Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVII. Short−Term Financial
Planning and Management- Credit and Inventory
Management
(^758) © The McGraw−Hill
Companies, 2002
Extensions to the EOQ Model
Thus far, we have assumed that a company will let its inventory run down to zero and
then reorder. In reality, a company will wish to reorder before its inventory goes to zero,
for two reasons. First, by always having at least some inventory on hand, the firm min-
imizes the risk of a stock-out and the resulting losses of sales and customers. Second,
when a firm does reorder, there will be some time lag before the inventory arrives. Thus,
to finish our discussion of the EOQ, we consider two extensions, safety stocks and re-
ordering points.
Safety Stocks Asafety stockis the minimum level of inventory that a firm keeps on
hand. Inventories are reordered whenever the level of inventory falls to the safety stock
level. The top of Figure 21.6 illustrates how a safety stock can be incorporated into an
EOQ model. Notice that adding a safety stock simply means that the firm does not run
its inventory all the way down to zero. Other than this, the situation here is identical to
that described in our earlier discussion of the EOQ.
Reorder Points To allow for delivery time, a firm will place orders before invento-
ries reach a critical level. The reorder pointsare the times at which the firm will actu-
ally place its inventory orders. These points are illustrated in the middle of Figure 21.6.
As shown, the reorder points simply occur some fixed number of days (or weeks or
months) before inventories are projected to reach zero.
One of the reasons that a firm will keep a safety stock is to allow for uncertain deliv-
ery times. We can therefore combine our reorder point and safety stock discussions in
the bottom part of Figure 21.6. The result is a generalized EOQ model in which the firm
orders in advance of anticipated needs and also keeps a safety stock of inventory.
Managing Derived-Demand Inventories
The third type of inventory management technique is used to manage derived-demand
inventories. As we described earlier, demand for some inventory types is derived from
or dependent on other inventory needs. A good example is given by the auto manufac-
turing industry, in which the demand for finished products depends on consumer de-
mand, marketing programs, and other factors related to projected unit sales. The demand
for inventory items such as tires, batteries, headlights, and other components is then
completely determined by the number of autos planned. Materials requirements plan-
ning and just-in-time inventory management are two methods for managing demand-
dependent inventories.
Materials Requirements Planning Production and inventory specialists have devel-
oped computer-based systems for ordering and/or scheduling production of demand-
dependent types of inventories. These systems fall under the general heading of materials
requirements planning (MRP). The basic idea behind MRP is that, once finished goods
inventory levels are set, it is possible to determine what levels of work-in-progress in-
ventories must exist to meet the need for finished goods. From there, it is possible to cal-
culate the quantity of raw materials that must be on hand. This ability to schedule
backwards from finished goods inventories stems from the dependent nature of work-in-
progress and raw materials inventories. MRP is particularly important for complicated
products for which a variety of components are needed to create the finished product.
Just-in-Time Inventory Just-in-time (JIT) inventoryis a modern approach to man-
aging dependent inventories. The goal of JIT is to minimize such inventories, thereby
CHAPTER 21 Credit and Inventory Management 731
materials requirements
planning (MRP)
A set of procedures used
to determine inventory
levels for demand-
dependent inventory
types such as work-in-
progress and raw
materials.
just-in-time (JIT)
inventory
A system for managing
demand-dependent
inventories that
minimizes inventory
holdings.