Lesson 1, Topic 1
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6.6 Describe and apply the management of stock and fixed assets in a business unit

ryanrori June 19, 2020

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1. Differentiate between fixed assets and stock in a business unit. 

 Good management is the art of making problems so interesting and their solutions so constructive that everyone wants to get to work and deal with them.

 Asset Management involves the process of planning and monitoring the fixed assets during their useful lives in an institution. Good asset management is critical in both the public and private sector, particularly given the fact that assets exist to support the delivery of programs or services; a link has to be established between program delivery and assets, corporate objectives are translated into program objectives, delivery strategies, outputs and outcomes. Assets within a program are one of the inputs utilized to enable program outcomes; therefore if assets do not contribute effectively towards program delivery, they should not be acquired, held or used

Asset

Analysis of the Definition “Asset”

 Tangible & intangible items held for use in the production or supply of goods or services, for rental to others, or for administrative purposes and are expected to be used during more than one period

 In business and accounting an asset is anything owned, whether in possession or by right to take possession, by a person or group acting together, e.g. a company, the value of which can be expressed in monetary terms. An asset is listed on the balance sheet. It has a normal balance of debit.

Assets may be classified in many ways. The principal distinction normally made for business purposes is between:

  • fixed assets and
  • current assets.

Other business subdivisions include intangible assets, that is, those assets that, though not visible, add to the earning power of the business, e.g. goodwill, patents, copyrights, etc. (also called invisible assets); liquid assets, that are a subdivision of current assets and also categories labelled trade investments, quoted investments, etc.

In the balance sheet of a company certain divisions are required by law, which vary from country to country.

Current assets

These are assets continually turned over in the course of a business during normal business activity. Examples: debtors, stock, cash and work in progress. The phrase net current assets (also called working capital) are often used and refer to the total of current assets less the total of current liabilities.

Fixed assets

A fixed asset is an asset with a useful life of more than one year and is used in the execution of or rendering of service.

Characteristics of a depreciable fixed asset are the following:

  • It is estimated that the asset will be used for more than one financial period (one year);
  • Has a limited useful life;
  • Is used in a process of delivering services

 Leased Assets

Examples of situations which would normally lead to a lease being classified as finance lease are:

  • The lease transfers ownership of the asset to the lessee but by the end of the lease term, the lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than the fair value at the date, the option becomes exercisable such that, at the inception of the lease, it is reasonably certain that the option will be exercised,
  • The lease term is for the major part of the economic life of the asset even if title is not transferred,
  • At the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset.

 Over-investing in fixed assets

In the early years of your new business, you need to limit drawing on your cash reserves unnecessarily. Over-investment in fixed assets, such as office furniture or computer equipment can be a problem. Acquiring fixed assets outright gives you ownership straightaway, but you have to pay for the full cost upfront, which drains cash.

The alternatives to ownership:

  • Leasing assets – at least while your business finds its feet. This allows you to spread payments in regular instalments over a fixed period, thus freeing up more cash. You may be able to upgrade equipment without having to buy more up-to-date models.
  • Hire purchase – you own the asset at the end of the payment process. This is not the case with leasing.

Working capital management

Successful business centres on investing in innovatory ideas, the right equipment and skilled human resources. To invest business needs capital – either from owners, retained profits or from others willing to advance credit or loans.

Cost of a fixed asset includes the cost of activities (cash or equivalent) necessarily incurred to bring the fixed asset to the condition and location essential for its intended use (e.g. purchase price plus transport and installation),

The following are examples of costs that should be capitalized if it can be directly attributed to the acquisition of the asset or bringing the asset to its working condition:

  • Administration and other general overhead costs
  • Start-up and other pre-production costs
  • Interest paid if part of a capital project
  • Any trade discount and rebates deducted in arriving at the purchase price

There are two types of capital need: for ‘fixed capital’ to invest in things such as buildings, plant and equipment; and ‘working capital’ principally to pay for stock and to cover the amount of credit extended to customers.

Fixed capital, as the name implies, tends not to vary in the short term but to move up (or down) in jumps when major investment decisions are made (or assets sold). Working capital, on the other hand, is much more fluid and fluctuates with the level of business.

The working capital cycle links directly with the cash operating cycle.

Working capital comprises short term net assets: stock, debtors, and cash, less creditors. Working capital management then is to do with management of all aspects of both current assets and current liabilities, so as to minimise the risk of insolvency while maximising return on assets.

Value added conversion work in progress

Even profitable companies fail if they have inadequate cash flow. Liabilities are settled with cash not profits. The primary objective of working capital management is to ensure that sufficient cash is available to:

  • meet day-to-day cash flow needs;
  • pay wages and salaries when they fall due;
  • pay creditors to ensure continued supplies of goods and services;
  • pay government taxation and providers of capital – dividends; and
  • ensure the long term survival of the business entity.

Poor working capital management can lead to:

  • over-capitalisation (and therefore waste through under utilisation of resources and hence poor returns); and
  • overtrading (trying to maintain a level of sales that is higher than working capital can sustain – for businesses which extend credit terms, more sales means more debtors and higher working capital demands).

Characteristics of over-capitalisation are excessive stocks, debtors, and cash, low return on investment with long term funds tied up in non-earning short term assets. Overtrading leads to escalating debtors and creditors, and if unchecked, ultimately to cash starvation.

Taking control of working capital means focusing on its main elements.

Control of the debtors’ element (the amount owed to the business in the short term) involves a fundamental trade-off between the cost of providing credit to customers (which includes financing bad debts and administration), and the additional net revenue that can be earned by doing so. The former can be kept to a minimum with effective credit control policies that will require:

  • setting and enforcing credit terms;
  • vetting customers prior to allowing them credit;
  • setting and reviewing individual credit limits;
  • efficient invoicing and statement generation;
  • prompt query resolution;
  • continuous review of debtors position (generating ‘aged debtors’ report);
  • effective chasing and collection procedures; and
  • limits beyond which legal action will be pursued.

Before allowing credit to a new customer trade and bank references should be sought.

Accounts can be asked for and analysed and a report including any county court judgements against the business and a credit score asked for from a credit rating business (such as Dun and Bradstreet). Salesmen’s views can also be canvassed and the premises of the potential customer visited.

