List of business and finance abbreviations

This is a list of business and finance abbreviations.

ARPU Average revenue per user ASP Average selling price ASAP (As soon As Possible) agcy. (agency) agt. (agent) assn. (assistant)

BRU Business Recovery Unit B2B Business to Business B2C Business to Consumer bldg. (building)

CAO C ie! Accounting O!!icer CA"R Compound annual gro#t rate CAP$% Capital $&penditure CAP' Capital asset pricing model CA Collaterali(ed )ebt Obligation C)S Credit )e!ault S#ap C$O C ie! $&ecutive O!!icer C*A C artered *inancial Analyst C*C Consumption o! !i&ed capital C*C+ Cas *lo# Cycle +ime C*' Certi!ied *inancial 'anager C*O P$% Capital $&penditures C*O C ie! *inancial O!!icer Page 1 o! 46

C*S Consolidated *inancial Statement C,A Certi!ied ,nternal Auditor C,* Cost ,nsurance -it *reig t C,'A C artered ,nstitute o! 'anagement Accountants C,SA Certi!ied ,n!ormation Systems Auditor C'A Certi!ied 'anagement Accountant C'O C ie! 'ar.eting O!!icer COB Close o! Business CO"S Cost o! "oods Sold COO C ie! Operating O!!icer CPA Certi!ied Public Accountant CPP Certi!ied Payroll Pro!essional CSO C ie! Security O!!icer CR' Customer Relations ip 'anagement C/P Cost /olume Pro!it C+O C ie! +ec nology O!!icer C0* Cost -it *reig t

))A )epletion )epreciation Amorti(ation1 ), )ispatc in!ormation disc. (discount) dept. (department)

$AR $!!ective annual rate $A2 $!!ective Annual 2ield $B,+ $arnings be!ore interest and ta&es $B,+)A $arnings be!ore ,nterest1 +a&es1 )epreciation1 and Amorti(ation $), $lectronic )ata ,nterc ange $*+POS $lectronic *unds +rans!er at Point o! Sale $PS $arnings per s are Page 2 o! 46

$%P $&port

*OB *reig t On Board *,*O *irst ,n1 *irst Out *3 *inancial leverage *P0A *inancial Planning 0 Analysis *PO *ollo# on public o!!er *,% *inancial ,n!ormation $&c ange *% *oreign e&c ange mar.et

"AAP "enerally Accepted Accounting Principles "AAS "enerally Accepted Audit Standards ")P "ross )omestic Product "*C* "ross !i&ed capital !ormation "R4 "oods Receipt 4ote "P "ross Pro!it "3 "eneral 3eger

5R 5uman Resources 56 (5ead7uarters)

,CB ,ndustry Classi!ication Benc mar. ,CR' ,nnovative Customer Relations ip 'anagement ,$ ,nterest e&pense ,'P ,mport ,PO ,nitial Public O!!ering ,R ,nterest Rate 8 typically re!erring to an ,R derivative product

J-journal;K;L

3C 3etter o! credit Page 3 o! 46

3,BOR 3ondon ,nterban. O!!ered Rate 3,*O 3ast ,n1 *irst Out 33C 3imited 3iability Company 3BO 3everaged Buyout

'+) 'ont 8to8date 'O6 'inimum Order 6uantity 'SO) 'ont ly Statement o! Select Operational )ata m!g. (manu!acturing date)

4A/ 4et Asset /alue 4C4) 4on8Circumvent and 4on8)isclosure 4)A 4on8)isclosure Agreement 4OA 4et Operating Assets 4OPA+ 4et Operating Pro!it A!ter +a& 4P/ 4et Present /alue

OP$% Operational $&penditures OC Opportunity Cost

P'AC Period 'oving Average Cost PO Pro!it Ob9ective PO Purc ase Order PP0$ Property1 plant1 and e7uipment P03 Pro!it and 3oss P:$ Price8to8earnings ratio PPP Purc asing po#er parity PR Purc ase Re7uisition

Q
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6+) 6uarter8to8date 6C 6uality control

R$ Retained $arnings ROA Return on assets ROC$ Return On Capital $mployed RO$ Return on $7uity RO, Return on ,nvestment RO,C Return on ,nvested Capital RO4A Return on net assets ROS Return on Sales RR Resource rent R0) Researc and )evelopment

St Sales (during time period t) SC' Supply C ain 'anagement S"0A Sales1 "eneral1 and Administrative e&penses S,R Stores ,ssuance Re7uisition S,OP Sales ,nventory and Operations Plan S,/ Structured ,nvestment /e icle SO5O Small O!!ice:5ome O!!ice SO% Sarbanes8O&ley

+CO +otal Cost o! O#ners ip +SR +otal S are older Return

"# $# %

-ACC -eig ted average cost o! capital -C -or.ing capital Page 5 o! 46

#. #ee. #r. #or. #o #or. order

& '

2+) 2ear8to8date 2O2 2ear8Over82ear 2AS 2ou8are8Stupid

Earnin(s Before Interest) !a*es) De+reciation) A,orti-ation) and Restructurin( or Rent Costs (EBITDAR) is a non-GAAP metri that an !e use" to e#aluate a om$an%&s 'inan ial Per'orman e. EBITDAR ( Re#enue - E)$enses (e) lu"in* ta)+ interest+ "e$re iation+ amorti,ation an" restru turin* or rent osts) De$en"in* on the om$an% an" the *oal o' the user+ the in"i ator an in lu"e either restru turin* osts or rent osts+ !ut usuall% not !oth. The EBITDAR in"i ator e)$an"s on EBITDA !% a""in* an a""itional e) lu"e" item to *i#e a !etter in"i ation o' the om$an%&s 'inan ial $er'orman e. EBITDAR+ -hen e#aluatin* the im$a t o' rent e)$ense is o'ten use" !% retail !usinesses an" airlines. T%$i all%+ in su h an anal%sis the rent e)$ense -ill !e a$itali,e" an" a""e" to the net "e!t o' the om$an% in or"er to !etter un"erstan" the le#era*e le#els in the om$an%&s a$ital stru ture.

EBI!DA /ibtd/ is an a ron%m 'or earnin(s before interest) ta*es) de+reciation) and a,orti-ation. It is a non-GAAP metri that is measure" e)a tl% as state". All interest+ ta)+ "e$re iation an" amorti,ation entries in the in ome statement are re#erse" out 'rom the !ottom-line net in ome. It $ur$orts to measure ash earnin*s -ithout a rual a ountin*+ an elin* ta)-juris"i tion e''e ts+ an" an elin* the e''e ts o' "i''erent a$ital stru tures. EBITDA "i''ers 'rom the o$eratin* ash 'lo- in a ash 'lo- statement $rimaril% !% e) lu"in* $a%ments 'or ta)es or interest as -ell as han*es in -or.in* a$ital. EBITDA also "i''ers 'rom 'ree ash 'lo- !e ause it e) lu"es ash re/uirements 'or re$la in* a$ital assets ( a$e)). EBI!DA ,ar(in re'ers to EBITDA "i#i"e" !% total re#enue. EBITDA mar*in measures the e)tent to -hi h ash o$eratin* e)$enses use u$ re#enue.

Contents

0 1se !% "e!thol"ers
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2 1se !% sharehol"ers 3 4on-$ro'ita!le !usinesses 5 6ee also 7 Re'eren es

"se b. debt/olders
EBITDA is -i"el% use" in loan o#enants. The theor% is that it measures the ash earnin*s that an !e use" to $a% interest an" re$a% the $rin i$al. 6in e interest is $ai" !e'ore in ome ta) is al ulate"+ the "e!thol"er an i*nore ta)es. The% are not intereste" in -hether the !usiness an re$la e its assets -hen the% -ear out+ there'ore an i*nore a$ital amorti,ation an" "e$re iation. There are t-o EBITDA metri s use". 0. The measure o' a "e!t&s $a%-!a . $erio" is Debt0EBI!DA. The lon*er the $a%!a . $erio"+ the *reater the ris.. The metri $resumes that the !usiness has sto$$e" ma.in* interest $a%ments (!e ause interest is a""e" !a .). But it is ar*ue" that on e that ha$$ens the "e!thol"er is unli.el% to -ait aroun" (sa%) three %ears to re o#er their $rin i$al -hile the !usiness ontinues to o$erate in "e'ault. 6o "oes the metri measure an%thin*8 There is also the $ro!lem o' a""in* !a . ta)es. This metri i*nores all ta) e)$enses e#en thou*h a *oo" $ortion are ash $a%ments+ an" the *o#ernment *ets $ai" 'irst. Prin i$al re$a%ments are not ta)-"e"u ti!le. 2. 9ne interest o#era*e ratio 1EBI!DA 0Interest E*+ense2 is use" to "etermine a 'irm&s a!ilit% to $a% interest on outstan"in* "e!t. The *reater the multi$le o' ash a#aila!le 'or interest $a%ments+ the less ris. to the len"er. The *reater the %ear-to-%ear #arian e in EBITDA+ the *reater the ris.. Be ause interest is ta)-"e"u ti!le it is a$$ro$riate to !a . out the ta) e''e ts o' the interest+ !ut this metri i*nores all ta)es. The ratios an !e ustomi,e" !% re"u in* De!t !% an% ash on the !alan e sheet or !% "e"u tin* maintenan e :a$E) 'rom EBITDA to 'orm a measure loser to 'ree ash 'lo-.

"se b. s/are/olders
Pu!li in#estors& use o' EBITDA arose 'rom their $er e$tion that a ountants& measure o' $ro'its+ usin* a rual a ountin* -as mani$ulate"+ that a measure o' ash earnin*s -oul" !e more relia!le.; It is true that PE an use this metri . An" it is true the $ro'essional anal%sts usin* "etaile" "is ounte" ash 'lomo"els shoul" re$la e non- ash e)$enses -ith $roje te" time--ei*hte" $a%ments. But none o' that a$$lies to retail in#estors& realit%. EBITDA "oes 49T measure ash earnin*s !e ause it omits all the ta) e)$enses e#en thou*h a *oo" $ortion are ash $a%ments. It also 'ails to orre t 'or other non- ash e)$enses+ e.*. -arrant% e)$ense+ !a" "e!t allo-an e+ in#entor% -rite-"o-n+ sto . o$tions *rante". It "oes not in lu"e the ash 'lo-s 'rom han*es in -or.in* a$ital. 6u$$ose a !usiness sells all its o$enin* in#entor% in a %ear an" re$la es the same num!er o' units !ut at a hi*her $ri e !e ause o' in'lation. The $ro'its o' a om$an% usin* <I<9 in#entor% #aluation -ill not in lu"e that e)tra ash ost. 6u$$ose the !usiness is e)$an"in* an" nee" to sto . a lar*er num!er o' units. That a""itional ash ost is not in an%one&s EBITDA measure.
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=hen usin* this metri to re$la e a ountant&s earnin*s it $resumes to measure an e onomi $ro'it. But an% e onomi $ro'it must in lu"e the ost o' a$ital an" the "e*ra"ation o' lon*-li'e assets. This metri sim$l% i*nores !oth. =arren Bu''ett 'amousl% as.e"+ >Does mana*ement thin. the tooth 'air% $a%s 'or a$ital e)$en"itures8> De$re iation ma% not !e e)a t !ut it is the most $ra ti al metho" a#aila!le. It su ee"s in e/uatin* the $ositions o' om$anies usin* three "i''erent -a%s to 'inan e lon*-li'e assets. It an !e inter$rete" as?;citation needed@
;. the allo ation o' the ori*inal ost+ at a later "ate+ -hen the asset -as use" to *enerate re#enue.

The time #alue o' mone% (same ar*ument use" a!o#e) means that "e$re iation ma% un"erstate the ost. 2. the amount o' ash re/uire" to !e retaine" in or"er to 'inan e the e#entual re$la ement asset. 6in e in'lation is the !asis 'or time-#alue-o'-mone%+ the amounts set asi"e to"a% must !e in#este" an" *ro- in #alue in or"er to $a% the in'late" $ri e in the 'uture. 3. the "e rease in #alue o' the !alan e sheet asset sin e the last re$ortin* $erio". Assets -ear out -ith use+ an" -ill e#entuall% ha#e to !e re$la e".

3edit4 Non5+rofitable businesses

=hen om$arin* !usinesses -ith non $ro'its+ their $otential to ma.e $ro'it is more im$ortant than their 4et Loss. 6in e ta)es on losses -ill !e mislea"in* in this onte)t+ ta)es an !e i*nore". :a$ital e)$en"itures an" their relate" "e!t result in 'i)e" osts. These are o' less im$ortan e than the #aria!le osts that an !e e)$e te" to *ro- -ith in reasin* sales #olume+ in or"er to o#er the 'i)e" osts. 6o "e$re iation an" interest osts are o' less im$ortan e. It is li.el% that an un$ro'ita!le !usiness is !urnin* ash (has a ne*ati#e ash 'lo-)+ so in#estors are most on erne" -ith >ho- lon* the ash -ill last !e'ore the !usiness must *et more 'inan in*> (resultin* in "e!t or e/uit% "ilution). EBITDA is not use" as a #aluation metri in these ir umstan es. It is a startin* $oint on -hi h 'uture *ro-th is a$$lie" an" 'uture $ro'ita!ilit% "is ounte" !a . to the $resent. E/uit% o-ners onl% !ene'it 'rom net $ro'its+ a'ter all the e)$enses are $ai".;citation needed@ Durin* the "ot om !u!!le om$anies $romote" their sto . !% em$hasisin* either EBITDA or $ro 'orma earnin*s in their 'inan ial re$orts+ an" e)$lainin* a-a% the (o'ten $oor) >in ome> num!er. This -oul" in#ol#e i*norin* one-time -rite-o''s+ asset im$airments an" other osts "eeme" to !e nonre urrin*. Be ause EBITDA (an" its #ariations) are not measures *enerall% a e$te" un"er 1.6. GAAP+ the 1.6. 6e urities an" E) han*e :ommission re/uires that om$anies re*isterin* se urities -ith it (an" -hen 'ilin* its $erio"i re$orts) re on ile EBITDA to net in ome in or"er to a#oi" mislea"in* in#estors.

Revenue
In !usiness+ revenue is in ome that a om$an% re ei#es 'rom its normal !usiness a ti#ities+ usuall% 'rom the sale o' *oo"s an" ser#i es to ustomers. In man% ountries+ su h as the 1nite" Kin*"om+ re#enue is re'erre" to as turnover. 6ome om$anies re ei#e re#enue 'rom interest+ "i#i"en"s or ro%alties $ai" to them !% other om$anies.;0@ Re#enue ma% re'er to !usiness in ome in *eneral+ or it ma% re'er to the amount+ in a monetar% unit+ re ei#e" "urin* a $erio" o' time+ as in >Last %ear+ :om$an% A ha" re#enue o' B52 million.> Pro'its or net in ome *enerall% im$l% total re#enue minus total e)$enses in a *i#en $erio". In a ountin*+ re#enue is o'ten re'erre" to as the >to$ line> "ue to its
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$osition on the in ome statement at the #er% to$. This is to !e ontraste" -ith the >!ottom line> -hi h "enotes net in ome.;2@ <or non-$ro'it or*ani,ations+ annual re#enue ma% !e re'erre" to as (ross recei+ts.;3@ This re#enue in lu"es "onations 'rom in"i#i"uals an" or$orations+ su$$ort 'rom *o#ernment a*en ies+ in ome 'rom a ti#ities relate" to the or*ani,ation&s mission+ an" in ome 'rom 'un"raisin* a ti#ities+ mem!ershi$ "ues+ an" 'inan ial in#estments su h as sto . shares in om$anies. In *eneral usa*e+ re#enue is in ome re ei#e" !% an or*ani,ation in the 'orm o' ash or ash e/ui#alents. 6ales re#enue or re#enues is in ome re ei#e" 'rom sellin* *oo"s or ser#i es o#er a $erio" o' time. Ta) re#enue is in ome that a *o#ernment re ei#es 'rom ta)$a%ers. In more 'ormal usa*e+ re#enue is a al ulation or estimation o' $erio"i in ome !ase" on a $arti ular stan"ar" a ountin* $ra ti e or the rules esta!lishe" !% a *o#ernment or *o#ernment a*en %. T-o ommon a ountin* metho"s+ ash !asis a ountin* an" a rual !asis a ountin*+ "o not use the same $ro ess 'or measurin* re#enue. :or$orations that o''er shares 'or sale to the $u!li are usuall% re/uire" !% la- to re$ort re#enue !ase" on *enerall% a e$te" a ountin* $rin i$les or International <inan ial Re$ortin* 6tan"ar"s. In a "ou!le-entr% !oo..ee$in* s%stem+ re#enue a ounts are *eneral le"*er a ounts that are summari,e" $erio"i all% un"er the hea"in* Re#enue or Re#enues on an in ome statement. Re#enue a ount names "es ri!e the t%$e o' re#enue+ su h as >Re$air ser#i e re#enue>+ >Rent re#enue earne"> or >6ales>.;5@

Contents
o

; Business revenue ;.; *inancial statement analysis 2 "overnment revenue < See also = 4otes and re!erences

Business revenue
Business re#enue is in ome 'rom a ti#ities that are or"inar% 'or a $arti ular or$oration+ om$an%+ $artnershi$+ or sole-$ro$rietorshi$. <or some !usinesses+ su h as manu'a turin* an"Cor *ro er%+ most re#enue is 'rom the sale o' *oo"s. 6er#i e !usinesses su h as la- 'irms an" !ar!er sho$s re ei#e most o' their re#enue 'rom ren"erin* ser#i es. Len"in* !usinesses su h as ar rentals an" !an.s re ei#e most o' their re#enue 'rom 'ees an" interest *enerate" !% len"in* assets to other or*ani,ations or in"i#i"uals. Re#enues 'rom a !usiness&s $rimar% a ti#ities are re$orte" as sales+ sales revenue or net sales. This in lu"es $ro"u t returns an" "is ounts 'or earl% $a%ment o' in#oi es. Dost !usinesses also ha#e re#enue that is in i"ental to the !usiness&s $rimar% a ti#ities+ su h as interest earne" on "e$osits in a "eman" a ount. This is in lu"e" in re#enue !ut not in lu"e" in net sales.;7@ 6ales re#enue "oes not in lu"e sales ta) olle te" !% the !usiness.

