BUSF_A01.qxd

Chapter 13 • Management of working capital

Note that incorporating a safety buffer means that the average inventories holding

level is no longer E/2 and so the basic model is not strictly valid; however, the model

can quite easily be adjusted to cope with this.

Let us be clear that the model that we have derived is a highly simplified, even

simplistic, attempt to balance the two types of cost. However, as we have seen, the

Figure 13.6
Graph of the
inventories level
against time for an
item of inventories,
assuming a safety
margin

An amount of inventories is delivered at time 0. This is steadily used until the level drops to

the reorder level, at which point a new consignment will be ordered. The reorder level should

be set at such an amount that there are sufficient inventories to maintain operations until the

new consignment arrives, and to provide a margin of safety. The size of the margin of safety

will probably depend on the reliability of the supplier in delivering within the expected time

period. It will also depend on the predictability of the rate at which inventories will be used

during the lead time. The lead time is the period that elapses between placing the order and

receiving the inventories.

l Annual demand may be (almost certainly is) impossible to predict with certainty,

though it may be possible to ascribe statistical probabilities to possible levels of

demand.

l The model ignores many of the costs associated with holding and failing to hold

inventories. This particularly applies to some of the costs of holding low levels of

inventories, such as loss of customer goodwill, production dislocation and loss of

flexibility.

Virtually all of these deficiencies are capable of being accommodated by increasing

the sophistication of the model. For example, the loss of customer goodwill and pro-

duction dislocation problems can to some extent be dealt with by revising the model

to incorporate a safety margin reflecting a pattern of inventories levels over time,

following more closely that which is depicted in Figure 13.6 than the one shown in

Figure 13.4. How large this margin of safety should be must be a matter of managerial

judgement. Some estimate of the costs of holding the additional inventories, the costs

of a stockout, and the probability of its occurrence, must give some guidance in the

exercise of the judgement.