The extent to which all means are called upon will depend on the amount of the credit sought, the period, past experiences with this customer or trade sector, and the importance of the business that is involved. But this is not a one-off requirement. One classic fraud is to start off with small amounts of credit, with invoices being settled promptly, eventually building up to a huge order and a disappearing customer.

Credit checking, even for established customers, should therefore feature in regular procedures. When the creditworthiness of a new customer is established, positive credit control calls for the setting of a credit limit, any settlement discounts, the credit period, and credit charges (if any).

The Late Payment of Commercial Debts (Interest) Act now allows small businesses to charge large interest on late payment of business debts by companies and public sector organisations. From last November they were also able to take similar action against other small businesses. Nevertheless, it is wise to inform customers this right will be exercised. Collection is a vital element of credit control and must include standard, polite and well constructed reminder letters, and effective telephone or e-mail follow up. Use of collection agencies should be considered, as could factoring – in its most comprehensive form a loan facility based on outstanding invoices plus a sales ledger and debtors control service.

Efficient control of debtors will assist cash flow, and help keep overdraft or other loan requirements down, and hence reduce interest costs. Debtors represent future cash – or they should do if proper credit control policies are pursued. Likewise stock will eventually become cash, but in the meantime represents working capital tied up in the business. Keeping levels to the minimum required for efficient operations will keep costs down. This means controlling buying, handling, storing, issuing, and recording stock.

The factors to consider when establishing the control levels are:

  • working capital available and the cost of capital;
  • average consumption or production requirements;
  • reordering periods – the time between raising an order and receiving delivery of goods;
  • storage space available;
  • market conditions;
  • economic order quantity (including discounts available for quantity);
  • likely life of stock – bearing in mind the possibility of loss through deterioration or obsolescence; and
  • the cost of placing orders including generating and checking the necessary paperwork as well as physical checking and handling procedures.

Control policies should include designating responsibility for raising and authorising orders, signing delivery notes and authorising payment of invoices.

Four basic levels will need to be established for each line/category of stock.

These are the:

  • maximum level – achieved at the point a new order of stock is physically received;
  • minimum level – the level at the point just prior to delivery of a new order (sometimes called buffer stocks – those held for short term emergencies);
  • reorder level – the point at which a new order should be placed so that stocks will not fall below the minimum level before delivery is received; and the
  • reorder quantity or economic order quantity – the quantity of stock that must be reordered to replenish the amount held at the point delivery arrives up to the maximum level.

Once these controls are implemented an efficient system of recording receipts and issues is vital to exercise full control of inventories. Trade creditors, amounts owed by the business for supplies and services, are a plus in the working capital equation. The higher the figure, the more has been extended by others (usually at no cost) towards working capital needs. But there are limits to the good news. Firms that go beyond agreed credit limits run into trouble; they lose out on cash discounts, can incur interest charges, upset their suppliers who may refuse future orders, may damage their credit rating, and even find themselves in court with additional costs and penalties to pay.

Credit periods vary from industry to industry with usual terms ranging from 28 to 95 days.

Just as in credit control, a settlement policy has to be in place so that invoices are properly authorised for payment (after any queries have been answered and credits claimed), and so that they can be paid when due with appropriate discounts deducted. Again, an eye has to be kept on the overall position with appropriate reports generated.

Cash is both the balancing figures between debtors, stock and creditors, and also the control element. It is not possible to extend credit, order stock or pay creditors if there is not the cash available to meet working capital demands.

There are two levels of control. The first concerns efficient banking – making sure money received is banked as soon as possible, making payments the most efficient way, and ensuring any surplus balances are put to interest earning use.

Here the liquidity, risk and return of investments must all come into play with the length of time before funds are needed playing an important role.

More fundamental than this is cash flow control – making sure funds are available when needed. In the short term this is best achieved by preparation of weekly or monthly forecasts for comparison with actual results. If these forecasts indicate unacceptable balances or deficits are likely at some point, it will be necessary to decide how these can be covered. Immediate solutions will include increased borrowing, rescheduling plans and payments, or even sale of an asset.

Longer term cash flow control will embrace all aspects of the business including working capital and fixed capital control, capitalisation, trading and dividend policy. For example it may be able to improve cash flow by improvements in operating efficiency or higher sales prices, improved working capital control, or revised fixed asset investment plans.

Cash flow forecasts form an integral part of the budgeting process. The objectives of the cash budget are to:

  • integrate trading and capital expenditure budgets with cash plans;
  • anticipate cash surpluses and deficits in time to generate plans to deal with these; and
  • provide a facility for comparison between budget and actual outcomes.

Accountants have an important part to play in all aspects of working capital control – through internal control procedures (such as invoice authorisation) and through reporting processes (such as production of ‘aged debtors’ lists and cash flow forecasts).

They can also bring analytical skills into play, typically by use of ratio analysis. Various ratios are considered important indicators of working capital strength (and can be applied internally or to potential customers).

A broad indication of a firm’s short term ability to finance its continued trading can be obtained by applying the ‘current ratio’. This is a straight comparison of current assets and current liabilities. If the latter should be less than the former, it is worth looking further. Many businesses operate this way when they start, often for long afterwards, sometimes always. Much will depend on the type of trade and the nature of both current liabilities and current assets.

For example a large element of prepayments in creditors will mean they will not be repaid but will be earned over time. On the other hand, debtors escalating at a faster rate than sales growth could indicate poor credit control and possible bad debt problems. Generally when it comes to current assets, cash is the most valuable element (it is immediately available to settle bills), and debtors are of more value than stock (they are nearer to being turned into cash).

Hence the tougher test – the ‘acid test’ – excludes the stock element from current assets. If current assets less the stock element total less than current liabilities the business, on the face of it, may not be able to settle its creditors as they fall due. And that suggests more finance might be needed, better working capital control will be required, or insolvency may be looming.

 1.1 The concepts of fixed assets and stock are explained with examples.

Fixed assets are such things as machines and buildings used by the company. Current assets are stocks, debtors and cash used in the day to day running of the business. For example, in a photocopying shop the photocopier is a fixed asset, the paper used to feed it is a stock, the people who owe the company for completed printing jobs are the debtors, and the money in the till is cash.

Everything you use to make your products, provide your services and to run your business is part of your stock.