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Ot/er revenue (a...a. non-o$eratin* re#enue) is re#enue 'rom $eri$heral (non- ore) o$erations. <or e)am$le+ a om$an% that manu'a tures an" sells automo!iles -oul" re or" the re#enue 'rom the sale o' an automo!ile as >re*ular> re#enue. I' that same om$an% also rente" a $ortion o' one o' its !uil"in*s+ it -oul" re or" that re#enue as Eother re#enueF an" "is lose it se$aratel% on its in ome statement to sho- that it is 'rom somethin* other than its ore o$erations.

Financial statement analysis

Main article: Financial statement analysis

Re#enue is a ru ial $art o' 'inan ial statement anal%sis. A om$an%Gs $er'orman e is measure" to the e)tent to -hi h its asset in'lo-s (re#enues) om$are -ith its asset out'lo-s (e)$enses). 4et In ome is the result o' this e/uation+ !ut re#enue t%$i all% enjo%s e/ual attention "urin* a stan"ar" earnin*s all. I' a om$an% "is$la%s soli" Eto$-line *ro-th+F anal%sts oul" #ie- the $erio"Gs $er'orman e as $ositi#e e#en i' earnin*s *ro-th+ or E!ottom-line *ro-thF is sta*nant. :on#ersel%+ hi*h in ome *ro-th -oul" !e tainte" i' a om$an% 'aile" to $ro"u e si*ni'i ant re#enue *ro-th. :onsistent re#enue *ro-th+ as -ell as in ome *ro-th+ is onsi"ere" essential 'or a om$an%&s $u!li l% tra"e" sto . to !e attra ti#e to in#estors. Re#enue is use" as an in"i ation o' earnin*s /ualit%. There are se#eral 'inan ial ratios atta he" to it+ the most im$ortant !ein* *ross mar*in an" $ro'it mar*in. Also+ om$anies use re#enue to "etermine !a" "e!t e)$ense usin* the in ome statement metho". Pri e C 6ales is sometimes use" as a su!stitute 'or a Pri e to earnin*s ratio -hen earnin*s are ne*ati#e an" the PCE is meanin*less. Thou*h a om$an% ma% ha#e ne*ati#e earnin*s+ it almost al-a%s has $ositi#e re#enue. Gross Dar*in is a al ulation o' re#enue less ost o' *oo"s sol"+ an" is use" to "etermine ho- -ell sales o#er "ire t #aria!le osts relatin* to the $ro"u tion o' *oo"s. 4et in omeCsales+ or $ro'it mar*in+ is al ulate" !% in#estors to "etermine ho- e''i ientl% a om$an% turns re#enues into $ro'its....

Govern,ent revenue
Main article: Government revenue

Go#ernment re#enue in lu"es all amounts o' mone% (i.e. ta)es an"Cor 'ees) re ei#e" 'rom sour es outsi"e the *o#ernment entit%. Lar*e *o#ernments usuall% ha#e an a*en % or "e$artment res$onsi!le 'or olle tin* *o#ernment re#enue 'rom om$anies an" in"i#i"uals.;H@ Go#ernment re#enue ma% also in lu"e reser#e !an. urren % -hi h is $rinte". This is re or"e" as an a"#an e to the retail !an. to*ether -ith a orres$on"in* urren % in ir ulation e)$ense entr%. The in ome "eri#es 'rom the 9''i ial :ash rate $a%a!le !% the retail !an.s 'or instruments su h as IJ "a% !ills.There is a /uestion as to -hether usin* *eneri !usiness !ase" a ountin* stan"ar"s an *i#e a 'air an" a urate $i ture o' *o#ernment a ounts in that -ith a monetar% $oli % statement to the reser#e !an. "ire tin* a $ositi#e in'lation rate. The e)$ense $ro#ision 'or the return o' urren % to the reser#e !an. is lar*el% s%m!oli in that to totall% an el the urren % in ir ulation $ro#ision all urren % -oul" ha#e to !e returne" to the reser#e !an. an" an elle".
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Gross +rofit
In a ountin*+ (ross +rofit or sales +rofit is the "i''eren e !et-een re#enue an" the ost o' ma.in* a $ro"u t or $ro#i"in* a ser#i e+ !e'ore "e"u tin* o#erhea"+ $a%roll+ ta)ation+ an" interest $a%ments. 4ote that this is "i''erent 'rom o$eratin* $ro'it (earnin*s !e'ore interest an" ta)es). 4et sales are al ulate"? 4et sales ( Gross sales K 6ales o' returns an" allo-an es. Gross $ro'it is 'oun" !% "e"u tin* the ost o' *oo"s sol"? Gross $ro'it ( 4et sales - :ost o' *oo"s sol". Gross $ro'it shoul" not !e on'use" -ith net in ome? 4et in ome ( Gross $ro'it K Total o$eratin* e)$enses K ta)es K interest. :ost o' *oo"s sol" is al ulate" "i''erentl% 'or mer han"isin* !usiness than 'or a manu'a turer. 9$eratin* Pro'it ( Gross Pro'it - Total o$eratin* e)$enses

Gross ,ar(in (also

alle" (ross +rofit ,ar(in or (ross +rofit rate) is the "i''eren e !et-een re#enue an" ost !e'ore a ountin* 'or ertain other osts. Generall%+ it is al ulate" as the sellin* $ri e o' an item+ less the ost o' *oo"s sol" ($ro"u tion or a /uisition osts+ essentiall%).

Contents

; Purpose 2 Construction < 5o# gross margin is used in sales = 'ar.up > "ross margin (as a percentage o! Revenue) ? Converting bet#een gross margin and mar.up ("ross Pro!it)
o o

?.; Converting mar.up to gross margin ?.2 Converting gross margin to mar.up @ Using gross margin to calculate selling price A )i!!erences bet#een industries B Re!erences

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Pur+ose
The $ur$ose o' mar*ins is to "etermine the #alue o' in remental sales+ an" to *ui"e $ri in* an" $romotion "e ision. ;0@ Dar*in on sales re$resents a .e% 'a tor !ehin" man% o' the most 'un"amental !usiness onsi"erations+ in lu"in* !u"*ets an" 'ore asts. All mana*ers shoul"+ an" *enerall% "o+ .no- their a$$ro)imate !usiness mar*ins. Dana*ers "i''er -i"el%+ ho-e#er+ in the assum$tions the% use in al ulatin* mar*ins an" in the -a%s the% anal%,e an" ommuni ate these im$ortant 'i*ures. ;0@ Percenta(e ,ar(ins and unit ,ar(ins Gross mar*in an !e e)$resse" as a $er enta*e or in total 'inan ial terms. I' the latter+ it an !e re$orte" on a $er-unit !asis or on a $er-$erio" !asis 'or a om$an%. Mar(in 1on sales2 is the "i''eren e !et-een sellin* $ri e an" ost. This "i''eren e is t%$i all% e)$resse" either as a $er enta*e o' sellin* $ri e or on a $er-unit !asis. Dana*ers nee" to .no- mar*ins 'or almost all mar.etin* "e isions. Dar*ins re$resent a .e% 'a tor in $ri in*+ return on mar.etin* s$en"in*+ earnin*s 'ore asts an" anal%ses o' ustomer $ro'ita!ilit%. In a sur#e% o' nearl% 2JJ senior mar.etin* mana*ers+ LM $er ent res$on"e" that the% 'oun" the >mar*in N> metri #er% use'ul -hile H7 $er ent 'oun" >unit mar*in> #er% use'ul.;0@ A 'un"amental #ariation in the -a% $eo$le tal. a!out mar*ins lies in the "i''eren e !et-een $er enta*e mar*ins an" unit mar*ins on sales. The "i''eren e is eas% to re on ile+ an" mana*ers shoul" !e a!le to s-it h !a . an" 'orth !et-een the t-o. ;0@ %/at is a unit6 E#er% !usiness has its o-n notion o' a Eunit+F ran*in* 'rom a ton o' mar*arine+ to H5 oun es o' ola+ to a !u .et o' $laster. Dan% in"ustries -or. -ith multi$le units an" al ulate mar*in a or"in*l%. Dar.eters must !e $re$are" to shi't !et-een #ar%in* $ers$e ti#es -ith little e''ort !e ause "e isions an !e roun"e" in an% o' these $ers$e ti#es. ;0@

Construction
In#esto$e"ia "e'ines Gross mar*in as? Gross mar*in ( (Re#enue - :ost o' *oo"s sol") C Re#enue;2@ It an !e e)$resse" in a!solute terms? Gross mar*in ( net sales - ost o' *oo"s sol" O annual sales return or as the ratio o' *ross $ro'it to ost o' *oo"s sol"+ usuall% in the 'orm o' a $er enta*e?

:ost o' sales (also .no-n as ost o' *oo"s sol" (:oGs) in lu"es #aria!le osts an" 'i)e" osts "ire tl% lin.e" to the sale+ su h as material osts+ la!or+ su$$lier $ro'it+ shi$$in* osts+ et . It "oes not in lu"e in"ire t 'i)e" osts li.e o''i e e)$enses+ rent+ a"ministrati#e osts+ et .
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Pi*her *ross mar*ins 'or a manu'a turer re'le t *reater e''i ien % in turnin* ra- materials into in ome. <or a retailer it -ill !e their mar.u$ o#er -holesale. Lar*er *ross mar*ins are *enerall% onsi"ere" i"eal 'or most om$anies+ -ith the e) e$tion o' "is ount retailers -ho instea" rel% on o$erational e''i ien % an" strate*i 'inan in* to remain om$etiti#e -ith lo-er mar*ins. T-o relate" metri s are unit mar*in an" mar*in $er ent?
Unit margin ($) C Selling price per unit (D) 8 Cost per unit (D) Margin (%) C Unit margin (D) : Selling price per unit (D)E;F

Per enta*e mar*ins an also !e al ulate" usin* total sales re#enue an" total osts. =hen -or.in* -ith either $er enta*e or unit mar*ins+ mar.eters an $er'orm a sim$le he . !% #eri'%in* that the in"i#i"ual $arts sum to the total.
To verify a unit margin ($): Selling price per unit C Unit margin G Cost per Unit To verify a margin (%): Cost as H o! sales C ;IIH 8 'argin HE;F

=hen onsi"erin* multi$le $ro"u ts -ith "i''erent re#enues an" osts+ -e an al ulate o#erall mar*in (N) on either o' t-o !ases?

+otal revenue and total costs !or all products1 or + e dollar8#eig ted average o! t e percentage margins o! t e di!!erent products.

E;F

Ho7 (ross ,ar(in is used in sales

Retailers an measure their $ro'it !% usin* t-o !asi metho"s+ mar.u$ an" mar*in+ !oth o' -hi h *i#e a "es ri$tion o' the *ross $ro'it. The mar.u$ e)$resses $ro'it as a $er enta*e o' the retailer&s ost 'or the $ro"u t. The mar*in e)$resses $ro'it as a $er enta*e o' the retailer&s sales $ri e 'or the $ro"u t. These t-o metho"s *i#e "i''erent $er enta*es as results+ !ut !oth $er enta*es are #ali" "es ri$tions o' the retailer&s $ro'it. It is im$ortant to s$e i'% -hi h metho" %ou are usin* -hen %ou re'er to a retailer&s $ro'it as a $er enta*e. 6ome retailers use mar*ins !e ause %ou an easil% al ulate $ro'its 'rom a sales total. I' %our mar*in is 3JN+ then 3JN o' %our sales total is $ro'it. I' %our mar.u$ is 3JN+ the $er enta*e o' %our "ail% sales that are $ro'it -ill not !e the same $er enta*e. 6ome retailers use mar.u$s !e ause it is easier to al ulate a sales $ri e 'rom a ost usin* mar.u$s. I' %our mar.u$ is 5JN+ then %our sales $ri e -ill !e 5JN a!o#e the item ost. I' %our mar*in is 5JN+ %our sales $ri e -ill not !e e/ual to 5JN o#er ost (in"ee" it -ill !e HJN a!o#e the item ost).

Mar8u+
The e/uation 'or al ulatin* the monetar% #alue o' *ross mar*in is? *ross mar*in ( sales - ost o' *oo"s sol" A sim$le -a% to .ee$ mar.u$ an" *ross mar*in 'a tors strai*ht is to remem!er that?
;. Percent o! mar.up is ;II times t e price di!!erence divided by t e cost. Page 13 o! 46

2. Percent o! gross margin is ;II times t e price di!!erence divided by t e selling price.

Gross ,ar(in 1as a +ercenta(e of Revenue2

Dost $eo$le 'in" it easier to -or. -ith *ross mar*in !e ause it "ire tl% tells %ou ho- mu h o' the sales re#enue+ or $ri e+ is $ro'it. In re'eren e to the t-o e)am$les a!o#e? The B2JJ $ri e that in lu"es a 0JJN mar.u$ re$resents a 7JN *ross mar*in. Gross mar*in is just the $er enta*e o' the sellin* $ri e that is $ro'it. In this ase 7JN o' the $ri e is $ro'it+ or B0JJ.

In the more om$le) e)am$le o' sellin* $ri e B33I+ a mar. u$ o' HHN re$resents a$$ro)imatel% a 5JN *ross mar*in. This means that 5JN o' the B33I is $ro'it. A*ain+ *ross mar*in is just the "ire t $er enta*e o' $ro'it in the sale $ri e. In a ountin*+ the *ross mar*in re'ers to sales minus ost o' *oo"s sol". It is not ne essaril% $ro'it as other e)$enses su h as sales+ a"ministrati#e+ an" 'inan ial must !e "e"u te".An" it means om$anies are re"u in* their ost o' $ro"u tion or $assin* their ost to ustomers. The hi*her the ratio+ the !etter.

Convertin( bet7een (ross ,ar(in and ,ar8u+ 1Gross Profit2

Converting markup to gross margin

E)am$les?
'ar.up C ;IIH C ;

'ar.up C ??.@H C I.??@

Converting gross margin to markup

E)am$les?
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"ross margin C >IH C I.>

"ross margin C =IH C I.=

"sin( (ross ,ar(in to calculate sellin( +rice

Gi#en the ost o' an item+ one an om$ute the sellin* $ri e re/uire" to a hie#e a s$e i'i *ross mar*in. <or e)am$le+ i' %our $ro"u t osts B0JJ an" the re/uire" *ross mar*in is 5JN+ then 6ellin* $ri e ( B0JJ C (0 - 5JN) ( B0JJ C J.HJ ( B0HH.HL

Differences bet7een industries

In some in"ustries+ li.e lothin* 'or e)am$le+ $ro'it mar*ins are e)$e te" to !e near the 5JN mar.+ as the *oo"s nee" to !e !ou*ht 'rom su$$liers at a ertain rate !e'ore the% are resol". In other in"ustries su h as so't-are $ro"u t "e#elo$ment+ sin e the ost o' "u$li ation is ne*li*i!le+ the *ross $ro'it mar*in an !e hi*her than MJN in man% ases.

