty associated with the demand forecasts and lead times increases. Likewise, all
other things being equal, the optimal safety stock increases as the cost of stock outs increases.
Determining the optimal safety stock involves balancing the expected costs of stock outs against
the cost of carrying the additional inventory.

Self Assessment

Fill in the blanks:
5. Under ......................., it is assumed that the stocks sold or consumed in any period are those
most recently acquired or made.

6. If a quantity of goods less than the base stock is owned at the end of any period, this
condition is considered .......................
7. In plants with a store department or section, the inventory management function is more
or less ....................... .
8. A combination of ....................... methods can give an idea of what are the items that can be
disposed off to train the inventory.

12.3 Valuation of Inventories

Decision about the desired level of inventory is difficult to relate the goal of shareholder wealth
maximization. Presumably maintenance of inadequate inventories could reduce profitability and
create additional uncertainty about shareholders returns. Whether such added risk can be diversified
away is open to question but some tendency to raise risk premiums contained in the cost of capital
and to reduce the value of equity shares may be present. In the other direction, excessive inventory
levels may reduce risk of production disruptions as well as risk premiums in the cost of capital
may also raise carrying costs more than enough to offset such gains. The precise optimum point,
in a valuation sense is by no means clear. However, in determining valuation method to use,
consideration is given to the size and turnover of inventories, the price outlook, tax laws, and
prevailing practices in the field. The financial manager’s influence will be felt practically in
establishing underlying policies, while the expert in the different areas play important roles in
evaluating the implication different procedures from the view point of their specialties.

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