1.2 The different fixed assets in a business unit are identified and an indication is given of the purpose of each asset in the business unit. 

 The term fixed assets generally refers to the long-term, tangible assets used in a business that are classified as property, plant and equipment. Examples of fixed assets are land, buildings, manufacturing equipment, office equipment, furniture, fixtures, and vehicles. Except for land, the fixed assets are depreciated over their useful lives.

 1.3 Stock in a business unit is identified and a list is compiled of the stock usually needed in a business unit. 

 Stock is the goods or merchandise kept on the premises of a business or warehouse and available for sale or distribution.

Stock control is used to show how much stock you have at a point in time, and how you keep track of it.

It applies to every item you use to produce from raw materials to finished goods and whether it is a product or service. It covers stock at each stage of the production process, from purchase and delivery to using and re-ordering the stock.

Having the right amount of stock is important as it ensures that capital is not tied up unnecessarily, and protects production if problems arise with the supply chain.

Everything you use to make your products, provide your services and to run your business is part of your stock.

Types of stock:

  • raw materials and components (used in production)
  • work in progress (unfinished goods in production)
  • finished goods (ready for sale)
  • consumables (fuel and stationery etc)
 1.4 The problems that occur in a specific business unit if there is insufficient stock are indicated and a plan is compiled to ensure that the required stock is available when needed. 

The size and nature of your business decided how much stock to keep, and the type of stock involved. If you are short of space, you may be able to buy stock in bulk and then pay a fee to your supplier to store it, calling it off as and when needed.

Keeping little or no stock and negotiating with suppliers to deliver stock as you need it

Advantages:

  • Lower storage costs
  • You can keep up to date and develop new products without wasting stock
  • Efficient and flexible – you only have what you need, when you need it

Disadvantages:

  • Risk of running out of stock
  • Meeting stock needs can become complicated and expensive
  • You are dependent on the efficiency of your suppliers

This might suit your business if it’s in developing environment or if your stock is expensive to buy and store. This method is also useful if your stock is perishable or is able to be replenished quickly.

Inherent in any system of inventory control is the concept of appropriate stock levels – normally expressed in physical units sometimes in monetary terms.

The objective of establishing control levels is to ensure that excessive stocks are never carried (and working capital thereby sacrificed) but that they never fall below the level at which they can be replenished before they run out.

The factors to consider when establishing the control levels are:

  • working capital available and the cost of capital;
  • average consumption or production requirements;
  • reordering periods – the time between raising an order and receiving delivery of goods;
  • storage space available;
  • market conditions;
  • economic order quantity (including discounts available for quantity);
  • likely life of stock – bearing in mind the possibility of loss through deterioration or obsolescence; and
  • the cost of placing orders including generating and checking the necessary paperwork as well as physical checking and handling procedures.

Control policies should include designating responsibility for raising and authorising orders, signing delivery notes and authorising payment of invoices.

Four basic levels will need to be established for each line/category of stock.

These are the:

  • maximum level – achieved at the point a new order of stock is physically received;
  • minimum level – the level at the point just prior to delivery of a new order (sometimes called buffer stocks – those held for short term emergencies);
  • reorder level – the point at which a new order should be placed so that stocks will not fall below the minimum level before delivery is received; and the
  • reorder quantity or economic order quantity – the quantity of stock that must be reordered to replenish the amount held at the point delivery arrives up to the maximum level.
 1.5 Problems if a business unit has too much stock are explained and an indication is given of how stockpiling impacts on the bottom line of the business.
  • Not good for perishable goods
  • Stock may be come out of date before it is used
  • Stock may depreciate with time
  • Higher storage and insurance costs

2. Explain the influence that stock management can have on the profitability of a business.

 2.1 The need for stock control is explained with reference to fraud, theft, carelessness and ensuring sufficient stock. 

 Poor stock control and over-investment in fixed assets can mean your capital is tied up unnecessarily.

Poor stock control

Efficient stock control (inventory) will mean you have the right amount of stock in the right place at the right time. It ensures that capital is not tied up unnecessarily, and protects production when there are problems with the supply chain.

Poor stock control can tie up capital unnecessarily. You need to put systems in place to keep close track of stock levels and values. Taking control will allow you to free up cash, while also having the right amount of stock on hand.

There are a number of ways you can approach stock control. You can:

  • re-order when stock reaches a minimum level
  • carry out regular reviews of stock
  • use just in time (JIT) delivery to avoid excessive stock build up
2.2 Two different ways of managing stock are explained with reference to records and stocktaking.

Stock control methods

There are several methods for controlling stock, all designed to provide an efficient system for deciding what, when and how much to order.

You may opt for one method or a mixture of two or more if you have various types of stock.

  • Minimum stock level – you identify a minimum stock level, and re-order when stock reaches that level. This is known as the just in time method.
  • Stock review – you have regular reviews of stock. At every review you place an order to return stocks to a predetermined level.

Just In Time (JIT) – this aims to reduce costs by cutting stock to a minimum. Items are delivered when they are needed for immediate use. This means that less storage is needed however there is a risk of running out of stock, so you need to be confident that your suppliers can deliver on demand.

Stock control systems – keeping track manually

Stocktaking involves making an inventory, or list, of stock, and noting its location and value. It’s often an annual exercise – a kind of audit to work out the value of the stock as part of the accounting process.

Codes, including barcodes, can make the whole process much easier but it can still be quite time-consuming. Checking stock more frequently – a rolling stocktake – avoids a massive annual exercise, but demands constant attention throughout the year. Radio Frequency Identification (RFID) tagging using hand-held readers can offer a simple and efficient way to maintain a continuous check on inventory.  Any stock control system must enable you to:

  • track stock levels
  • make orders
  • issue stock

The simplest manual system is the stock book, which suits small businesses with few stock items. It enables you to keep a log of stock received and stock issued.

It can be used alongside a simple re-order system. For example, the two-bin system works by having two containers of stock items. When one is empty, it’s time to start using the second bin and order more stock to fill up the empty one.

Stock cards are used for more complex systems. Each type of stock has an associated card, with information such as:

  • description
  • value
  • location
  • re-order levels, quantities and lead times (if this method is used)
  • supplier details
  • information about past stock history

More sophisticated manual systems incorporate coding to classify items. Codes might indicate the value of the stock, its location and which batch it is from, which is useful for quality control.