Cost of (oods sold 1COG 2 re'ers to the in#entor%

osts o' those *oo"s a !usiness has sol" "urin* a $arti ular $erio". :osts are asso iate" -ith $arti ular *oo"s usin* one o' se#eral 'ormulas+ in lu"in* s$e i'i i"enti'i ation+ 'irst-in 'irst-out (<I<9)+ or a#era*e ost. :osts in lu"e all osts o' $ur hase+ osts o' on#ersion an" other osts in urre" in !rin*in* the in#entories to their $resent lo ation an" on"ition. :osts o' *oo"s ma"e !% the !usiness in lu"e material+ la!or+ an" allo ate" o#erhea". The osts o' those *oo"s not %et sol" are "e'erre" as osts o' in#entor% until the in#entor% is sol" or -ritten "o-n in #alue.

Contents

0 9#er#ie2 Im$ortan e o' in#entories 3 :ost o' *oo"s 'or resale 5 :ost o' *oo"s ma"e !% the !usiness 7 I"enti'i ation on#entions H E)am$le L =rite-"o-ns an" allo-an es M Alternati#e #ie-s

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I 6ee also 0J <urther rea"in* 00 Re'eren es

Overvie7
Dan% !usinesses sell *oo"s that the% ha#e !ou*ht or $ro"u e". =hen the *oo"s are !ou*ht or $ro"u e"+ the osts asso iate" -ith su h *oo"s are a$itali,e" as $art o' in#entor% (or sto .) o' *oo"s. ;0@ These osts are treate" as an e)$ense in the $erio" the !usiness re o*ni,es in ome 'rom sale o' the *oo"s.;2@ Determinin* osts re/uires .ee$in* re or"s o' *oo"s or materials $ur hase" an" an% "is ounts on su h $ur hase. In a""ition+ i' the *oo"s are mo"i'ie"+;3@ the !usiness must "etermine the osts in urre" in mo"i'%in* the *oo"s. 6u h mo"i'i ation osts in lu"e la!or+ su$$lies or a""itional material+ su$er#ision+ /ualit% ontrol+ use o' e/ui$ment+ an" other o#erhea" osts. Prin i$les 'or "eterminin* osts ma% !e easil% state"+ !ut a$$li ation in $ra ti e is o'ten "i''i ult "ue to a #ariet% o' onsi"eration in the allo ation o' osts.;5@ :ost o' *oo"s sol" ma% also re'le t a"justments. Amon* the $otential a"justments are "e line in #alue o' the *oo"s (i.e.+ lo-er mar.et #alue than ost)+ o!soles en e+ "ama*e+ et . =hen multi$le *oo"s are !ou*ht or ma"e+ it ma% !e ne essar% to i"enti'% -hi h osts relate to -hi h $arti ular *oo"s sol". This ma% !e "one usin* an i"enti'i ation on#ention+ su h as s$e i'i i"enti'i ation o' the *oo"s+ 'irst-in-'irst-out (<I<9)+ or a#era*e ost. Alternati#e s%stems ma% !e use" in some ountries+ su h as last-in-'irst-out (LI<9)+ *ross $ro'it metho"+ retail metho"+ or om!inations o' these. :ost o' *oo"s sol" ma% !e the same or "i''erent 'or a ountin* an" ta) $ur$oses+ "e$en"in* on the rules o' the $arti ular juris"i tion.

I,+ortance of inventories
In#entories ha#e a si*ni'i ant e''e t on $ro'its. A !usiness that ma.es or !u%s *oo"s to sell must .ee$ tra . o' in#entories o' *oo"s un"er all a ountin* an" in ome ta) rules. An e)am$le illustrates -h%. <re" !u%s auto $arts an" resells them. In 2JJM+ <re" !u%s B0JJ -orth o' $arts. Pe sells $arts 'or BMJ that he !ou*ht 'or B3J+ an" has BLJ -orth o' $arts le't. In 2JJI+ he sells the remain"er o' the $arts 'or B0MJ. I' he .ee$s tra . o' in#entor%+ his $ro'it in 2JJM is B7J+ an" his $ro'it in 2JJI is B00J+ or B0HJ in total. I' he "e"u te" all the osts in 2JJM+ he -oul" ha#e a loss o' B2J in 2JJM an" a $ro'it o' B0MJ in 2JJI. The total is the same+ !ut the timin* is mu h "i''erent. All ountries& a ountin* an" in ome ta) rules (i' the ountr% has an in ome ta)) re/uire the use o' in#entories 'or all !usinesses that re*ularl% sell *oo"s the% ha#e ma"e or !ou*ht.

Cost of (oods for resale

:ost o' *oo"s $ur hase" 'or resale in lu"es $ur hase $ri e as -ell as all other osts o' a /uisitions.;7@ This ost shoul" re'le t an% "is ounts. A""itional osts ma% in lu"e 'rei*ht $ai" to a /uire the *oo"s+ ustoms "uties+ sales or use ta)es not re o#era!le $ai" on materials use"+ an" 'ees $ai" 'or a /uisition.
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<or 'inan ial re$ortin* $ur$oses su h $erio" osts as $ur hasin* "e$artment+ -arehouse+ an" other o$eratin* e)$enses are usuall% not treate" as $art o' in#entor% or ost o' *oo"s sol". <or 1.6. in ome ta) $ur$oses+ some o' these $erio" osts must !e a$itali,e" as $art o' in#entor%.;H@ :osts o' sellin*+ $a .in*+ an" shi$$in* *oo"s to ustomers are treate" as o$eratin* e)$enses relate" to the sale. Both International an" 1.6. a ountin* stan"ar"s re/uire that ertain a!normal osts+ su h as those asso iate" -ith i"le a$a it%+ must !e treate" as e)$enses rather than $art o' in#entor%. Qalue a""e" ta) is *enerall% not treate" as $art o' ost o' *oo"s sol" i' it ma% !e use" as an in$ut re"it or other-ise re o#era!le 'rom the ta)in* authorit%.;L@

Cost of (oods ,ade b. t/e business

The ost o' *oo"s $ro"u e" in the !usiness shoul" in lu"e all osts o' $ro"u tion.;M@ The .e% om$onents o' ost *enerall% in lu"e?

Parts+ ra- materials an" su$$lies use"+ La!or+ in lu"in* asso iate" osts su h as $a%roll ta)es an" !ene'its+ an" 9#erhea" o' the !usiness allo a!le to $ro"u tion.

Dost !usinesses ma.e more than one o' a $arti ular item. Thus+ osts are in urre" 'or multi$le items rather than a $arti ular item sol". Determinin* ho- mu h o' ea h o' these om$onents to allo ate to $arti ular *oo"s re/uires either tra .in* the $arti ular osts or ma.in* some allo ations o' osts. Parts an" ra- materials are o'ten tra .e" to $arti ular sets (e.g.+ !at hes or $ro"u tion runs) o' *oo"s+ then allo ate" to ea h item. La!or osts in lu"e "ire t la!or an" in"ire t la!or. Dire t la!or osts are the -a*es $ai" to those em$lo%ees -ho s$en" all their time -or.in* "ire tl% on the $ro"u t !ein* manu'a ture". In"ire t la!or osts are the -a*es $ai" to other 'a tor% em$lo%ees in#ol#e" in $ro"u tion. :osts o' $a%roll ta)es an" 'rin*e !ene'its are *enerall% in lu"e" in la!or osts+ !ut ma% !e treate" as o#erhea" osts. La!or osts ma% !e allo ate" to an item or set o' items !ase" on time.ee$in* re or"s. Daterials an" la!or ma% !e allo ate" !ase" on $ast e)$erien e+ or standard osts. =here materials or la!or osts 'or a $erio" e) ee" the e)$e te" amount o' stan"ar" osts+ a variance. 6u h #arian es are then allo ate" amon* ost o' *oo"s sol" an" remainin* in#entor% at the en" o' the $erio". Determinin* o#erhea" osts o'ten in#ol#es ma.in* assum$tions a!out -hat osts shoul" !e asso iate" -ith $ro"u tion a ti#ities an" -hat osts shoul" !e asso iate" -ith other a ti#ities. Tra"itional ost a ountin* metho"s attem$t to ma.e these assum$tions !ase" on $ast e)$erien e an" mana*ement ju"*ment as to 'a tual relationshi$s. A ti#it% !ase" ostin* attem$ts to allo ate osts !ase" on those 'a tors that "ri#e the !usiness to in ur the osts. 9#erhea" osts are o'ten allo ate" to sets o' $ro"u e" *oo"s !ase" on the ratio o' la!or hours or osts or the ratio o' materials use" 'or $ro"u in* the set o' *oo"s. 9#erhea" osts ma% !e re'erre" to as 'a tor% o#erhea" or 'a tor% !ur"en 'or those osts in urre" at the $lant le#el or overall burden 'or those osts in urre" at the or*ani,ation le#el. =here la!or hours are use"+ a burden rate or o#erhea" ost $er hour o' la!or ma% !e a""e" alon* -ith la!or osts. 9ther metho"s ma% !e use" to asso iate o#erhea" osts -ith $arti ular *oo"s $ro"u e". 9#erhea" rates ma% !e stan"ar" rates+ in -hi h ase there ma% !e #arian es+ or ma% !e a"juste" 'or ea h set o' *oo"s $ro"u e".
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Qaria!le $ro"u tion o#erhea"s are allo ate" to units $ro"u e" !ase" on a tual use o' $ro"u tion 'a ilities. <i)e" $ro"u tion o#erhea"s are o'ten allo ate" !ase" on normal a$a ities or e)$e te" $ro"u tion.;I@ Dore or 'e-er *oo"s ma% !e $ro"u e" than e)$e te" -hen "e#elo$in* ost assum$tions (li.e !ur"en rates). These "i''eren es in $ro"u tion le#els o'ten result in too mu h or too little ost !ein* assi*ne" to the *oo"s $ro"u e". This also *i#es rise to #arian es.

Identification conventions
In some ases+ the ost o' *oo"s sol" ma% !e i"enti'ie" -ith the item sol". 9r"inaril%+ ho-e#er+ the i"entit% o' *oo"s is lost !et-een the time o' $ur hase or manu'a ture an" the time o' sale.;0J@ Determinin* -hi h *oo"s ha#e !een sol"+ an" the ost o' those *oo"s+ re/uires either i"enti'%in* the *oo"s or usin* a on#ention to assume -hi h *oo"s -ere sol". This ma% !e re'erre" to as a ost 'loassum$tion or in#entor% i"enti'i ation assum$tion or on#ention.;00@ The 'ollo-in* metho"s are a#aila!le in man% juris"i tions 'or asso iatin* osts -ith *oo"s sol" an" *oo"s still on han"?

6$e i'i i"enti'i ation. 1n"er this metho"+ $arti ular items are i"enti'ie"+ an" osts are tra .e" -ith res$e t to ea h item.;02@ This ma% re/uire onsi"era!le re or".ee$in*. This metho" annot !e use" -here the *oo"s or items are in"istin*uisha!le or 'un*i!le. A#era*e ost. The a#era*e ost metho" relies on a#era*e unit ost to al ulate ost o' units sol" an" en"in* in#entor%. 6e#eral #ariations on the al ulation ma% !e use"+ in lu"in* -ei*hte" a#era*e an" mo#in* a#era*e. <irst-In <irst-9ut (<I<9) assumes that the items $ur hase" or $ro"u e" 'irst are sol" 'irst. :osts o' in#entor% $er unit or item are "etermine" at the time ma"e or a /uire". The ol"est ost (i.e.+ the 'irst in) is then mat he" a*ainst re#enue an" assi*ne" to ost o' *oo"s sol". Last-In <irst-9ut (LI<9) is the re#erse o' <I<9. 6ome s%stems $ermit "eterminin* the osts o' *oo"s at the time a /uire" or ma"e+ !ut assi*nin* osts to *oo"s sol" un"er the assum$tion that the *oo"s ma"e or a /uire" last are sol" 'irst. :osts o' s$e i'i *oo"s a /uire" or ma"e are a""e" to a $ool o' osts 'or the t%$e o' *oo"s. 1n"er this s%stem+ the !usiness ma% maintain osts un"er <I<9 !ut tra . an o''set in the 'orm o' a LI<9 reser#e. 6u h reser#e (an asset or ontra-asset) re$resents the "i''eren e in ost o' in#entor% un"er the <I<9 an" LI<9 assum$tions. 6u h amount ma% !e "i''erent 'or 'inan ial re$ortin* an" ta) $ur$oses in the 1nite" 6tates. Dollar Qalue LI<9. 1n"er this #ariation o' LI<9+ in reases or "e reases in the LI<9 reser#e are "etermine" !ase" on "ollar #alues rather than /uantities. Retail in#entor% metho". Resellers o' *oo"s ma% use this metho" to sim$li'% re or".ee$in*. The al ulate" ost o' *oo"s on han" at the en" o' a $erio" is the ratio o' ost o' *oo"s a /uire" to the retail #alue o' the *oo"s times the retail #alue o' *oo"s on han". :ost o' *oo"s a /uire" in lu"es !e*innin* in#entor% as $re#iousl% #alue" $lus $ur hases. :ost o' *oo"s sol" is then !e*innin* in#entor% $lus $ur hases less the al ulate" ost o' *oo"s on han" at the en" o' the $erio".

E*a,+le
inventory turnover= cost of good sold/avg inventory

Jane o-ns a !usiness that resells ma hines. At the start o' 2JJI+ she has no ma hines or $arts on han". 6he !u%s ma hines A an" B 'or 0J ea h+ an" later !u%s ma hines : an" D 'or 02 ea h. All the
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ma hines are the same+ !ut the% ha#e serial num!ers. Jane sells ma hines A an" : 'or 2J ea h. Per ost o' *oo"s sol" "e$en"s on her in#entor% metho". 1n"er s$e i'i i"enti'i ation+ the ost o' *oo"s sol" is 0J O 02+ the $arti ular osts o' ma hines A an" :. I' she uses <I<9+ her osts are 2J (0JO0J). I' she uses a#era*e ost+ here osts are 22 ( (0JO0JO02O02)C5 ) 2). I' she uses LI<9+ her osts are 25 (02O02). Thus+ her $ro'it 'or a ountin* an" ta) $ur$oses ma% !e 2J+ 0M+ or 0H+ "e$en"in* on her in#entor% metho". A'ter the sales+ her in#entor% #alues are either 2J+ 22 or 25. A'ter %ear en"+ Jane "e i"es she an ma.e more mone% !% im$ro#in* ma hines B an" D. 6he !u%s an" uses 0J o' $arts an" su$$lies+ an" it ta.es H hours at 2 $er hour to ma.e the im$ro#ements to ea h ma hine. Jane has o#erhea"+ in lu"in* rent an" ele tri it%. 6he al ulates that the o#erhea" a""s J.7 $er hour to her osts. Thus+ Jane has s$ent 2J to im$ro#e ea h ma hine (0JC2 O 02 O (H ) J.7) ). 6he sells ma hine D 'or 57. Per ost 'or that ma hine "e$en"s on her in#entor% metho". I' she use" <I<9+ the ost o' ma hine D is 02 $lus 2J she s$ent im$ro#in* it+ 'or a $ro'it o' 03. Remem!er+ she use" u$ the t-o 0J ost items alrea"% un"er <I<9. I' she uses a#era*e ost+ it is 00 $lus 2J+ 'or a $ro'it o' 05. I' she use" LI<9+ the ost -oul" !e 0J $lus 2J 'or a $ro'it o' 07. In %ear 3+ Jane sells the last ma hine 'or 3M an" /uits the !usiness. 6he re o#ers the last o' her osts. Per total $ro'its 'or the three %ears are the same un"er all in#entor% metho"s. 9nl% the timin* o' in ome an" the !alan e o' in#entor% "i''er. Pere is a om$arison un"er <I<9+ A#era*e :ost+ an" LI<9? Cost of Goods old 555555 Profit 555555 'ear ales FIFO Av(9 :IFO FIFO Av(9 :IFO 0 5J 2J 22 25 2J 0M 0H 2 57 32 30 3J 03 05 07 3 3M 32 30 3J H L M Total 023 M5 M5 M5 3I 3I 3I

%rite5do7ns and allo7ances

The #alue o' *oo"s hel" 'or sale !% a !usiness ma% "e line "ue to a num!er o' 'a tors. The *oo"s ma% $ro#e to !e "e'e ti#e or !elo- normal /ualit% stan"ar"s (su!normal). The *oo"s ma% !e ome o!solete. The mar.et #alue o' the *oo"s ma% sim$l% "e line "ue to e onomi 'a tors. =here the mar.et #alue o' *oo"s has "e line" 'or -hate#er reasons+ the !usiness ma% hose to #alue its in#entor% at the lo-er o' ost or mar.et #alue+ also .no-n as net realizable value.;03@ This ma% !e re or"e" !% a ruin* an e)$ense (i.e.+ reatin* an in#entor% reser#e) 'or "e lines "ue to o!soles en e+ et . :urrent $erio" net in ome as -ell as net in#entor% #alue at the en" o' the $erio" is re"u e" 'or the "e line in #alue. An% $ro$ert% hel" !% a !usiness ma% "e line in #alue or !e "ama*e" !% unusual e#ents+ su h as a 'ire. The loss o' #alue -here the *oo"s are "estro%e" is a ounte" 'or as a loss+ an" the in#entor% is 'ull% -ritten o''. Generall%+ su h loss is re o*ni,e" 'or !oth 'inan ial re$ortin* an" ta) $ur$oses. Po-e#er+ !oo. an" ta) amounts ma% "i''er un"er some s%stems.