Choose a system

There are many software systems available. Talk to others in your line of business about the software they use, or contact your trade association for advice.

Make a checklist of your requirements. For example, your needs might include:

  • multiple prices for items
  • prices in different currencies
  • automatic updating, selecting groups of items to update, single-item updating
  • using more than one warehouse
  • ability to adapt to your changing needs
  • quality control and batch tracking
  • integration with other packages
  • multiple users at the same time

Avoid choosing software that’s too complicated for your needs as it will be a waste of time and money.

Using RFID for inventory control, stock security and quality management

Radio Frequency Identification (RFID) allows a business to identify individual products and components, and to track them throughout the supply chain from production to point-of-sale.

An RFID tag is a tiny microchip, plus a small aerial, which can contain a range of digital information about the particular item. Tags are encapsulated in plastic, paper or similar material, and fixed to the product or its packaging, to a pallet or container, or even to a van or delivery truck.

The tag is interrogated by an RFID reader which transmits and receives radio signals to and from the tag. Readers can range in size from a hand-held device to a “portal” through which several tagged devices can be passed at once, eg on a pallet. The information that the reader collects is collated and processed using special computer software. Readers can be placed at different positions within a factory or warehouse to show when goods are moved, providing continuous inventory control.

Using RFID tagging for stock control offers several advantages over other methods such as barcodes:

  • tags can be read remotely, often at a distance of several metres
  • several tags can be read at once, enabling an entire pallet-load of products to be checked simultaneously
  • tags can be given unique identification codes, so that individual products can be tracked
  • certain types of tag can be overwritten, enabling information about items to be updated, eg when they are moved from one part of a factory to another

The costs associated with RFID tagging have fallen over recent years, and continue to do so, to bring the process within the reach of more and more businesses. The benefits of more efficient stock control and improved security make it particularly attractive to retailers, wholesalers or distributors who stock a wide range of

2.3 The importance of quality, quantity, time, price and source in managing stock are explained with examples.

 Control the quality of your stock

Quality control is a vital aspect of stock control – especially as it may affect the safety of customers or the quality of the finished product.

Efficient stock control should incorporate stock tracking and batch tracking. This means being able to trace a particular item backwards or forwards from source to finished product, and identifying the other items in the batch.

The British Standards Institution (BSI) has a scheme to certify businesses that have achieved a certain standard of quality management. Achieving the standard is one way of showing customers and regulators that you take quality control seriously

2.4 The rate of stock turnover for a business unit is calculated and an indication is given of how knowing turnover assists in planning.

 Stock control administration

There are many administrative tasks associated with stock control. Depending on the size and complexity of your business, they may be done as part of an administrator’s duties, or by a dedicated stock controller.

For security reasons, it’s good practice to have different staff responsible for finance and stock.

Typical paperwork to be processed includes:

  • delivery and supplier notes for incoming goods
  • purchase orders, receipts and credit notes
  • returns notes
  • requisitions and issue notes for outgoing goods

Stock can tie up a large slice of your business capital, so accurate information about stock levels and values is essential for your company’s accounting.

Figures should be checked systematically, either through a regular audit of stock – stocktaking – or an ongoing programme of checking stock – rolling stock take.

If the figures don’t add up, you need to investigate as there could be stock security problems or a failure in the system.

2.5 An Economic Ordering Quantity Model (EOQ) model is explained and applied to a business unit to calculate the optimum stock level for three items in a business unit.

Economic order quantity (EOQ)

We could buy-in, or make for stock either a few large orders or frequent small orders for a given usage. Few big orders involve low acquisition and high holding costs. Conversely many small orders result in low holding and high acquisition costs. Purchasing an economic order quantity (a.k.a. economic batch quantity, economic lot size or EOQ) seeks to reconcile ordering and holding costs to obtain an optimum order size.

Cost of holding stock and ordering/acquisition cost are represented by the formulae

  • The value of the average stockholding = (Q/2 x item cost/value) where Q is the order quantity. The holding cost/unit (Ch) is derived from the average inventory value) multiplied by the cost of carrying the item over the period (one year) expressed as a % of the item cost/value.
  • Order cost (Co) is derived from the number of orders placed (D/Q – demand p.a. divided by order quantity) multiplied by the cost of placing an order.

The order/acquisition cost (or set-up cost for a make-to-stock situation).

Therefore Total cost = Ch + Co

These relationships can be seen in the graphic representation of EOQ.

The EOQ is found at the lowest point on the total cost curve. Here the order size optimises the cost of stockholding with the cost of acquisition. The equation is:

As an example, in a company where order cost is estimated at R100.00 and with a holding cost of 25% of item value if annual demand is 1000 units at a supply price of R360.00, if we substitute these figures in the EOQ formula then the EOQ is 48 units (47.1 Kango hammers will not be supplied!).

EOQ Evaluation and Assumptions of simple EOQ

  • demand (units of supply, not issue) is known and steady so average inventory can be estimated
  • quantity discounts do not apply – the effect of buying discount/price breaks needs to be calculated additionally.

3. Explain the management of fixed assets in a business unit.

3.1 The fixed assets in a business unit are identified from a balance sheet.

 Balance Sheets

 A balance sheet is a snapshot of a business’ financial condition at a specific moment in time, usually at the close of an accounting period. A balance sheet comprises assets, liabilities, and owners’ or stockholders’ equity. Assets and liabilities are divided into short- and long-term obligations including cash accounts such as checking, money market, or government securities. At any given time, assets must equal liabilities plus owners’ equity. An asset is anything the business owns that has monetary value. Liabilities are the claims of creditors against the assets of the business.

What is a balance sheet used for?

A balance sheet helps a small business owner quickly get an understanding of the financial strength and capabilities of the business. Is the business in a position to expand? Can the business easily handle the normal financial ebbs and flows of revenues and expenses? Or should the business take immediate steps to bolster cash reserves?

Balance sheets can identify and analyse trends, particularly in the area of receivables and payables. Is the receivables cycle lengthening? Can receivables be collected more aggressively? Is some debt uncollectible? Has the business been slowing down payables to forestall an inevitable cash shortage?

Balance sheets, along with income statements, are the most basic elements in providing financial reporting to potential lenders such as banks, investors, and vendors who are considering how much credit to grant the firm.

 Assets
Assets are subdivided into current and long-term assets to reflect the ease of liquidating each asset. Cash, for obvious reasons, is considered the most liquid of all assets. Long-term assets, such as real estate or machinery, are less likely to sell overnight or have the capability of being quickly converted into a current asset such as cash.

Current assets

Current assets are any assets that can be easily converted into cash within one calendar year. Examples of current assets would be checking or money market accounts, accounts receivable, and notes receivable that are due within one year’s time.

  • Cash
    Money available immediately, such as in checking accounts, is the most liquid of all short-term assets.
  • Accounts receivables
    This is money owed to the business for purchases made by customers, suppliers, and other vendors.
  • Notes receivables
    Notes receivables that are due within one year are current assets. Notes that cannot be collected on or within one year should be considered long-term assets.

Fixed assets

 Fixed assets include land, buildings, machinery, and vehicles that are used in connection with the business.

  • Land
    Land is considered a fixed asset but, unlike other fixed assets, is not depreciated, because land is considered an asset that never wears out.
  • Buildings
    Buildings are categorised as fixed assets and are depreciated over time.
  • Office equipment
    This includes office equipment such as copiers, fax machines, printers, and computers used in your business.
  • Machinery
    This figure represents machines and equipment used in your plant to produce your product. Examples of machinery might include lathes, conveyor belts, or a printing press.
  • Vehicles
    This would include any vehicles used in your business.
  • Total fixed assets
    This is the total rand value of all fixed assets in your business, less any accumulated depreciation.

Total assets

This figure represents the total rand value of both the short-term and long-term assets of your business.

Liabilities and owners’ equity

This includes all debts and obligations owed by the business to outside creditors, vendors, or banks that are payable within one year, plus the owners’ equity. Often, this side of the balance sheet is simply referred to as “Liabilities.”

  • Accounts payable
    This is comprised of all short-term obligations owed by your business to creditors, suppliers, and other vendors. Accounts payable can include supplies and materials acquired on credit.
  • Notes payable
    This represents money owed on a short-term collection cycle of one year or less. It may include bank notes, mortgage obligations, or vehicle payments.
  • Accrued payroll and withholding
    This includes any earned wages or withholdings that are owed to or for employees but have not yet been paid.
  • Total current liabilities
    This is the sum total of all current liabilities owed to creditors that must be paid within a one-year time frame.
  • Long-term liabilities
    These are any debts or obligations owed by the business that are due more than one year out from the current date.
  • Mortgage note payable
    This is the balance of a mortgage that extends out beyond the current year. For example, you may have paid off three years of a fifteen-year mortgage note, of which the remaining eleven years, not counting the current year, are considered long-term.
  • Owners’ equity
    Sometimes this is referred to as stockholders’ equity. Owners’ equity is made up of the initial investment in the business as well as any retained earnings that are reinvested in the business.
  • Common stock
    This is stock issued as part of the initial or later-stage investment in the business.
  • Retained earnings
    These are earnings reinvested in the business after the deduction of any distributions to shareholders, such as dividend payments.

Total liabilities and owners’ equity

This comprises all debts and monies that are owed to outside creditors, vendors, or banks and the remaining monies that are owed to shareholders, including retained earnings reinvested in the business.

A BALANCE SHEET shows what a firm owns (assets) and what a firm owes (liabilities) and the difference between the two (equity) at a given point in time. It merely states the assets of the firm and how they were financed

Assets  =  owner’s equity + liabilities

 Assets are the possessions of the enterprise and have a money value.


ASSETS

Non-Current

Land & Buildings

Equipment

Vehicles

Current

Bank

Debtors

Inventory

LIABILITIES

Long-term

Bond

Hire Purchase Debt

Debentures

Current

Creditors

Bank Overdraft

Dividends payable

Taxation payable

Other Valuable Ratios

  1. Solvability / Debt to Assets

Debt should not be more than 50% of the assets.  The higher the ratio the higher the risk to supplies of funds.

  1. Liquidity

Liquidity is the ability to pay your short term credit.

  1. Operating Ratios

 


Micro Drive Inc.:  December Balance Sheets (Millions of Rand)


REQUIRED
 

 Use the above information to complete the attached Balance Sheet.

 BALANCE SHEET

 

3.2 The asset register for a business unit is updated for three case studies.

 In its simplest form an asset register is just a list of all the assets owned by an organisation. You might think that it is obvious that an organisation should have a list of all the things it owns, and it is. But in reality, it very often doesn’t work like this. If the organisation is small, then it often relies on a few people to remember all the things it owns. For example, do you have a list of all the things you own in your home?

Large organisations often have many different lists; for example, the finance department might have a list of the value of all the assets, while the maintenance department might have a list of when certain assets need to be serviced. The problem here is that these lists usually don’t agree, so you never know which one is right.

COMPOSITIONS OF AN ASSET REGISTER

 There is mandatory information that constitutes an asset register. A mere compilation of information does not produce an asset register

Mandatory information includes:

  • Date, description, serial number, bar code number, asset number, location, room number, business unit, username, depreciation start date Life span, cost price, accumulated depreciation, net book value, residual amount, date of audit, status, rights and obligations.

 For this list of assets to be useful, it has to contain enough information on each asset so that the asset can be effectively managed. Some of the information that should be contained in an asset register is given below:

  • Each asset must have a unique name that clearly identifies the asset throughout the entire organisation.
  • There should be a basic set of data that is the same for all the assets within the organisation, such as the location, age and assessments of value, performance, condition and risk.
  • The register should also record for each asset any information over and above the basic set of data that is necessary to effectively manage the asset. This would also include regular monitoring information such as when the asset was last serviced, or how much it has been used.
  • The asset register by itself is not particularly useful to an organisation. It must be kept up-to-date, and it must provide useful information to the organisation. How this is done is defined by the Asset Management Plan.
  • It is not feasible for an organisation to include every single thing it owns, down to the last pencil and washer on the asset register, so a line has to be drawn somewhere. Ultimately, the value of the information recorded must be greater than the cost of obtaining and maintaining it. But this is not easy to establish. Normally, in order to decide on which assets to include in a register, organisations would look at the following for each type of asset:
    • the value of the asset to the organisation,
    • the information required to effectively manage that type of asset, and
    • the cost of obtaining and maintaining that information.