Alternative vie7s
Alternati#es to tra"itional ost a ountin* ha#e !een $ro$ose" !% #arious mana*ement theorists. These in lu"e? Page 19 o! 46

Throu*h$ut A ountin*+ un"er the Theor% o' :onstraints+ un"er -hi h onl% "ire t materials osts are in lu"e" in ost o' *oo"s sol" an" in#entor%. Lean a ountin*+ in -hi h most tra"itional ostin* metho"s are i*nore" in 'a#or o' measurin* -ee.l% >#alue streams>. Resour e onsum$tion a ountin*+ -hi h "is ar"s most urrent a ountin* on e$ts in 'a#or o' $ro$ortional ostin* !ase" on simulations.

4one o' these #ie-s on'orm to 1.6. Generall% A e$te" A ountin* Prin i$les or International A ountin* 6tan"ar"s+ nor are an% a e$te" 'or most in ome or other ta) re$ortin* $ur$oses.

Inventory
Inventor. means a list om$ile" 'or some 'ormal $ur$ose+ su h as the "etails o' an estate *oin* to $ro!ate+ or the ontents o' a house let 'urnishe". This remains the $rime meanin* in British En*lish.;0@ In the 16A an" :ana"a the term has "e#elo$e" 'rom a list o' *oo"s an" materials to the *oo"s an" materials themsel#es+ es$e iall% those hel" a#aila!le in sto . !% a !usiness; an" this has !e ome the $rimar% meanin* o' the term in 4orth Ameri an En*lish+ e/ui#alent to the term >sto .> in British En*lish. In a ountin*+ in#entor% or sto . is onsi"ere" an asset.

Contents
o o o o o o o

; ,nventory 'anagement 2 Business inventory 2.; + e reasons !or .eeping stoc. 2.2 Special terms used in dealing #it inventory 2.< +ypology 2.= ,nventory e&amples 2.=.; 'anu!acturing

< Principle o! inventory proportionality <.; Purpose <.2 Applications <.< Roots = 5ig 8level inventory management > Accounting !or inventory Page 20 o! 46

o o o o o

>.; *inancial accounting >.2 Role o! inventory accounting >.< *,*O vs. 3,*O accounting >.= Standard cost accounting >.> + eory o! constraints cost accounting ? 4ational accounts @ )istressed inventory A ,nventory credit B See also ;I Re!erences ;; *urt er reading

Inventor. Mana(e,ent
In#entor% mana*ement is $rimaril% a!out s$e i'%in* the sha$e an" $er enta*e o' sto .e" *oo"s. It is re/uire" at "i''erent lo ations -ithin a 'a ilit% or -ithin man% lo ations o' a su$$l% net-or. to $ro ee" the re*ular an" $lanne" ourse o' $ro"u tion an" sto . o' materials. The s o$e o' in#entor% mana*ement on erns the 'ine lines !et-een re$lenishment lea" time+ arr%in* osts o' in#entor%+ asset mana*ement+ in#entor% 'ore astin*+ in#entor% #aluation+ in#entor% #isi!ilit%+ 'uture in#entor% $ri e 'ore astin*+ $h%si al in#entor%+ a#aila!le $h%si al s$a e 'or in#entor%+ /ualit% mana*ement+ re$lenishment+ returns an" "e'e ti#e *oo"s an" "eman" 'ore astin*.Balan in* these om$etin* re/uirements lea"s to o$timal in#entor% le#els+ -hi h is an on-*oin* $ro ess as the !usiness nee"s shi't an" rea t to the -i"er en#ironment. In#entor% mana*ement in#ol#es a retailer see.in* to a /uire an" maintain a $ro$er mer han"ise assortment -hile or"erin*+ shi$$in*+ han"lin*+ an" relate" osts are .e$t in he .. It also in#ol#es s%stems an" $ro esses that i"enti'% in#entor% re/uirements+ set tar*ets+ $ro#i"e re$lenishment te hni/ues+ re$ort a tual an" $roje te" in#entor% status an" han"les all 'un tions relate" to the tra .in* an" mana*ement o' material. This -oul" in lu"e the monitorin* o' material mo#e" into an" out o' sto .room lo ations an" the re on ilin* o' the in#entor% !alan es. Also ma% in lu"e AB: anal%sis+ lot tra .in*+ % le ountin* su$$ort et . Dana*ement o' the in#entories+ -ith the $rimar% o!je ti#e o' "eterminin*C ontrollin* sto . le#els -ithin the $h%si al "istri!ution 'un tion to !alan e the nee" 'or $ro"u t a#aila!ilit% a*ainst the nee" 'or minimi,in* sto . hol"in* an" han"lin* osts.

Business inventor.
The reasons for keeping stock
There are three !asi reasons 'or .ee$in* an in#entor%?

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;. +ime 8 + e time lags present in t e supply c ain1 !rom supplier to user at every stage1 re7uires t at you maintain certain amounts o! inventory to use in t is Jlead time.J 5o#ever1 in practice1 inventory is to be maintained !or consumption during Kvariations in lead timeK. 3ead time itsel! can be addressed by ordering t at many days in advance. 2. Uncertainty 8 ,nventories are maintained as bu!!ers to meet uncertainties in demand1 supply and movements o! goods. <. $conomies o! scale 8 ,deal condition o! Jone unit at a time at a place # ere a user needs it1 # en e needs itJ principle tends to incur lots o! costs in terms o! logistics. So bul. buying1 movement and storing brings in economies o! scale1 t us inventory.

All these sto . reasons an a$$l% to an% o-ner or $ro"u t

Special terms used in dealing with inventory

Stock Keeping Unit (SLU) is a uni7ue combination o! all t e components t at are assembled into t e purc asable item. + ere!ore1 any c ange in t e pac.aging or product is a ne# SLU. + is level o! detailed speci!ication assists in managing inventory. Stockout means running out o! t e inventory o! an SLU.E2F J4e# old stoc.J (sometimes abbreviated 4OS) is a term used in business to re!er to merc andise being o!!ered !or sale t at #as manu!actured long ago but t at as never been used. Suc merc andise may not be produced anymore1 and t e ne# old stoc. may represent t e only mar.et source o! a particular item at t e present time.

Typology
;. Bu!!er:sa!ety stoc. 2. Cycle stoc. (Used in batc processes1 it is t e available inventory1 e&cluding bu!!er stoc.) <. )e8coupling (Bu!!er stoc. eld bet#een t e mac ines in a single process # ic serves as a bu!!er !or t e ne&t one allo#ing smoot !lo# o! #or. instead o! #aiting t e previous or ne&t mac ine in t e same process) =. Anticipation stoc. (Building up e&tra stoc. !or periods o! increased demand 8 e.g. ice cream !or summer) >. Pipeline stoc. ("oods still in transit or in t e process o! distribution 8 ave le!t t e !actory but not arrived at t e customer yet)

Inventory examples
=hile a ountants o'ten "is uss in#entor% in terms o' *oo"s 'or sale+ or*ani,ations - manu'a turers+ ser#i e-$ro#i"ers an" not-'or-$ro'its - also ha#e in#entories ('i)tures+ 'urniture+ su$$lies+ ...) that the% "o not inten" to sell. Danu'a turers&+ "istri!utors&+ an" -holesalers& in#entor% ten"s to luster in -arehouses. Retailers& in#entor% ma% e)ist in a -arehouse or in a sho$ or store a essi!le to ustomers. In#entories not inten"e" 'or sale to ustomers or to lients ma% !e hel" in an% $remises an or*ani,ation uses. 6to . ties u$ ash an"+ i' un ontrolle"+ it -ill !e im$ossi!le to .no- the a tual le#el o' sto .s an" there'ore im$ossi!le to ontrol them. =hile the reasons 'or hol"in* sto . -ere o#ere" earlier+ most manu'a turin* or*ani,ations usuall% "i#i"e their >*oo"s 'or sale> in#entor% into?

Ra# materials 8 materials and components sc eduled !or use in ma.ing a product. Page 22 o! 46

-or. in process1 -,P 8 materials and components t at ave begun t eir trans!ormation to !inis ed goods. *inis ed goods 8 goods ready !or sale to customers. "oods !or resale 8 returned goods t at are salable.

<or e)am$le?

Manufacturing
A anne" 'oo" manu'a turer&s materials in#entor% in lu"es the in*re"ients to 'orm the 'oo"s to !e anne"+ em$t% ans an" their li"s (or oils o' steel or aluminum 'or onstru tin* those om$onents)+ la!els+ an" an%thin* else (sol"er+ *lue+ ...) that -ill 'orm $art o' a 'inishe" an. The 'irm&s -or. in $ro ess in lu"es those materials 'rom the time o' release to the -or. 'loor until the% !e ome om$lete an" rea"% 'or sale to -holesale or retail ustomers. This ma% !e #ats o' $re$are" 'oo"+ 'ille" ans not %et la!ele" or su!-assem!lies o' 'oo" om$onents. It ma% also in lu"e 'inishe" ans that are not %et $a .a*e" into artons or $allets. Its 'inishe" *oo" in#entor% onsists o' all the 'ille" an" la!ele" ans o' 'oo" in its -arehouse that it has manu'a ture" an" -ishes to sell to 'oo" "istri!utors (-holesalers)+ to *ro er% stores (retailers)+ an" e#en $erha$s to onsumers throu*h arran*ements li.e 'a tor% stores an" outlet enters. E)am$les o' ase stu"ies are #er% re#ealin*+ an" onsistentl% sho- that the im$ro#ement o' in#entor% mana*ement has t-o $arts? the a$a!ilit% o' the or*anisation to mana*e in#entor%+ an" the -a% in -hi h it hooses to "o so. <or e)am$le+ a om$an% ma% -ish to install a om$le) in#entor% s%stem+ !ut unless there is a *oo" un"erstan"in* o' the role o' in#entor% an" its $arameters+ an" an e''e ti#e !usiness $ro ess to su$$ort that+ the s%stem annot !rin* the ne essar% !ene'its to the or*anisation in isolation. T%$i al In#entor% Dana*ement te hni/ues in lu"e Pareto :ur#e AB: :lassi'i ation;3@ an" E onomi 9r"er Ruantit% Dana*ement. A more so$histi ate" metho" ta.es these t-o te hni/ues 'urther+ om!inin* ertain as$e ts o' ea h to reate The K :ur#e Detho"olo*%. ;5@ A ase stu"% o' .- ur#e;7@ !ene'its to one om$an% sho-s a su ess'ul im$lementation. 1nne essar% in#entor% a""s enormousl% to the -or.in* a$ital tie" u$ in the !usiness+ as -ell as the om$le)it% o' the su$$l% hain. Re"u tion an" elimination o' these in#entor% &-ait& states is a .e% on e$t in Lean.;H@ Too !i* an in#entor% re"u tion too /ui .l% an ause a !usiness to !e anore)i . There are -ell-$ro#en $ro esses an" te hni/ues to assist in in#entor% $lannin* an" strate*%+ !oth at the !usiness o#er#ie- an" $art num!er le#el. Dan% o' the !i* DRPCan" ERP s%stems "o not o''er the ne essar% in#entor% $lannin* tools -ithin their inte*rate" $lannin* a$$li ations.

Princi+le of inventor. +ro+ortionalit.

Purpose
In#entor% $ro$ortionalit% is the *oal o' "eman"-"ri#en in#entor% mana*ement. The $rimar% o$timal out ome is to ha#e the same num!er o' "a%s& (or hours&+ et .) -orth o' in#entor% on han" a ross all $ro"u ts so that the time o' runout o' all $ro"u ts -oul" !e simultaneous. In su h a ase+ there is no >e) ess in#entor%+> that is+ in#entor% that -oul" !e le't o#er o' another $ro"u t -hen the 'irst $ro"u t
Page 23 o! 46

runs out. E) ess in#entor% is su!-o$timal !e ause the mone% s$ent to o!tain it oul" ha#e !een utili,e" !etter else-here+ i.e. to the $ro"u t that just ran out. The se on"ar% *oal o' in#entor% $ro$ortionalit% is in#entor% minimi,ation. B% inte*ratin* a urate "eman" 'ore astin* -ith in#entor% mana*ement+ re$lenishment in#entories an !e s he"ule" to arri#e just in time to re$lenish the $ro"u t "estine" to run out 'irst+ -hile at the same time !alan in* out the in#entor% su$$l% o' all $ro"u ts to ma.e their in#entories more $ro$ortional+ an" there!% loser to a hie#in* the $rimar% *oal. A urate "eman" 'ore astin* also allo-s the "esire" in#entor% $ro$ortions to !e "%nami !% "eterminin* e)$e te" sales out into the 'uture; this allo-s 'or in#entor% to !e in $ro$ortion to e)$e te" short-term sales or onsum$tion rather than to $ast a#era*es+ a mu h more a urate an" o$timal out ome. Inte*ratin* "eman" 'ore astin* into in#entor% mana*ement in this -a% also allo-s 'or the $re"i tion o' the > an 'it> $oint -hen in#entor% stora*e is limite" on a $er-$ro"u t !asis.

pplications
The te hni/ue o' in#entor% $ro$ortionalit% is most a$$ro$riate 'or in#entories that remain unseen !% the onsumer. As o$$ose" to >.ee$ 'ull> s%stems -here a retail onsumer -oul" li.e to see 'ull shel#es o' the $ro"u t the% are !u%in* so as not to thin. the% are !u%in* somethin* ol"+ un-ante" or stale; an" "i''erentiate" 'rom the >tri**er $oint> s%stems -here $ro"u t is reor"ere" -hen it hits a ertain le#el; in#entor% $ro$ortionalit% is use" e''e ti#el% !% just-in-time manu'a turin* $ro esses an" retail a$$li ations -here the $ro"u t is hi""en 'rom #ie-. 9ne earl% e)am$le o' in#entor% $ro$ortionalit% use" in a retail a$$li ation in the 1nite" 6tates is 'or motor 'uel. Dotor 'uel (e.*. *asoline) is *enerall% store" in un"er*roun" stora*e tan.s. The motorists "o not .no- -hether the% are !u%in* *asoline o'' the to$ or !ottom o' the tan.+ nor nee" the% are. A""itionall%+ these stora*e tan.s ha#e a ma)imum a$a it% an" annot !e o#er'ille". <inall%+ the $ro"u t is e)$ensi#e. In#entor% $ro$ortionalit% is use" to !alan e the in#entories o' the "i''erent *ra"es o' motor 'uel+ ea h store" in "e"i ate" tan.s+ in $ro$ortion to the sales o' ea h *ra"e. E) ess in#entor% is not seen or #alue" !% the onsumer+ so it is sim$l% ash sun. (literall%) into the *roun". In#entor% $ro$ortionalit% minimi,es the amount o' e) ess in#entor% arrie" in un"er*roun" stora*e tan.s. This a$$li ation 'or motor 'uel -as 'irst "e#elo$e" an" im$lemente" !% Petrolso't :or$oration in 0IIJ 'or :he#ron Pro"u ts :om$an%. Dost major oil om$anies use su h s%stems to"a%. ;L@

!oots
The use o' in#entor% $ro$ortionalit% in the 1nite" 6tates is thou*ht to ha#e !een ins$ire" !% Ja$anese just-in-time $arts in#entor% mana*ement ma"e 'amous !% To%ota Dotors in the 0IMJs.;3@

Hi(/5level inventor. ,ana(e,ent

It seems that aroun" 0MMJ;M@ there -as a han*e in manu'a turin* $ra ti e 'rom om$anies -ith relati#el% homo*eneous lines o' $ro"u ts to #erti all% inte*rate" om$anies -ith un$re e"ente" "i#ersit% in $ro esses an" $ro"u ts. Those om$anies (es$e iall% in metal-or.in*) attem$te" to a hie#e su ess throu*h e onomies o' s o$e - the *ains o' jointl% $ro"u in* t-o or more $ro"u ts in one 'a ilit%. The mana*ers no- nee"e" in'ormation on the e''e t o' $ro"u t-mi) "e isions on o#erall $ro'its an" there'ore nee"e" a urate $ro"u t- ost in'ormation. A #ariet% o' attem$ts to a hie#e this -ere unsu ess'ul "ue to the hu*e o#erhea" o' the in'ormation $ro essin* o' the time. Po-e#er+ the
Page 24 o! 46