 

Effective Asset Registers

  1. Decide on an Identification and Classification System
  • Because it is so necessary for each asset to be uniquely identified the development of a comprehensive and detailed classification and identification system is the first step. The simplest form of identification system is just to give each asset a sequential number. This is easy to implement, but gives the users no information about what type of asset a particular number refers to.
  • A more intelligent form of identification classifies each asset according to one or more criteria, and then assigns a code to each classification. An individual asset’s identification number is then made up of the classification codes, and a sequential number to distinguish it from any other assets that are identically classified. An example of a classification system may be to classify assets according to their physical location, their type and their function or cost centre within the organisation.
  1. Determine Boundaries for the Identification System
  • Once the classification system has been decided upon, it is necessary to determine exactly what types of assets fall into which class, and to assign a code to each class. Asset type classifications may be common across the entire water services sector, but location classifications would obviously be local to each institution. Each institution would thus have to decide on the exact boundaries of each location class, and assign unique codes to those classes.
  1. Determine the Asset Types and their Measures
  • A list of all the different types of assets must be drawn up. This may have been done as part of the classification system if that system classifies assets according to their type. It could also be standardised across the sector. Part of this exercise will also be to determine which assets will be included in the register, and which ones will be left out.
  • For each type of asset it would then be necessary to determine exactly what information about that asset would need to be recorded, the units of measure and the level of accuracy necessary. It would also be necessary to draw up unambiguous and effective measures for the value, performance, condition and risk assessment of each class of asset. Assets that require exactly the same information to be recorded, and that can use the same measures of value, performance, condition and risk should be grouped into the same class of asset.

 

  1. Determine required values for Asset Measures
  • Once measures of performance, condition and risk have been determined for each class of asset, it is necessary to determine the required values of these measures. The required levels of service set in the AMP will determine these required values. Levels of service will have to be determined for specific functions of the organisation, for example, minimum pressures and quantities to be delivered. These levels of service must then be translated into required values for the performance, condition and risk for the individual assets that are required to provide that service

 

  1. Capture data and a measure of data accuracy for all assets

 

  • Once all of the above definitions have been completed, it will be necessary to capture the information on all the assets in the organisation. To start with this can be done from existing information such as drawings, insurance reports, etc. The accuracy of this information must then be verified, by means of field surveys. The accuracy can should then be continuously upgraded by checking it whenever possible, such as during maintenance. By keeping careful records of the accuracy of the data in the register it is possible to determine where verification is most needed, and to prove to the users that the data is accurate and can be used for effective decision making.
  • Depending on the size of the organisation, and the nature of the equipment, it may well be necessary to employ sophisticated tools such as surveys and GIS tools

 

  1. Register Maintenance and Use
  • Setting up an asset register is a once off process, but the register cannot be left there. To be useful the register must be kept up-to-date and the accuracy must be continuously verified. An important part of creating the register is to determine who is responsible for maintaining what data, and setting out the policies and procedures for this maintenance.
  • At this stage it is also necessary to determine the outputs of the register, in the form of what reports are to be produced, and to determine who has access to which reports. These policies, procedures and reports will not be static, but will usually grow and develop over time
3.3 The valuation of assets in a business unit is explained with reference to depreciation and investment.

 Assets are valued at their net replacement value.

This is calculated as the original cost of the asset minus the accumulated depreciation.

3.4 Reasons for depreciation are explained with examples and an indication is given of the purpose of depreciation.

Depreciation is the value of the asset written off during year to account for wear and tear of the asset during the year. Assets that are purchases for continued and long-term use in earning profit in a business. Examples: land, buildings, machinery, etc. They are written off against profits over their anticipated life by charging an annual amount calculated so as to eliminate the original cost (historical cost), less residual value, over that period.

4. Apply the basic principles of stock and fixed asset management to a business unit.

 4.1 The risk associated with the management of stock in a business unit is identified and quantified in terms of probability and severity.

 Inventory management

Businesses need to hold stock or inventory to ensure that they can meet demand from their customers and provide supplies to their operations. However, the cost of holding stock can be substantial – the rate of interest on the value of the stock, the costs of storage, handling and administration, the deterioration of the stock and its possible obsolescence if demand patterns change. Clearly, the benefits of holding stock need to outweigh the associated costs.

Holding appropriate stocks is essential to maintain high levels of customer service and increased sales and profits, and these may need to be increased to cope with uncertain demand. Supply uncertainty can also be a good reason for holding stocks, to lock in low prices or to provide consistency of supply.

There are also less justifiable reasons for holding stock. These include failing to:

  • Identify product accurately
  • Use automatic data capture systems to eliminate manual counting errors
  • Share standard, accurate and timely planning and performance data with customers and suppliers, so that unnecessary fluctuations in activity can be minimised
  • Simplify and standardise joint business processes with other trading partners, so that speed and certainty of response can be achieved from all supply chain participants
  • Improve the responsiveness of production and distribution facilities to provide more flexibility, for example in batch sizes and changeover times
  • Employ modern supply chain techniques such as co-managed inventory, continuous replenishment, and collaborative event management, which can provide the highest levels of service at the lowest total costs, including stock costs

Although inventory levels no longer represent the largest asset of most resellers, it is still one of its most important assets. Without inventory there can be no product sales. Without sales, there is no company. How a company manages its inventory has significant effects on total cash flow and profitability as well.

A common misconception is that money invested in inventory will earn a return, in other words, the inventory can be resold for more than it cost. However, this is not always the case. Unless inventory appreciates in value, costs incurred to maintain the inventory will gradually eat away at any potential profit on sale. In the computer technology industry inventory definitely does not appreciate and the costs of maintaining inventory are high. The inventory must be financed, stored, moved about, insured, protected from theft, counted and kept track of. The more inventory the greater the expense. These expenses can be 20% to 30% (or more) of the cost of the inventory over a year’s time. But even these expenses in total are minor compared to the real expense in the computer technology industry; obsolescence. Products have been known to become obsolete within a few months of the product’s release and become totally worthless within six months to a year.

Since money tied up in inventory can be invested in other assets or used to produce an economic return for the company, the real “costs” of ownership of inventory include lost opportunity costs as well as the carrying and obsolescence costs identified above. It is obvious therefore, that effective inventory management is not only recommended but also essential to the economic well being of the reseller. Inventory models have been developed as an aid in management of inventory levels and have proved extremely useful in minimizing inventory requirements. Any procedure that can reduce the investment required to generate a given sales volume may have a beneficial effect on the firm’s rate of return and hence on the value of the company.

Determinants of the Size of Inventories

The major determinants of investment in inventory are the following:

(1) Level of sales; obviously, the higher level of sales the higher the expected level of inventory.

(2)Availability of products; a product’s availability from manufacturers and distributors will effect its inventory levels in the channel. and (3) Obsolescence of product.

Obsolescence

The rate of technological advances in the computer industry is astounding. Products become obsolete almost as soon as they are first released. With the speed at which products become obsolete, it is to the company’s disadvantage to try to stock inventory. Products held in inventory, even for periods as short as 30 days, can lose over 50% or more of their value. And even then the products may become redundant due to the fact that new products will not work with the “obsolete” item.

Traditional Inventory Management

Traditional inventory management systems attempt to determine the ideal level of inventory by calculating the optimum purchase size. First, a basic stock must be on hand to balance inflows and outflows of the items, with the size of the stock depending upon the patterns of flows, whether regular or irregular. Second, because the unexpected may always occur, it may be necessary to have safety stocks on hand. They represent the little extra to avoid the costs of not having enough to meet current needs. Third, additional amounts may be required to meet future growth needs. These are anticipation stocks. Related to anticipation stocks is the recognition that there are optimum purchase sizes, defined as economic ordering quantities.

With the foregoing as a basic foundation, we can develop the theoretical basis for determining the optimal investment in inventory, as shown in the illustration below. Some costs rise with larger inventories, among these are warehousing costs, interest on funds tied up in inventories, insurance, obsolescence, and so forth. Other costs decline with larger inventories, these include the loss of profits resulting from sales lost because of running out of stock, possible purchase discounts, and so on.

Optimum Investment In Inventory

The costs that decline with higher inventories are designated by the declining curve in the illustration; those that rise with larger inventories are designated by the rising curve. The total costs curve is the total of the rising and declining curves, and it represents the total cost of ordering and holding inventories. At the point where the absolute value of the slope of the rising curve is equal to the absolute value of the slope of the declining curve (that is, where marginal rising costs are equal to marginal declining costs), the total costs curve is at a minimum. This represents the optimum size of the investment in inventory.

Economic Order Quantity

The total cost of inventories is the summation of these rising and declining costs, or the total costs curve. It has been shown that, under reasonable assumptions, the minimum point on the total costs curve can be found by an equation called the EOQ formula:

EOQ = Square Root (2FU/CP)

Where: EOQ is the economic ordering quantity, or the optimum quantity to be ordered each time an order is placed.
F = fixed costs of placing and receiving an order.
U = annual usage in units.
C = carrying cost expressed as a percentage of inventory value.
P = purchase price per unit of inventory.

For any level of usage, dividing U by EOQ indicates the number of orders that must be placed each year. The average inventory on hand (the average balance sheet inventory figure) will be

Average inventory = EOQ/2

Use of EOQ Model in the Computer Technology Industry

Let us assume that you will sell 1000 units of a laptop over the next year. The laptop is priced at R2,000. The cost of placing an order is estimated at R17.50. The critical calculation is the carrying costs. Costs such as interest, insurance and warehousing can probably be estimated at 20% of the price of a unit. But what about obsolescence? How much is a one-year-old laptop worth? Obsolescence can be calculated by estimating the “depreciation” over a year’s time. If we assume the laptop will lose 50% of its value in a year, the total carrying costs will be equal to 70% (20% plus 50%). The calculation of the EOQ is as follows:

2FU = 2 X R17.50 X 1,000 = 35,000

CP = 70% X R2,000 = 1,400

2FU = 35,000 divided by 1,400 = 25
CP

The square root of 25 is 5.

The calculation shows that the EOQ = 5. The average inventory level should be half of the EOQ or 2 to 3 units. Therefore, if 1,000 units are sold throughout the year, the average daily unit sales will be 4 (1,000 divided by 260 business days per year). What this illustration points out is that the risk of obsolescence is far greater than the cost of placing orders.

Just in Time Inventory Management

JIT inventory management is only one component of an overall JIT philosophy. The inventory related objectives of the JIT philosophy are two-fold: first, to purchase only those products that are necessary to complete sales at the necessary time; and second, to eliminate unnecessary inventories. Under a JIT approach, product is “pulled” into inventory as a result of sales, rather than “pushed” into inventory to create future demand.

The essence of JIT is to purchase products only after sales are made and be able to deliver these products to customer when and where the customer needs the product and in the correct quantities. The JIT approach to inventory management has been taken to the next level in the last few years. Now with drop ship (direct shipments from Manufacturer or Distributor to the customer) options available, a reseller does not even have to touch the product, lowering handling costs as well. With the level of sophistication currently in place at the major distributors in the channel, product can be distributed anywhere in the country within two business days at no additional cost. With this product delivery system in place, why would any reseller want to incur the carrying costs of inventory?

The advantages of a JIT inventory approach are tremendous: lower inventory levels, smaller facilities, less obsolescence, lower financing costs, lower insurance costs, more effective use of capital, and the list goes on. The disadvantage is the risk of stock shortages. Although the risk of stock shortages can at times be fairly high, the overall benefits of a JIT inventory model far outweigh the disadvantages.

What is Inventory?

  • Stock of Material
  • Stored Capacity

Purpose of Inventory

  • Meet anticipated Demand
  • Separate Production and Distribution
  • Take advantage of quantity discounts
  • Provide hedge against Inflation
  • Protect against Shortages
  • Permit smooth operation of Work-in-Process

Why Hold Inventory?