!ur*eonin* nee" 'or 'inan ial re$ortin* a'ter 0IJJ reate" una#oi"a!le $ressure 'or 'inan ial a ountin* o' sto . an" the mana*ement nee" to ost mana*e $ro"u ts !e ame o#ersha"o-e". In $arti ular+ it -as the nee" 'or au"ite" a ounts that seale" the 'ate o' mana*erial ost a ountin*. The "ominan e o' 'inan ial re$ortin* a ountin* o#er mana*ement a ountin* remains to this "a% -ith 'ee) e$tions+ an" the 'inan ial re$ortin* "e'initions o' & ost& ha#e "istorte" e''e ti#e mana*ement & ost& a ountin* sin e that time. This is $arti ularl% true o' in#entor%. Pen e+ hi*h-le#el 'inan ial in#entor% has these t-o !asi 'ormulas+ -hi h relate to the a ountin* $erio"?
;. Cost o! Beginning ,nventory at t e start o! t e period G inventory purc ases #it in t e period G cost o! production #it in t e period C cost o! goods available 2. Cost o! goods available M cost o! ending inventory at t e end o! t e period C cost o! goods sold

The !ene'it o' these 'ormulae is that the 'irst a!sor!s all o#erhea"s o' $ro"u tion an" ra- material osts into a #alue o' in#entor% 'or re$ortin*. The se on" 'ormula then reates the ne- start $oint 'or the ne)t $erio" an" *i#es a 'i*ure to !e su!tra te" 'rom the sales $ri e to "etermine some 'orm o' sales-mar*in 'i*ure. Danu'a turin* mana*ement is more intereste" in inventory turnover ratio or average days to sell inventory sin e it tells them somethin* a!out relati#e in#entor% le#els.
,nventory turnover ratio (also .no#n as inventory turns) C cost o! goods sold : Average ,nventory C Cost o! "oods Sold : ((Beginning ,nventory G $nding ,nventory) : 2)

an" its in#erse

Average )ays to Sell ,nventory C 4umber o! )ays a 2ear : ,nventory +urnover Ratio C <?> days a year : ,nventory +urnover Ratio

This ratio estimates ho- man% times the in#entor% turns o#er a %ear. This num!er tells homu h ashC*oo"s are tie" u$ -aitin* 'or the $ro ess an" is a riti al measure o' $ro ess relia!ilit% an" e''e ti#eness. 6o a 'a tor% -ith t-o in#entor% turns has si) months sto . on han"+ -hi h is *enerall% not a *oo" 'i*ure ("e$en"in* u$on the in"ustr%)+ -hereas a 'a tor% that mo#es 'rom si) turns to t-el#e turns has $ro!a!l% im$ro#e" e''e ti#eness !% 0JJN. This im$ro#ement -ill ha#e some ne*ati#e results in the 'inan ial re$ortin*+ sin e the &#alue& nostore" in the 'a tor% as in#entor% is re"u e". =hile these a ountin* measures o' in#entor% are #er% use'ul !e ause o' their sim$li it%+ the% are also 'rau*ht -ith the "an*er o' their o-n assum$tions. There are+ in 'a t+ so man% thin*s that an #ar% hi""en un"er this a$$earan e o' sim$li it% that a #ariet% o' &a"justin*& assum$tions ma% !e use". These in lu"e?

Speci!ic ,denti!ication -eig ted Average Cost 'oving8Average Cost *,*O and 3,*O.

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In#entor% Turn is a 'inan ial a ountin* tool 'or e#aluatin* in#entor% an" it is not ne essaril% a mana*ement tool. In#entor% mana*ement shoul" !e 'or-ar" loo.in*. The metho"olo*% a$$lie" is !ase" on histori al ost o' *oo"s sol". The ratio ma% not !e a!le to re'le t the usa!ilit% o' 'uture $ro"u tion "eman"+ as -ell as ustomer "eman". Business mo"els+ in lu"in* Just in Time (JIT) In#entor%+ Qen"or Dana*e" In#entor% (QDI) an" :ustomer Dana*e" In#entor% (:DI)+ attem$t to minimi,e on-han" in#entor% an" in rease in#entor% turns. QDI an" :DI ha#e *aine" onsi"era!le attention "ue to the su ess o' thir"$art% #en"ors -ho o''er a""e" e)$ertise an" .no-le"*e that or*ani,ations ma% not $ossess.

Accountin( for inventor.

Ea h ountr% has its o-n rules a!out a ountin* 'or in#entor% that 'it -ith their 'inan ialre$ortin* rules. <or e)am$le+ or*ani,ations in the 1.6. "e'ine inventor. to suit their nee"s -ithin 16 Generall% A e$te" A ountin* Pra ti es (GAAP)+ the rules "e'ine" !% the <inan ial A ountin* 6tan"ar"s Boar" (<A6B) (an" others) an" en'or e" !% the 1.6. 6e urities an" E) han*e :ommission (6E:) an" other 'e"eral an" state a*en ies. 9ther ountries o'ten ha#e similar arran*ements !ut -ith their o-n GAAP an" national a*en ies instea". It is intentional that 'inan ial a ountin* uses stan"ar"s that allo- the $u!li to om$are 'irms& $er'orman e+ ost a ountin* 'un tions internall% to an or*ani,ation an" $otentiall% -ith mu h *reater 'le)i!ilit%. A "is ussion o' in#entor% 'rom stan"ar" an" Theor% o' :onstraints-!ase" (throu*h$ut) ost a ountin* $ers$e ti#e 'ollo-s some e)am$les an" a "is ussion o' in#entor% 'rom a 'inan ial a ountin* $ers$e ti#e. The internal ostin*C#aluation o' in#entor% an !e om$le). =hereas in the $ast most enter$rises ran sim$le+ one-$ro ess 'a tories+ su h enter$rises are /uite $ro!a!l% in the minorit% in the 20st entur%. =here &one $ro ess& 'a tories e)ist+ there is a mar.et 'or the *oo"s reate"+ -hi h esta!lishes an in"e$en"ent mar.et #alue 'or the *oo". To"a%+ -ith multista*e-$ro ess om$anies+ there is mu h in#entor% that -oul" on e ha#e !een 'inishe" *oo"s -hi h is nohel" as &-or. in $ro ess& (=IP). This nee"s to !e #alue" in the a ounts+ !ut the #aluation is a mana*ement "e ision sin e there is no mar.et 'or the $artiall% 'inishe" $ro"u t. This some-hat ar!itrar% &#aluation& o' =IP om!ine" -ith the allo ation o' o#erhea"s to it has le" to some uninten"e" an" un"esira!le results.

Financial accounting
An or*ani,ation&s in#entor% an a$$ear a mi)e" !lessin*+ sin e it ounts as an asset on the !alan e sheet+ !ut it also ties u$ mone% that oul" ser#e 'or other $ur$oses an" re/uires a""itional e)$ense 'or its $rote tion. In#entor% ma% also ause si*ni'i ant ta) e)$enses+ "e$en"in* on $arti ular ountries& la-s re*ar"in* "e$re iation o' in#entor%+ as in Thor Po-er Tool :om$an% #. :ommissioner. In#entor% a$$ears as a urrent asset on an or*ani,ation&s !alan e sheet !e ause the or*ani,ation an+ in $rin i$le+ turn it into ash !% sellin* it. 6ome or*ani,ations hol" lar*er in#entories than their o$erations re/uire in or"er to in'late their a$$arent asset #alue an" their $er ei#e" $ro'ita!ilit%.
Page 26 o! 46

In a""ition to the mone% tie" u$ !% a /uirin* in#entor%+ in#entor% also !rin*s asso iate" osts 'or -arehouse s$a e+ 'or utilities+ an" 'or insuran e to o#er sta'' to han"le an" $rote t it 'rom 'ire an" other "isasters+ o!soles en e+ shrin.a*e (the't an" errors)+ an" others. 6u h hol"in* osts an mount u$? !et-een a thir" an" a hal' o' its a /uisition #alue $er %ear. Businesses that sto . too little in#entor% annot ta.e a"#anta*e o' lar*e or"ers 'rom ustomers i' the% annot "eli#er. The on'li tin* o!je ti#es o' ost ontrol an" ustomer ser#i e o'ten $it an or*ani,ation&s 'inan ial an" o$eratin* mana*ers a*ainst its sales an" mar.etin* "e$artments. 6ales$eo$le+ in $arti ular+ o'ten re ei#e sales- ommission $a%ments+ so una#aila!le *oo"s ma% re"u e their $otential $ersonal in ome. This on'li t an !e minimise" !% re"u in* $ro"u tion time to !ein* near or less than ustomers& e)$e te" "eli#er% time. This e''ort+ .no-n as >Lean $ro"u tion> -ill si*ni'i antl% re"u e -or.in* a$ital tie" u$ in in#entor% an" re"u e manu'a turin* osts (6ee the To%ota Pro"u tion 6%stem).

!ole of inventory accounting

B% hel$in* the or*ani,ation to ma.e !etter "e isions+ the a ountants an hel$ the $u!li se tor to han*e in a #er% $ositi#e -a% that "eli#ers in rease" #alue 'or the ta)$a%erGs in#estment. It an also hel$ to in enti#ise $ro*ress an" to ensure that re'orms are sustaina!le an" e''e ti#e in the lon* term+ !% ensurin* that su ess is a$$ro$riatel% re o*ni,e" in !oth the 'ormal an" in'ormal re-ar" s%stems o' the or*ani,ation. To sa% that the% ha#e a .e% role to $la% is an un"erstatement. <inan e is onne te" to most+ i' not all+ o' the .e% !usiness $ro esses -ithin the or*ani,ation. It shoul" !e steerin* the ste-ar"shi$ an" a ounta!ilit% s%stems that ensure that the or*ani,ation is on"u tin* its !usiness in an a$$ro$riate+ ethi al manner. It is riti al that these 'oun"ations are 'irml% lai". 6o o'ten the% are the litmus test !% -hi h $u!li on'i"en e in the institution is either -on or lost. <inan e shoul" also !e $ro#i"in* the in'ormation+ anal%sis an" a"#i e to ena!le the or*ani,ationsG ser#i e mana*ers to o$erate e''e ti#el%. This *oes !e%on" the tra"itional $reo u$ation -ith !u"*ets K ho- mu h ha#e -e s$ent so 'ar+ ho- mu h "o -e ha#e le't to s$en"8 It is a!out hel$in* the or*ani,ation to !etter un"erstan" its o-n $er'orman e. That means ma.in* the onne tions an" un"erstan"in* the relationshi$s !et-een *i#en in$uts K the resour es !rou*ht to !ear K an" the out$uts an" out omes that the% a hie#e. It is also a!out un"erstan"in* an" a ti#el% mana*in* ris.s -ithin the or*ani,ation an" its a ti#ities.

FIF" vs# LIF" accounting

Main article: F F! an" # F! accounting

=hen a mer hant !u%s *oo"s 'rom in#entor%+ the #alue o' the in#entor% a ount is re"u e" !% the ost o' *oo"s sol" (:9G6). This is sim$le -here the :oG has not #arie" a ross those hel" in sto .; !ut -here it has+ then an a*ree" metho" must !e "eri#e" to e#aluate it. <or ommo"it% items that one annot tra . in"i#i"uall%+ a ountants must hoose a metho" that 'its the nature o' the sale. T-o $o$ular metho"s that normall% e)ist are? <I<9 an" LI<9 a ountin* ('irst in 'irst out+ last in - 'irst out). <I<9 re*ar"s the 'irst unit that arri#e" in in#entor% as the 'irst one sol". LI<9 onsi"ers the last unit arri#in* in in#entor% as the 'irst one sol". =hi h metho" an a ountant sele ts an ha#e a si*ni'i ant e''e t on net in ome an" !oo. #alue an"+ in turn+ on ta)ation. 1sin* LI<9 a ountin* 'or in#entor%+ a om$an% *enerall% re$orts lo-er net in ome an" lo-er !oo. #alue+ "ue to the e''e ts o' in'lation. This *enerall% results in lo-er ta)ation. Page 27 o! 46

Due to LI<9&s $otential to s.e- in#entor% #alue+ 1K GAAP an" IA6 ha#e e''e ti#el% !anne" LI<9 in#entor% a ountin*.

Standard cost accounting

6tan"ar" ost a ountin* uses ratios alle" e''i ien ies that om$are the la!our an" materials a tuall% use" to $ro"u e a *oo" -ith those that the same *oo"s -oul" ha#e re/uire" un"er >stan"ar"> on"itions. As lon* as similar a tual an" stan"ar" on"itions o!tain+ 'e- $ro!lems arise. 1n'ortunatel%+ stan"ar" ost a ountin* metho"s "e#elo$e" a!out 0JJ %ears a*o+ -hen la!or om$rise" the most im$ortant ost in manu'a ture" *oo"s. 6tan"ar" metho"s ontinue to em$hasi,e la!or e''i ien % e#en thou*h that resour e no- onstitutes a (#er%) small $art o' ost in most ases. 6tan"ar" ost a ountin* an hurt mana*ers+ -or.ers+ an" 'irms in se#eral -a%s. <or e)am$le+ a $oli % "e ision to in rease in#entor% an harm a manu'a turin* mana*er&s $er'orman e e#aluation. In reasin* in#entor% re/uires in rease" $ro"u tion+ -hi h means that $ro esses must o$erate at hi*her rates. =hen (not i') somethin* *oes -ron*+ the $ro ess ta.es lon*er an" uses more than the stan"ar" la!or time. The mana*er a$$ears res$onsi!le 'or the e) ess+ e#en thou*h sChe has no ontrol o#er the $ro"u tion re/uirement or the $ro!lem. In a"#erse e onomi times+ 'irms use the same e''i ien ies to "o-nsi,e+ ri*htsi,e+ or other-ise re"u e their la!or 'or e. =or.ers lai" o'' un"er those ir umstan es ha#e e#en less ontrol o#er e) ess in#entor% an" ost e''i ien ies than their mana*ers. Dan% 'inan ial an" ost a ountants ha#e a*ree" 'or man% %ears on the "esira!ilit% o' re$la in* stan"ar" ost a ountin*. The% ha#e not+ ho-e#er+ 'oun" a su essor.

Theory of constraints cost accounting

Eli%ahu D. Gol"ratt "e#elo$e" the Theor% o' :onstraints in $art to a""ress the ost-a ountin* $ro!lems in -hat he alls the > ost -orl".> Pe o''ers a su!stitute+ alle" throu*h$ut a ountin*+ that uses throu*h$ut (mone% 'or *oo"s sol" to ustomers) in $la e o' out$ut (*oo"s $ro"u e" that ma% sell or ma% !oost in#entor%) an" onsi"ers la!or as a 'i)e" rather than as a #aria!le ost. Pe "e'ines in#entor% sim$l% as e#er%thin* the or*ani,ation o-ns that it $lans to sell+ in lu"in* !uil"in*s+ ma hiner%+ an" man% other thin*s in a""ition to the ate*ories liste" here. Throu*h$ut a ountin* re o*ni,es onl% one lass o' #aria!le osts? the trul% #aria!le osts+ li.e materials an" om$onents+ -hi h #ar% "ire tl% -ith the /uantit% $ro"u e" <inishe" *oo"s in#entories remain !alan e-sheet assets+ !ut la!or-e''i ien % ratios no lon*er e#aluate mana*ers an" -or.ers. Instea" o' an in enti#e to re"u e la!or ost+ throu*h$ut a ountin* 'o uses attention on the relationshi$s !et-een throu*h$ut (re#enue or in ome) on one han" an" ontrolla!le o$eratin* e)$enses an" han*es in in#entor% on the other. Those relationshi$s "ire t attention to the onstraints or !ottlene .s that $re#ent the s%stem 'rom $ro"u in* more throu*h$ut+ rather than to $eo$le - -ho ha#e little or no ontrol o#er their situations.

National accounts
Page 28 o! 46

In#entories also $la% an im$ortant role in national a ounts an" the anal%sis o' the !usiness % le. 6ome short-term ma roe onomi 'lu tuations are attri!ute" to the in#entor% % le.

Distressed inventor.
Also .no-n as "istresse" or e)$ire" sto .+ "istresse" in#entor% is in#entor% -hose $otential to !e sol" at a normal ost has $asse" or -ill soon $ass. In ertain in"ustries it oul" also mean that the sto . is or -ill soon !e im$ossi!le to sell. E)am$les o' "istresse" in#entor% in lu"e $ro"u ts that ha#e rea he" their e)$ir% "ate+ or ha#e rea he" a "ate in a"#an e o' e)$ir% at -hi h the $lanne" mar.et -ill no lon*er $ur hase them (e.*. 3 months le't to e)$ir%)+ lothin* that is "e'e ti#e or out o' 'ashion+ musi that is no lon*er $o$ular an" ol" ne-s$a$ers or ma*a,ines. It also in lu"es om$uter or onsumer-ele troni e/ui$ment that is o!solete or "is ontinue" an" -hose manu'a turer is una!le to su$$ort it. 9ne urrent e)am$le o' "istresse" in#entor% is the QP6 'ormat.;I@ In 2JJ0+ :is o -rote o'' in#entor% -orth 16 B2.27 !illion "ue to "u$li ate or"ers.;0J@ This is one o' the !i**est in#entor% -rite-o''s in !usiness histor%.

Inventor. credit
In#entor% re"it re'ers to the use o' sto .+ or in#entor%+ as ollateral to raise 'inan e. =here !an.s ma% !e relu tant to a e$t tra"itional ollateral+ 'or e)am$le in "e#elo$in* ountries -here lan" title ma% !e la .in*+ in#entor% re"it is a $otentiall% im$ortant -a% o' o#er omin* 'inan in* onstraints. This is not a ne- on e$t; ar haeolo*i al e#i"en e su**ests that it -as $ra ti e" in An ient Rome. 9!tainin* 'inan e a*ainst sto .s o' a -i"e ran*e o' $ro"u ts hel" in a !on"e" -arehouse is ommon in mu h o' the -orl". It is+ 'or e)am$le+ use" -ith Parmesan heese in Ital%.;00@ In#entor% re"it on the !asis o' store" a*ri ultural $ro"u e is -i"el% use" in Latin Ameri an ountries an" in some Asian ountries.;02@ A $re on"ition 'or su h re"it is that !an.s must !e on'i"ent that the store" $ro"u t -ill !e a#aila!le i' the% nee" to all on the ollateral; this im$lies the e)isten e o' a relia!le net-or. o' erti'ie" -arehouses. Ban.s also 'a e $ro!lems in #aluin* the in#entor%. The $ossi!ilit% o' su""en 'alls in ommo"it% $ri es means that the% are usuall% relu tant to len" more than a!out HJN o' the #alue o' the in#entor% at the time o' the loan.

Stock management
toc8 ,ana(e,ent is the 'un tion o' un"erstan"in* the sto . mi) o' a om$an% an" the "i''erent "eman"s on that sto .. The "eman"s are in'luen e" !% !oth e)ternal an" internal 'a tors an" are !alan e" !% the reation o' Pur hase or"er re/uests to .ee$ su$$lies at a reasona!le or $res ri!e" le#el.

Contents
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; Retail supply c ain ;.; -eig ted Average Price 'et od 2 So!t#are applications < Business models Page 29 o! 46

= See also > Re!erences

Retail su++l. c/ain

6to . mana*ement in the retail su$$l% hain 'ollo-s the 'ollo-in* se/uen e?
;. Re7uest !or ne# stoc. !rom stores to ead o!!ice 2. 5ead o!!ice issues purc ase orders to t e vendor <. /endor s ips t e goods =. -are ouse receives t e goods >. -are ouse stoc.s and distributes to t e stores ?. Stores receive t e goods @. "oods are sold to customers at t e stores

The mana*ement o' the in#entor% in the su$$l% hain in#ol#es mana*in* the $h%si al /uantities as -ell as the ostin* o' the *oo"s as it 'lo-s throu*h the su$$l% hain. In mana*in* the ost $ri es o' the *oo"s throu*hout the su$$l% hain+ se#eral ostin* metho"s are em$lo%e"?
;. Retail met od 2. -eig ted Average Price met od <. *,*O (*irst ,n *irst Out) met od =. 3,*O (3ast ,n *irst Out) met od >. 3PP (3ast Purc ase Price) met od ?. B4' (Bottle nec. met od)

$eighted verage Price %ethod

The al ulation an !e "one 'or "i''erent $erio"s. I' the al ulation is "one on a monthl% !asis+ then it is re'erre" to the $erio"i metho". In this metho"+ the a#aila!le sto . is al ulate" !%? ADD 6to . at !e*innin* o' $erio" ADD 6to . $ur hase" "urin* the $erio" AQERAGE total ost !% total /t% to arri#e at the A#era*e :ost o' Goo"s 'or the $erio". This A#era*e :ost Pri e is a$$lie" to all mo#ements an" a"justments in that $erio". En"in* sto . in /t% is arri#e" at !% A$$l%in* all the han*es in /t% to the A#aila!le !alan e. Dulti$l%in* the sto . !alan e in /t% !% the A#era*e ost *i#es the 6to . ost at the en" o' the $erio". 1sin* the $er$etual metho"+ the al ulation is "one u$on e#er% $ur hase transa tion.
Page 30 o! 46

Thus+ the al ulation is the same !ase" on the $erio"i transa tion ($er$etual).

al ulation -hether !% $erio" ($erio"i ) or !%

The onl% "i''eren e is the &$erio"i it%& or s o$e o' the al ulation. - Perio"i is "one monthl% Per$etual is "one 'or the "uration o' the $ur hase until the ne)t $ur hase In $ra ti e+ the "ail% a#era*in* has !een use" to losel% a$$ro)imate the $er$etual metho". H. Bottle ne . metho" ( "e$en"s on $ro$er $lannin* su$$ort)

oft7are a++lications
The im$lementation o' in#entor% mana*ement a$$li ations has !e ome a #alua!le tool 'or or*ani,ations loo.in* to more e''i ientl% mana*e sto .. =hile the a$a!ilities o' a$$li ations #ar%+ most in#entor% mana*ement a$$li ations *i#e or*ani,ations a stru ture" metho" o' a ountin* 'or all in omin* an" out*oin* in#entor% -ithin their 'a ilities. 9r*ani,ations sa#e a si*ni'i ant amount in osts asso iate" -ith manual in#entor% ounts+ a"ministrati#e errors an" re"u tions in in#entor% sto .outs.

Business ,odels
Just-in-time In#entor% (JIT)+ Qen"or Dana*e" In#entor% (QDI) an" :ustomer Dana*e" In#entor% (:DI) are a 'e- o' the $o$ular mo"els !ein* em$lo%e" !% or*ani,ations loo.in* to ha#e *reater sto . mana*ement ontrol. JIT is a mo"el -hi h attem$ts to re$lenish in#entor% 'or or*ani,ations -hen the in#entor% is re/uire". The mo"el attem$ts to a#oi" e) ess in#entor% an" its asso iate" osts. As a result+ om$anies re ei#e in#entor% onl% -hen the nee" 'or more sto . is a$$roa hin*. QDI an" :DI are t-o !usiness mo"els that a"here to the JIT in#entor% $rin i$les. QDI *i#es the #en"or in a #en"orC ustomer relationshi$ the a!ilit% to monitor+ $lan an" ontrol in#entor% 'or their ustomers. :ustomers relin/uish the or"er ma.in* res$onsi!ilities in e) han*e 'or timel% in#entor% re$lenishment that in reases or*ani,ational e''i ien %. :DI allo-s the ustomer to or"er an" ontrol their in#entor% 'rom their #en"orsCsu$$liers. Both QDI an" :DI !ene'it the #en"or as -ell as the ustomer. Qen"ors see a si*ni'i ant in rease in sales "ue to in rease" in#entor% turns an" ost sa#in*s reali,e" !% their ustomers+ -hile ustomers reali,e similar !ene'its. toc8 control is use" to e#aluate ho- mu h sto . is use". It is also use" to .no- -hat is nee"e" to !e or"ere". 6to . ontrol an onl% ha$$en i' a sto . ta.e has ta.en $la e. 6to . rotation must !e $ut into use -ith sto . ontrol !% usin* the ol"est $ro"u ts !e'ore the ne-er $ro"u ts. toc85ta8in( or inventor. c/ec8in( is the $h%si al #eri'i ation o' the /uantities an" on"ition o' items hel" in an in#entor% or -arehouse. This ma% !e "one to $ro#i"e an au"it o' e)istin* sto . #aluation. It is also the sour e o' sto . "is re$an % in'ormation. 6to .-ta.in* ma% !e $er'orme" as an intensi#e annual he . or ma% !e "one ontinuousl% !% means o' a % le ount.;0@
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Cash conversion cycle

In mana*ement a ountin*+ the Cas/ Conversion C.cle (CCC) measures ho- lon* a 'irm -ill !e "e$ri#e" o' ash i' it in reases its in#estment in resour es in or"er to e)$an" ustomer sales. It is thus a measure o' the li/ui"it% ris. entaile" !% *ro-th. Po-e#er+ shortenin* the ::: reates its o-n ris.s? -hile a 'irm oul" e#en a hie#e a ne*ati#e ::: !% olle tin* 'rom ustomers !e'ore $a%in* su$$liers+ a $oli % o' stri t olle tions an" la) $a%ments is not al-a%s sustaina!le.

Contents
o

; )e!inition ;.; )erivation 2 See also < $&ternal lin.s

Definition
CC = !a"# $et%een !i#$ur#ing ca#& an! c'((ecting ca#& in c'nnecti'n %it& un!erta)ing a C !i#crete unit 'f '*erati'n#+ = ,nvent'r" c'nver#i'n *eri'! 0vg+ ,nvent'r" = 1234 5 365 Receiva$(e# c'nver#i'n *eri'! 0vg+ 0cc'unt# Receiva$(e 1re!it 4a(e# 5 365 . /a"a$(e# c'nver#i'n *eri'! 0vg+ 0cc'unt# /a"a$(e 1234 5 365

&erivation
Cas/flo7s insufficient9 The term > ash on#ersion % le> re'ers to the times$an !et-een a 'irm&s "is!ursin* an" olle tin* ash. Po-e#er+ the ::: annot !e "ire tl% o!ser#e" in ash'lo-s+ !e ause these are also in'luen e" !% in#estment an" 'inan in* a ti#ities; it must !e "eri#e" 'rom 6tatement o' <inan ial Position "ata asso iate" -ith the 'irm&s o$erations. E;uation describes retailer9 Althou*h the term > ash on#ersion % le> te hni all% a$$lies to a 'irm in an% in"ustr%+ the e/uation is *eneri all% 'ormulate" to a$$l% s$e i'i all% to a retailer. 6in e a retailer&s o$erations onsist in !u%in* an" sellin* in#entor%+ the e/uation mo"els the time !et-een
(;) disbursing cas to satis!y t e accounts payable created by purc ase o! inventory1 and (2) collecting cas to satis!y t e accounts receivable generated by t at sale.

E;uation describes a fir, t/at bu.s < sells on account9 Also+ the e/uation is -ritten to a ommo"ate a 'irm that buys and sells on account. <or a cash-only firm+ the e/uation -oul" onl% nee" "ata 'rom sales o$erations (e.*. han*es in in#entor%)+ !e ause disbursing cash -oul" !e "ire tl% measura!le as purchase of inventory+ an" collecting cash -oul" !e "ire tl% measura!le as
Page 32 o! 46

sale of inventory. Po-e#er+ no su h 0?0 orres$on"en e e)ists 'or a 'irm that buys and sells on account? In reases an" "e reases in in#entor% "o not o asion ash'lo-s !ut a ountin* #ehi les (re ei#a!les an" $a%a!les+ res$e ti#el%); in reases an" "e reases in ash -ill remo#e these a ountin* #ehi les (re ei#a!les an" $a%a!les+ res$e ti#el%) 'rom the !oo.s. Thus+ the ::: must !e al ulate" !% tra in* a han*e in ash throu*h its e''e t u$on re ei#a!les+ in#entor%+ $a%a!les+ an" 'inall% !a . to ashSthus+ the term cash conversion cycle+ an" the o!ser#ation that these 'our a ounts >arti ulate> -ith one another.
Labe l Transaction Suppliers (agree to) deliver inventory A Firm owes ! cash (debt) to suppliers Customers (agree to) ac$uire that inventory Firm is owed % cash (credit) from customers Firm disburses ! cash to suppliers C Firm removes its debts to its suppliers Firm collects % cash from customers Firm removes its credit from its customersAccounting (use different accounting vehicles if the transactions occur in a different order)

"perations (increasing inventory by !)

Create accounting vehicle (increasing accounts payable by !)

"perations (decreasing inventory by %)

Create accounting vehicle (boo&ing 'C"(S' e)pense of %* accruing revenue and increasing accounts receivable of %)

Cashflows (decreasing cash by !)

+emove accounting vehicle (decreasing accounts payable by !)

Cashflows (increasing cash by %)

+emove accounting vehicle (decreasing accounts receivable by %-)

Ta.in* these 'our transa tions in $airs+ anal%sts "ra- attention to 'i#e im$ortant inter#als+ re'erre" to as conversion c.cles (or conversion +eriods)?

t e 1a#& 1'nver#i'n 1"c(e emerges as interval CN) (i.e. "is$ursing cas%Ncollecting cas%). t e *a"a$(e# c'nver#i'n *eri'! (or J)ays payables outstandingJ) emerges as interval ANC (i.e. o&ing cas%N"is$ursing cas%) t e '*erating c"c(e emerges as interval AN) (i.e. o#ing cas Ncollecting cas ) Page 33 o! 46

t e invent'r" c'nver#i'n *eri'! or J)ays inventory outstandingJ emerges as interval ANB (i.e. o&ing cas%N$eing o&e" cas%) t e receiva$(e# c'nver#i'n *eri'! (or J)ays sales outstandingJ) emerges as interval BN) (i.e.$eing o&e" cas%Ncollecting cas%

Kno-le"*e o' an% three o' these on#ersion % les $ermits "eri#ation o' the 'ourth (lea#in* asi"e the operating cycle+ -hi h is just the sum o' the inventory conversion period an" the receivables conversion period.) Pen e+
interva( 61 7 89 111 (in !a"#) = = interva( 60 7 :9 interva( 6: 7 89 Receiva$(e# c'nver#i'n *eri'! . . interva( 60 7 19 /a"a$(e# c'nver#i'n *eri'!

,nvent'r" c'nver#i'n *eri'!

In al ulatin* ea h o' these three onstituent :on#ersion :% les+ -e use the e/uation TIDE (LEQELCRATE (sin e ea h inter#al rou*hl% e/uals the TIDE nee"e" 'or its LEQEL to !e a hie#e" at its orres$on"in* RATE).

-e estimate its 3$/$3 Jduring t e period in 7uestionJ as t e average o! its levels in t e t#o balance8s eets t at surround t e periodO (3t;G3t2):2. +o estimate its RA+$1 #e note t at Accounts Receivable gro#s only # en revenue is accruedP and ,nventory s rin.s and Accounts Payable gro#s by an amount e7ual to t e CO"S e&pense (in t e long run1 since CO"S actually accrues sometime a!ter t e inventory delivery1 # en t e customers ac7uire it).

/a"a$(e# c'nver#i'n *eri'!O Rate C Einventory increase G CO"SF1 since t ese are t e items !or t e period t at can increase Jtrade accounts payables1J i.e. t e ones t at gre# its inventory.

4O+,C$ t at #e ma.e an e&ception # en calculating t is intervalO alt oug #e use a period average !or t e 3$/$3 o! inventory1 #e also consider any increase in inventory as contributing to its RA+$ o! c ange. + is is because t e purpose o! t e CCC is to measure t e e!!ects o! inventory gro#t on cas outlays. ,! inventory gre# during t e period1 #e #ant to .no# about it. ,nvent'r" c'nver#i'n *eri'!O Rate C CO"S1 since t is is t e item t at (eventually) s rin.s inventory. Receiva$(e# c'nver#i'n *eri'!O Rate C revenue1 since t is is t e item t at can gro# receivables (sales).

Consignment stock
Consi(n,ent stoc8 is sto . le*all% o-ne" !% one $art%+ !ut hel" !% another. 9-nershi$ o' onsi*nment sto . is $asse" onl% -hen the sto . is use" (issue"). 1nuse" sto . in a -arehouse ma% !e returne" to the su$$lier.

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As o-nershi$ o' onsi*nment sto . is not trans'erre" until use+ in#oi in* is not imme"iate. To a ount 'or a re$lenishment o' onsi*nment sto . at a ustomer site+ a manu'a turer must re"it inventor. an" "e!it custo,er consi(n,ent stoc8. 9nl% a'ter a ustomer a tuall% uses the onsi*nment sto . ma% an accounts +a.able !e reate".

'conomic order (uantity

Econo,ic order ;uantit. is the le#el o' in#entor% that minimi,es total in#entor% hol"in* osts an" or"erin* osts. It is one o' the ol"est lassi al $ro"u tion s he"ulin* mo"els. The 'rame-or. use" to "etermine this or"er /uantit% is also .no-n as %ilson EOQ Model or %ilson For,ula. The mo"el -as "e#elo$e" !% <or" =. Parris in 0I03+ !ut R. P. =ilson+ a onsultant -ho a$$lie" it e)tensi#el%+ is *i#en re"it 'or his in-"e$th anal%sis.;0@

Overvie7
E9R a$$lies onl% -hen "eman" 'or a $ro"u t is onstant o#er the %ear an" ea h ne- or"er is "eli#ere" in 'ull -hen in#entor% rea hes ,ero. There is a 'i)e" ost 'or ea h or"er $la e"+ re*ar"less o' the num!er o' units or"ere". There is also a ost 'or ea h unit hel" in stora*e+ sometimes e)$resse" as a $er enta*e o' the $ur hase ost o' the item. =e -ant to "etermine the o$timal num!er o' units to or"er so that -e minimi,e the total ost asso iate" -ith the $ur hase+ "eli#er% an" stora*e o' the $ro"u t. The re/uire" $arameters to the solution are the total "eman" 'or the %ear+ the $ur hase ost 'or ea h item+ the 'i)e" ost to $la e the or"er an" the stora*e ost 'or ea h item $er %ear. 4ote that the num!er o' times an or"er is $la e" -ill also a''e t the total ost+ thou*h this num!er an !e "etermine" 'rom the other $arameters.

"nderl.in( assu,+tions
;. + e ordering cost is constant. 2. + e rate o! demand is .no#n1 and spread evenly t roug out t e year. <. + e lead time is !i&ed. =. + e purc ase price o! t e item is constant i.e. no discount is available >. + e replenis ment is made instantaneously1 t e # ole batc is delivered at once. ?. Only one product is involved.

E9R is the /uantit% to or"er+ so that or"erin* ost O arr%in* ost 'in"s its minimum. (A ommon misun"erstan"in* is that the 'ormula tries to 'in" -hen these are e/ual.)

$ariables

Q C order 7uantity Q T C optimal order 7uantity

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D C annual demand 7uantity o! t P C purc

ase cost per unit

e product

S C !i&ed cost per order (not per unit1 typically cost o! ordering and s
is not t e cost o! goods)

ipping and andling. + is

olding cost per unit (also .no#n as carrying cost or storage cost) (#are ouse space1 re!rigeration1 insurance1 etc. usually not related to t e unit cost)

H C annual

!/e !otal Cost function

The sin*le-item E9R 'ormula 'in"s the minimum $oint o' the 'ollo-in* ost 'un tion? Total :ost ( $ur hase ost O or"erin* ost O hol"in* ost - Pur hase ost? This is the #aria!le ost o' *oo"s? $ur hase unit $ri e U annual "eman" /uantit%. This is PUD - 9r"erin* ost? This is the ost o' $la in* or"ers? ea h or"er has a 'i)e" ost 6+ an" -e nee" to or"er DCR times $er %ear. This is 6 U DCR - Pol"in* ost? the a#era*e /uantit% in sto . (!et-een 'ull% re$lenishe" an" em$t%) is RC2+ so this ost is P U RC2

. To "etermine the minimum $oint o' the total ost ur#e+ set the or"erin* ost e/ual to the hol"in* ost?

6ol#in* 'or R *i#es RT (the o$timal or"er /uantit%)?

There'ore?

RT is in"e$en"ent o' P; it is a 'un tion o' onl% 6+ D+ P.

E*tensions
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6e#eral e)tensions an !e ma"e to the E9R mo"el+ in lu"in* !a .or"erin* osts an" multi$le items. A""itionall%+ the e onomi or"er inter#al an !e "etermine" 'rom the E9R an" the e onomi $ro"u tion /uantit% mo"el (-hi h "etermines the o$timal $ro"u tion /uantit%) an !e "etermine" in a similar 'ashion. A #ersion o' the mo"el+ the Baumol-To!in mo"el+ has also !een use" to "etermine the mone% "eman" 'un tion+ -here a $erson&s hol"in*s o' mone% !alan es an !e seen in a -a% $arallel to a 'irm&s hol"in*s o' in#entor%.;2@

E*a,+le

Suppose annual re7uirement 7uantity (6) C ;IIII units Cost per order (CO) C D2 Cost per unit (CU)C DA Carrying cost Hage (Hage o! CU) C I.I2 Carrying cost Per unit C DI.;?

E onomi or"er /uantit% ( E onomi or"er /uantit% ( 7JJ units

4um!er o' or"er $er %ear (!ase" on E9R) 4um!er o' or"er $er %ear (!ase" on E9R) ( 2J Total ost ( Total ost ( Total ost (

C T Q O C!(Q C "!Q) O CC("!Q C 2) M T 0JJJJ O 2(0JJJJ C 7JJ) O J.0H(7JJ C 2) BMJJMJ

I' -e he . the total ost 'or an% or"er /uantit% other than 7JJ((E9R)+ -e -ill see that the ost is hi*her. <or instan e+ su$$osin* HJJ units $er or"er+ then Total ost ( Total ost (

M T 0JJJJ O 2(0JJJJ C HJJ) O J.0H(HJJ C 2) BMJJM0

6imilarl%+ i' -e hoose 3JJ 'or the or"er /uantit% then Total ost ( Total ost (

M T 0JJJJ O 2(0JJJJ C 3JJ) O J.0H(3JJ C 2) BMJJI0

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This illustrates that the E onomi 9r"er Ruantit% is al-a%s in the !est interests o' the entit%.

Inventor. invest,ent is a

om$onent o' *ross "omesti $ro"u t (GDP). =hat is $ro"u e" in a ertain ountr% is naturall% also sol" e#entuall%+ !ut some o' the *oo"s $ro"u e" in a *i#en %ear ma% !e sol" in a later %ear rather than in the %ear the% -ere $ro"u e". :on#ersel%+ some o' the *oo"s sol" in a *i#en %ear mi*ht ha#e !een $ro"u e" in an earlier %ear. The "i''eren e !et-een *oo"s $ro"u e" ($ro"u tion) an" *oo"s sol" (sales) in a *i#en %ear is alle" in#entor% in#estment. The term an !e a$$lie" to the e onom% as a -hole or to an in"i#i"ual 'irm.

Contents

0 De'inition o' in#entor% in#estment 2 Dathemati al relationshi$ o' in#entor% in#estment to in#entories 3 Inten"e" an" uninten"e" in#entor% in#estment 5 Relationshi$ to ma roe onomi e/uili!rium 7 In#entor% in#estment o#er the !usiness % le H Re'eren es

Definition of inventor. invest,ent

In#entor% in#estment ( $ro"u tion - sales;0@

Thus+ i' $ro"u tion $er unit time e) ee"s sales $er unit time+ then in#entor% in#estment $er unit time is $ositi#e; as a result+ at the en" o' that $erio" o' time the sto . o' in#entories on han" -ill !e *reater than it -as at the !e*innin*. The re#erse is true i' $ro"u tion is less than sales.

Mat/e,atical relations/i+ of inventor. invest,ent to inventories

In "is rete time+ the en"-o'-$erio" sto . o' in#entories minus the !e*innin*-o'-$erio" sto . o' in#entories e/uals the 'lo- o' in#entor% in#estment $er time $erio". In ontinuous time+ the time "eri#ati#e o' the sto . o' in#entories e/uals the instantaneous 'lo- o' in#entor% in#estment.

Intended and unintended inventor. invest,ent

A $ositi#e 'lo- o' Intended inventor. invest,ent o urs -hen a 'irm e)$e ts that sales -ill !e hi*h enou*h that the urrent le#el o' in#entories on han" ma% !e insu''i ientS$erha$s !e ause in the $resen e o' #er% short-term 'lu tuations in the timin* o' ustomer $ur hases+ there is a ris. o' tem$oraril% !ein* una!le to su$$l% the $ro"u t -hen a ustomer "eman"s it. To a#oi" that $ros$e t+ the 'irm "eli!eratel% !uil"s u$ its in#entoriesSthat is+ en*a*es in $ositi#e inten"e" in#entor% in#estment !% "eli!eratel% $ro"u in* more than it e)$e ts to sell. E onomists #ie- this $ositi#e inten"e" in#entor% in#estment as a 'orm o' s$en"in*Sin e''e t+ the 'irm is !u%in* in#entories 'rom itsel'.;0@
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:on#ersel%+ i' a 'irm "e i"es that its urrent le#el o' in#entories is unjusti'ia!l% hi*hSsome o' the in#entories are ta.in* u$ ostl% -arehouse s$a e -hile e) ee"in* -hat is nee"e" to $re#ent sto .-outs Sthen it -ill en*a*e in a ne*ati#e 'lo- o' inten"e" in#entor% in#estment. It "oes this !% "eli!eratel% $ro"u in* less than -hat it e)$e ts to sell. Positi#e or ne*ati#e unintended inventor. invest,ent o urs -hen ustomers !u% a "i''erent amount o' the 'irm&s $ro"u t than the 'irm e)$e te" "urin* a $arti ular time $erio". I' ustomers !u% less than e)$e te"+ in#entories une)$e te"l% !uil" u$ an" uninten"e" in#entor% in#estment turns out to ha#e !een $ositi#e. I' ustomers !u% more than e)$e te"+ in#entories une)$e te"l% "e line an" uninten"e" in#entor% in#estment turns out to ha#e !een ne*ati#e. Either $ositi#e or ne*ati#e inten"e" in#entor% in#estment an oin i"e -ith either $ositi#e or ne*ati#e uninten"e" in#entor% in#estment. The% are se$arate+ unrelate" e#ents? one is !ase" on "eli!erate a tions to a"just the sto . o' in#entories+ -hile the other results 'rom mis$re"i tions o' ustomer "eman".

Relations/i+ to ,acroecono,ic e;uilibriu,

In ma roe onomi s+ e/uili!rium in the *oo"s mar.et o urs -hen the su$$l% o' *oo"s (out$ut) e/uals the "eman" 'or *oo"s (the sum o' #arious t%$es o' e)$en"itureS onsumer e)$en"iture+ *o#ernment e)$en"iture on *oo"s+ net e)$en"itures !% $eo$le outsi"e the ountr% on the ountr%&s e)$orts+ 'i)e" in#estment e)$en"iture on $h%si al a$ital+ an" inten"e" in#entor% in#estment). I' these are in"ee" e/ual 'or a $arti ular time $erio"+ there is no uninten"e" in#entor% in#estment an" there is *oo"s mar.et e/uili!rium. I' the% are not e/ual there is "ise/uili!rium in the *oo"s mar.et+ re'le te" in the $resen e o' $ositi#e or ne*ati#e uninten"e" in#entor% in#estment.

Inventor. invest,ent over t/e business c.cle

A t%$i al !usiness % le $la%s out in the 'ollo-in* -a%. ;2@ 6tartin* 'rom some $oint in the !usiness % le+ some *rou$ ( onsumers+ *o#ernment+ $ur hasers o' e)$orts+ et .) "e i"es 'or some reason to ha#e a sustaine" in rease in their s$en"in*. This ma% ome as a sur$rise to $ro"u ers+ -ho initiall% e)$erien e ne*ati#e in#entor% in#estment as their sales ha#e une)$e te"l% e) ee"e" their $ro"u tion. 4o- their in#entories are too lo-+ 'or t-o reasons? (0) In#entories ha#e a i"entall% *one "o-n+ an" (2) the o$timal le#el o' in#entoriesS-hat $ro"u ers -ant to ha#e on han"Shas *one u$ !e ause sustaine" ustomer "eman" has *one u$ an" there is in rease" "an*er o' tem$orar% sto .-outs. In or"er to !uil" in#entories u$ to an a$$ro$riate le#el+ 'irms en*a*e in $ositi#e inten"e" in#entor% in#estment. This $ositi#e 'lo- o' inten"e" in#entor% in#estment ontinues until the tar*et le#el o' in#entories is rea he". Durin* this time+ the e onom% is in a !oom !oth "ue to the ori*inal sustaine" in rease in s$en"in* an" "ue to the $ositi#e 'lo- o' inten"e" in#entor% in#estment. At some $oint+ there is a sustaine" "e line in some t%$e o' s$en"in* 'or some reason. (9ne reason ma% sim$l% !e that+ on e in#entories rea h their "esire" le#el+ there sto$s !ein* $ositi#e inten"e" in#entor% in#estment; !ut there ma% !e other reasons as -ell.) Then there is $ositi#e uninten"e" in#entor% in#estment as 'irms are au*ht !% sur$rise !% the e)ternal "ro$ in "eman" an" the% 'ail to simultaneousl% lo-er their $ro"u tion. 4o- in#entories are too hi*h+ 'or t-o reasons? (0) The% ha#e a i"entall% risen+ an" (2) the o$timal le#el o' in#entories is lo-er no- "ue to the ne-+ lo-er le#el o' sustaine" "eman". 6o in or"er to lo-er their in#entories+ 'orms "eli!eratel% ut !a . their $ro"u tion to !elo- the le#el o' "eman" !% their ustomers+ thus ausin* in#entories to !e "eli!eratel% "ra-n "o-n Sthat is+ inten"e" in#entor% in#estment is ne*ati#e. Inten"e" in#entor% in#estment remains ne*ati#e
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until the tar*et le#el o' in#entories is rea he". Durin* this time+ the e onom%+ ha#in* $ea.e" out+ is in a "o-nturn (a re ession) !oth "ue to the sustaine" "e rease in non-in#entor% e)$en"iture an" "ue to the ne*ati#e 'lo- o' inten"e" in#entor% in#estment. At some $oint+ there is a sustaine" in rease in some t%$e o' s$en"in* 'or some reason. (9ne reason ma% sim$l% !e that+ on e in#entories sin. to their "esire" le#el+ there sto$s !ein* ne*ati#e inten"e" in#entor% in#estment+ -hi h *oes u$ 'rom ne*ati#e to ,ero; !ut a*ain there ma% !e other reasons as -ell.) At this $oint there is ne*ati#e uninten"e" in#entor% in#estment as 'irms are au*ht !% sur$rise !% the e)ternal in rease in "eman" an" the% 'ail to simultaneousl% raise their $ro"u tion. 4o- in#entories are too lo-+ a*ain 'or t-o reasons+ an" -e are !a . -here -e starte" in the % le. The re ession has !ottome" out+ sustaine" s$en"in* is on e a*ain hi*h+ tar*et in#entor% le#els are hi*her than a tual in#entor% le#els+ an" inten"e" in#entor% in#estment is $ositi#e.

Inventory management software

In#entor% mana*ement so't-are is a om$uter-!ase" s%stem 'or tra .in* $ro"u t le#els+ or"ers+ sales an" "eli#eries.;0@ It an also !e use" in the manu'a turin* in"ustr% to reate a -or. or"er+ !ill o' materials an" other $ro"u tion-relate" "o uments. :om$anies use inventor. ,ana(e,ent soft7are to a#oi" $ro"u t o#ersto . an" outa*es. It is a tool 'or or*ani,in* in#entor% "ata that !e'ore -as *enerall% store" in har"- o$% 'orm or in Di roso't E) el s$rea"sheets.

Contents
o o o o o o o o o o

; Components ;.; Asset trac.ing ;.2 Barcoding ;.< Order management ;.= Service management 2 5istory < Purpose = 'anu!acturing uses:applications > Advantages >.; Cost savings >.2 -are ouse organi(ation >.< Updated data >.= +ime savings ? )isadvantages ?.; $&pense ?.2 Comple&ity Page 40 o! 46

@ See also A Re!erences

Co,+onents
In#entor% mana*ement so't-are is ma"e u$ o' se#eral om$onents+ all -or.in* to*ether to reate a ohesi#e in#entor% an" sto .s 'or man% or*anisations ontrol s%stems. These om$onents in lu"e (in al$ha!eti al or"er)?

sset tracking
=hen a $ro"u t is in a -arehouse or store+ it an !e tra .e" #ia its !ar o"e an"Cor other tra .in* riteria+ su h as serial num!er+ lot num!er or re#ision num!er.;2@

)arcoding
Bar o"es are the means -here!% "ata on $ro"u ts an" or"ers is in$utte" into in#entor% mana*ement so't-are. A !ar o"e rea"er is re/uire" to rea" !ar o"es an" loo. u$ in'ormation on the $ro"u ts the% re$resent.;3@

"rder management
9n e $ro"u ts rea h a ertain lo- le#el+ a om$an%Gs in#entor% mana*ement s%stem an !e $ro*ramme" to tell mana*ers to reor"er that $ro"u t. This hel$s om$anies a#oi" runnin* out o' $ro"u ts or t%in* u$ too mu h a$ital in in#entor%.;5@

Service management
:om$anies that are $rimaril% ser#i e-oriente" rather than $ro"u t-oriente" an use in#entor% mana*ement so't-are to tra . the ost o' the materials the% use to $ro#i"e ser#i es+ su h as leanin* su$$lies. This -a%+ the% an atta h $ri es to their ser#i es that re'le t the total ost o' $er'ormin* them.
;7@

Histor.
The 1ni#ersal Pro"u t :o"e (1P:) -as a"o$te" !% the *ro er% in"ustr% in A$ril 0IL3 as the stan"ar" !ar o"e 'or all *ro ers+ thou*h it -as not intro"u e" at retailin* lo ations until 0IL5.;H@ This hel$e" "ri#e "o-n osts 'or in#entor% mana*ement !e ause retailers in the 1nite" 6tates an" :ana"a "i"nGt ha#e to $ur hase multi$le !ar o"e rea"ers to s an om$etin* !ar o"es. There -as no- one $rimar% !ar o"e 'or *ro ers an" other retailers to !u% one t%$e o' rea"er 'or. In the earl% 0IMJs+ P:s "e!ute" an" starte" !e omin* $o$ular.;L@ This 'urther $ushe" "o-n the ost o' !ar o"es an" rea"ers. It also allo-e" the 'irst #ersions o' in#entor% mana*ement so't-are to !e $ut into $la e. 9ne o' the !i**est hur"les in sellin* rea"ers an" !ar o"es to retailers -as the 'a t that the% "i"nGt ha#e a $la e to store the in'ormation the% s anne". As om$uters !e ame more ommon an" a''or"a!le+ this hur"le -as o#er ome. 9n e !ar o"es an" in#entor% mana*ement $ro*rams starte" s$rea"in* throu*h *ro er% stores+ in#entor% mana*ement !% han" !e ame less $ra ti al. =ritin*
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in#entor% "ata !% han" on $a$er -as re$la e" !% s annin* $ro"u ts an" in$uttin* in'ormation into a om$uter !% han". 6tartin* in the earl% 2JJJs+ in#entor% mana*ement so't-are $ro*resse" to the $oint -here !usiness$eo$le no lon*er nee"e" to in$ut "ata !% han" !ut oul" instantl% u$"ate their "ata!ase -ith !ar o"e rea"ers.;M@

Pur+ose
:om$anies o'ten use in#entor% mana*ement so't-are to re"u e their arr%in* osts.;I@ The so't-are is use" to tra . $ro"u ts an" $arts as the% are trans$orte" 'rom a #en"or to a -arehouse+ !et-een -arehouses+ an" 'inall% to a retail lo ation or "ire tl% to a ustomer. In#entor% mana*ement so't-are is use" 'or a #ariet% o' $ur$oses+ in lu"in*?

'aintaining a balance bet#een too muc and too little inventory. +rac.ing inventory as it is transported bet#een locations. Receiving items into a #are ouse or ot er location. Pic.ing1 pac.ing and s ipping items !rom a #are ouse. Leeping trac. o! product sales and inventory levels. Cutting do#n on product obsolescence and spoilage.

Manufacturin( uses0a++lications
Danu'a turers mainl% use in#entor% mana*ement so't-are to reate -or. or"ers an" !ills o' materials. This 'a ilitates the manu'a turin* $ro ess !% hel$in* manu'a turers e''i ientl% assem!le the tools an" $arts the% nee" to $er'orm s$e i'i tas.s. <or more- om$le) manu'a turin* jo!s+ manu'a turers an reate multile#el -or. or"ers an" !ills o' materials+ -hi h ha#e a timeline o' $ro esses that nee" to ha$$en in the $ro$er or"er to !uil" a 'inal $ro"u t. 9ther -or. or"ers that an !e reate" usin* in#entor% mana*ement so't-are in lu"e re#erse -or. or"ers an" auto -or. or"ers. Danu'a turers also use in#entor% mana*ement so't-are 'or tra .in* assets+ re ei#in* ne- in#entor% an" a""itional tas.s !usinesses in other in"ustries use it 'or.

Advanta(es
There are se#eral a"#anta*es to usin* in#entor% mana*ement so't-are in a !usiness settin*.

Cost savings
In man% ases+ a om$an%Gs in#entor% re$resents one o' its lar*est in#estments+ alon* -ith its -or.'or e an" lo ations.;0J@ In#entor% mana*ement so't-are hel$s om$anies ut e)$enses !% minimi,in* the amount o' unne essar% $arts an" $ro"u ts in stora*e. It also hel$s om$anies .ee$ lost sales to a minimum !% ha#in* enou*h sto . on han" to meet "eman".;00@

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$arehouse organi*ation
In#entor% mana*ement so't-are an hel$ "istri!utors+ -holesalers+ manu'a turers an" retailers o$timi,e their -arehouses. I' ertain $ro"u ts are o'ten sol" to*ether or are more $o$ular than others+ those $ro"u ts an !e *rou$e" to*ether or $la e" near the "eli#er% area to s$ee" u$ the $ro ess o' $i .in*+ $a .in* an" shi$$in* to ustomers.

+pdated data
1$-to-"ate "ata on in#entor% on"itions an" le#els is also an a"#anta*e in#entor% mana*ement so't-are *i#es om$anies. :om$an% e)e uti#es an usuall% a ess the so't-are throu*h a mo!ile "e#i e+ la$to$ or P: to he . urrent in#entor% num!ers.

Time savings
=ith the ai" o' restri te" user ri*hts+ om$an% mana*ers an allo- man% em$lo%ees to assist in in#entor% mana*ement. The% an *rant em$lo%ees enou*h in'ormation a ess to re ei#e $ro"u ts+ ma.e or"ers+ trans'er $ro"u ts an" "o other tas.s -ithout om$romisin* om$an% se urit%. This an s$ee" u$ the in#entor%-mana*ement $ro ess an" sa#e mana*ersG time.

Disadvanta(es
The main "isa"#anta*es o' in#entor% mana*ement so't-are are its ost an" om$le)it%.

'xpense
:ost an !e a major "isa"#anta*e o' in#entor% mana*ement so't-are.;02@ Dan% lar*e om$anies use in#entor% mana*ement so't-are+ !ut small !usinesses an 'in" it "i''i ult to a''or" it. Bar o"e rea"ers an" other har"-are an om$oun" this $ro!lem !% a""in* e#en more ost to om$anies. The a"#anta*e o' allo-in* multi$le em$lo%ees to $er'orm in#entor%-mana*ement tas.s is tem$ere" !% the ost o' a""itional !ar o"e rea"ers.

Complexity
In#entor% mana*ement so't-are is not ne essaril% sim$le or eas% to learn. A om$an%Gs mana*ement team must "e"i ate a ertain amount o' time to learnin* a ne- s%stem+ in lu"in* its so't-are an" har"-are+ in or"er to $ut it to use. Dost in#entor% mana*ement so't-are in lu"es trainin* manuals an" other in'ormation a#aila!le to users. Des$ite its a$$arent om$le)it%+ in#entor% mana*ement so't-are o''ers a "e*ree o' sta!ilit% to om$anies. <or e)am$le+ i' an IT em$lo%ee in har*e o' the s%stem lea#es the om$an%+ a re$la ement an !e om$arati#el% ine)$ensi#e to train om$are" to i' the om$an% use" multi$le $ro*rams to store in#entor% "ata.;03@

A +inc/5+oint is the le#el o' in#entories o' a

ommo"it% or $ro"u t !elo- -hi h onsumers o' that ommo"it% or $ro"u t !e ome on erne" a!out se urit% o' su$$l%. =hen in#entories are !elo- the $in h-$oint+ small han*es in the !alan e o' su$$l% an" "eman" an ause lar*e han*es in the $ri e o' the ommo"it% or $ro"u t.;0@;2@

Page 43 o! 46

The term -as su**este" in 0IMM !% =alter :urloo. (E)e uti#e Qi e-Presi"ent o' In o Lt") an" -as 'irst $u!lishe" !% Ra%mon" Gol"ie -ith Ro! Daiman in 0IIJ. In 2JJJ Ra%mon" Gol"ie tra"emar.e" the term.

A stoc8out+ or out5of5stoc8 (996) e#ent is an e#ent that

auses in#entor% to !e e)hauste". Reor"er $oints are o'ten s$e i'ie" in su h a -a% as to re"u e the li.elihoo" o' sto .outs "urin* re$lenishment+ "ue to the #en"or&s lea" time+ -hi h ause interru$tions to sales or "eli#eries. 6to .outs are e''e ti#el% the o$$osite o' o#ersto .s+ -here too mu h in#entor% is retaine".

4afet" #t'c) (a(#' ca((e! $uffer #t'c)) is a term used by

logisticians to describe a level o! e&tra stoc. t at is maintained to mitigate ris. o! stoc.outs (s ort!all in ra# material or pac.aging) due to uncertainties in supply and demand. Ade7uate sa!ety stoc. levels permit business operations to proceed according to t eir plans.E;F Sa!ety stoc. is eld # en t ere is uncertainty in t e demand level or lead time !or t e productP it serves as an insurance against stoc.outs.

=ith a ne- $ro"u t+ sa'et% sto . an !e utili,e" as a strate*i tool until the om$an% an ju"*e hoa urate their 'ore ast is a'ter the 'irst 'e- %ears+ es$e iall% -hen use" -ith a material re/uirements $lannin* -or.sheet. The less a urate the 'ore ast+ the more sa'et% sto . is re/uire". =ith a material re/uirements $lannin* (DRP) -or.sheet a om$an% an ju"*e ho- mu h the% -ill nee" to $ro"u e to meet their 'ore aste" sales "eman" -ithout rel%in* on sa'et% sto .. Po-e#er+ a ommon strate*% is to tr% an" re"u e the le#el o' sa'et% sto . to hel$ .ee$ in#entor% osts lo- on e the $ro"u t "eman" !e omes more $re"i ta!le. This an !e e)tremel% im$ortant 'or om$anies -ith a smaller 'inan ial ushion or those tr%in* to run on lean manu'a turin*+ -hi h is aime" to-ar"s eliminatin* -aste throu*hout the $ro"u tion $ro ess. The amount o' sa'et% sto . an or*ani,ation hooses to .ee$ on han" an "ramati all% a''e t their !usiness. Too mu h sa'et% sto . an result in hi*h hol"in* osts o' in#entor%. In a""ition+ $ro"u ts -hi h are store" 'or too lon* a time an s$oil+ e)$ire+ or !rea. "urin* the -arehousin* $ro ess. Too little sa'et% sto . an result in lost sales an"+ thus+ a hi*her rate o' ustomer turno#er. As a result+ 'in"in* the ri*ht !alan e !et-een too mu h an" too little sa'et% sto . is essential.

Reasons for safet. stoc8

6a'et% sto .s are mainl% use" in a >Da.e To 6to .> manu'a turin* strate*%. This strate*% is em$lo%e" -hen the lea" time o' manu'a turin* is too lon* to satis'% the ustomer "eman" at the ri*ht ostC/ualit%C-aitin* time. The main *oal o' sa'et% sto .s is to a!sor! the #aria!ilit% o' the ustomer "eman". In"ee"+ the Pro"u tion Plannin* is !ase" on a 'ore ast+ -hi h is (!% "e'inition) "i''erent 'orm the real "eman". B% a!sor!in* these #ariations+ sa'et% sto . im$ro#es the ustomer ser#i e le#el. B% reatin* a sa'et% sto .+ %ou -ill also $re#ent sto .-outs 'rom other #ariations ?

an up#ard trend in t e demand a problem in t e incoming product !lo# (mac inery brea.do#n1 supplies delayed1 stri.e1 ...) Page 44 o! 46

Reducin( safet. stoc8

6a'et% sto . is use" as a !u''er to $rote t or*ani,ations 'rom sto .outs ause" !% ina urate $lannin* or $oor s he"ule a"heren e !% su$$liers. As su h+ its ost (in !oth material an" mana*ement) is o'ten seen as a "rain on 'inan ial resour es that results in re"u tion initiati#es. In a""ition+ time sensiti#e *oo"s su h as 'oo"+ "rin.+ an" other $erisha!le items oul" s$oil an" *o to -aste i' hel" as sa'et% sto . 'or too lon*.;2@ Qarious metho"s e)ist to re"u e sa'et% sto .+ these in lu"e !etter use o' te hnolo*%+ in rease" olla!oration -ith su$$liers+ an" more a urate 'ore astin* ;3@;5@ In a lean su$$l% en#ironment+ lea" times are re"u e"+ -hi h an hel$ minimi,e sa'et% sto . le#els thus re"u in* the li.elihoo" an" im$a t o' sto .outs.;7@ Due to the ost o' sa'et% sto .+ man% or*ani,ations o$t 'or a ser#i e le#el le" sa'et% sto . al ulation; 'or e)am$le+ a I7N ser#i e le#el oul" result in sto .outs+ !ut is at a le#el that is satis'a tor% to the om$an%. The lo-er the ser#i e le#el+ the lo-er the re/uirement 'or sa'et% sto .. An Enter$rise Resour e Plannin* s%stem (ERP s%stem) an also hel$ an or*ani,ation re"u e its le#el o' sa'et% sto .. Dost ERP s%stems $ro#i"e a t%$e o' Pro"u tion Plannin* mo"ule. An ERP mo"ule su h as this an hel$ a om$an% "e#elo$ hi*hl% a urate an" "%nami sales 'ore asts an" sales an" o$erations $lans. B% reatin* more a urate an" "%nami 'ore asts+ a om$an% re"u es their han e o' $ro"u in* insu''i ient in#entor% 'or a *i#en $erio" an"+ thus+ shoul" !e a!le to re"u e the amount o' sa'et% sto . that the% re/uire.;H@ In a""ition+ ERP s%stems use esta!lishe" 'ormulas to hel$ al ulate a$$ro$riate le#els o' sa'et% sto . !ase" on the $re#iousl% "e#elo$e" $ro"u tion $lans. =hile an ERP s%stem ai"s an or*ani,ation in estimatin* a reasona!le amount o' sa'et% sto .+ the ERP mo"ule must !e set u$ to $lan re/uirements e''e ti#el%. ;L@

Inventor. +olic.
The si,e o' the sa'et% sto . "e$en"s on the t%$e o' in#entor% $oli % that is in e''e t. An in#entor% no"e is su$$lie" 'rom a >sour e> -hi h 'ul'ills or"ers 'or the onsi"ere" $ro"u t a'ter a ertain re$lenishment lea" time. In a >$erio"i re#ie-> in#entor% $oli % the in#entor% le#el is he .e" $erio"i all% (su h as on e a month) an" an or"er is $la e" at that time i' ne essar%; in this ase the ris. $erio" is e/ual to the time until the ne)t re#ie- $lus the re$lenishment lea" time. 9n the other han"+ i' the in#entor% $oli % is a > ontinuous re#ie-> $oli % (su h as an 9r"er $oint-9r"er Ruantit% $oli % or an 9r"er Point-9r"er 1$ To $oli %) the in#entor% le#el is !ein* he . ontinuousl% an" or"ers an !e $la e" imme"iatel%+ so the ris. $erio" is just the re$lenishment lea" time. There'ore > ontinuous re#ie-> in#entor% $oli ies an ma.e "o -ith a smaller sa'et% sto ..

E*a,+le calculation
A ommonl% use" a$$roa h al ulates;M@ the sa'et% sto . !ase" on the 'ollo-in* 'a tors?

)emand rateO t e amount o! items consumed by customers1 on average1 per unit time. 3ead timeO t e delay bet#een t e time t e reorder point (inventory level # ic initiates an orderEBF) is reac ed and rene#ed availability. Service levelO t e desired probability t at a c osen level o! sa!ety stoc. #ill not lead to a stoc.out. 4aturally1 # en t e desired service level is increased1 t e re7uired sa!ety stoc. increases as #ell. *orecast errorO an estimate o! o# !ar actual demand may be !rom !orecasted demand. $&pressed as t e standard deviation o! demand. Page 45 o! 46

The al ulation? 0. => 49RD6I4Q(6er#i e le#el) + 'or e)am$le V(0.H5 'or a I7N ser#i e le#el 2. afet. stoc8> WVT6RRT(A#*. Lea" Time T 6tan"ar" De#iation o' Deman"X2 O A#*. Deman"X2 T 6tan"ar" De#iation o' Lea" TimeX2)Y 3. Re5order Point 1ROP2> A#era*e Lea" TimeTA#era*e Deman" O #$SQ%&'Avg. (ead &ime $ Standard Deviation of Demand)* + Avg. Demand)* $ Standard Deviation of (ead &ime)*, 4otes?

talici'e" section of t%e (!) formula is safety stock + e !irst term in t e ROP !ormula (Average 3ead timeQAverage )emand) is t e average demand during t e lead time. + e second (italici(ed) term is t e term t at allo#s !or t e sa!ety stoc.. ,n ot er #ords1 t e '*tima( #afet" #t'c) (eve(+ + e s7rt(avgleadtime) is needed to scale t e standard deviation o! t e demand period to t e lengt o! t e lead time period.

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