  • Independence of Operation
  • Variation in Demand
  • Flexibility in Scheduling
  • Supply Variability (Lead Time)
  • Economic purchase order size

 Disadvantages of Inventories

  • Higher Cost
  • Item Cost
  • Ordering Cost – Purchasing Agents’ wages, forms & folders, Overhead, etc.
  • Holding Cost – Building cost, taxes, insurance, etc.
  • Difficult to Control
  • Hides Production Problems

Inventory Cost? – Cost associated with inventories

  • Cost of the items you buy (purchases)
  • Cost of placing an Order (buying)
  • Cost of holding the items you produce (holding)
  • Cost of having too much (disposal/salvage)
  • Cost of not having enough (shortages)

 Inventory Holding Cost – Averages

% of Inventory

Category                          Value

Housing (building) Cost                 6%

Material Handling Cost                  3%

Labour Cost                                  3%

Inventory Investment Cost            11%

Pilferage, scrap, obsolescence     3%

Total Holding Cost                       26%

Inventory Record keeping

Ways to Order Inventory

  • Keep track of how many in stock, deliveries, sales
  • Periodic physical verification – Annual, semi-annual, periodic

Inventory Questions

  • How much to buy?
  • When to buy?

 Inventory Models

  • Fixed Order Quantity Models
  • Economic Order Quantity (EOQ)
  • Quantity Discount (QD)
  • Fixed Order Period Model
  • Mini/Max Model

 

EOQ Assumptions

  • Known and constant Demand
  • Known and constant Lead Time
  • Instantaneous receipt of ordered Material
  • No quantity discounts
  • Only Ordering Costs & Holding Costs
  • Suppliers always have ordered items – no Out-of-Stock by supplier.

Benefits of the EOQ Model

  • Profit function is very shallow.
  • Even if assumption doesn’t hold, profits are close to optimal.
  • Estimated parameter will not throw you off very far.

Quantity Discount Model

  •  Answer how much to order and when to order.
  • Allows for quantity discounts
  • Reduced price when item purchased in larger quantities
  • Other EOQ assumptions apply
  • Trade-off is between lower unit cost and increased (higher) holding cost!

Quantity Discount Model calculation Steps

  • Compute EOQ for each quantity discount price.
  • Is computed EOQ in the discount range?
  • If not, use lowest cost quantity in the discount range.
  • Compute Total Cost for EOQ or lowest cost quantity in discount range.
  • Select quantity with the lowest Total Cost, including the cost of the items purchased.

 Fixed-Period Model

  •  Answers how much to Order
  • Orders placed at fixed intervals
  • Inventory brought up to target amount
  • Amounts ordered may vary
  • No continuous inventory count – possibility of being out of stock between intervals
  • Useful when vendor visits routinely – “Wonder Bread” visits daily

 Benefits of Fixed-Period Model

  •  Do not have to continuously monitor inventory levels.
  • Does not require computerised inventory system.
  • Low cost of maintenance.
  • Higher inventory carrying cost.

 Mini/Max Model

  •  Answers how much to Order.
  • Orders placed when inventory reaches minimum level or below.
  • Order amounts determined by subtracting current inventory level from maximum level.
  • Order amounts vary.
  • Must have a method of knowing current inventory level.

 

Mini/Max Problems:

  • Must have system for determining current inventory – Point of Sale registers.
  • May have periods where Out-of-Stock situations exist.
  • Cost of Out-of-Stock situations.
  • No consideration of Lead-time requirements – possibility of being out of stock.

Inventory Control Systems

As demand and lead times are variable, you can either

  • order fixed quantities of stock at variable times or
  • order variable quantities at fixed times

 Fixed quantity systems (Re-order levels)

  • easy to manage
  • cope well with demand variability/changes and facilitate lower stocks
  • orders can also be processed for convenience e.g. small orders can be consolidated to secure supplier discounts.

Using EOQ, fixed systems initiate replenishment orders when stock falls below a pre-determined (re-order) level. Re-order level is calculated as mean demand during the mean lead time, plus the safety stock. As a rough indicator, half the mean lead time usage can be taken as the safety stock (RoL = I.5DL).

 Two-bin replenishment system

Imagine two equally sized bins (bays, pallets or similar) used for storage in the warehouse or at the workstation storage point. The RoL must thus be seen visually. With the first bin empty, a new full bin is “called” to arrive before the second bin is exhausted. The call is rotated. With an efficient rotation system there will be little paperwork. In a computerised environment the bins/pallets themselves can be bar coded and their movement/position and batch numbers of bin components can be traced.

 Stock records

A two bin system is suited to components needing to be issued in large quantities and where the bin size and hence RoL can be checked simply. With many stock items this is inappropriate. More detailed control over issues is needed hence a stock record system showing receipts/issues and balance is required. Paper or computer records require time to check stock against reorder levels. There may be differences between the physical or actual stock and the book stock. “The record says we have 5 in the warehouse but I could only find three and one of these was damaged”. Computerised systems enable replenishment orders to be raised as soon as stock falls below a reorder level.

In a supermarket, the record for each stock item is decremented as each sale is logged at the checkout. With computer interconnectivity, the regional warehouse receives the store’s replenishment needs and makes up a replenishment package for next day delivery. Periodic stock checks to count the stock physically enable the store to feed in adjustment figures to reconcile physical against book stock. Thus stock losses can be accounted for.

Such systems assist with demand forecasting. Up-to-date demand figures feed in to reorder level and order quantity calculations.

Fixed time/order cycle systems

Annual requirements for low value, low bulk items can be estimated and ordered in a routine re-order cycle.

We may need to set a maximum stock level (average demand + safety stock). At the routine re-order time current stock can be subtracted from the maximum to give the order quantity (frequency of ordering could be based on EOQ).

Safety stock must accommodate unexpected increases in demand and the risk of stock-out situation. Compare this to a re-order level system where the risk is limited only to variations in demand in the lead-time period. For a fixed time, re-order cycle system the time at risk is re-order lead time plus the re-order cycle time. Calculation of the maximum stock level formula gives a higher level of safety stock.

 Comparing Responsiveness as demand changes

Re-order level approach

– average stock levels stay more or less the same and are less responsive to changes in demand. There is a risk of stock outs with unexpected rising demand but outstanding re-supply orders can be chased.

Re-order cycle systems

– rising demand can exhaust stocks with no outstanding orders in the pipeline.

Which System?

Of the systems (annual demand, two-bin, re-order cycle, re-order level) none are universally versatile. Many organisations operate a hybrid. Choosing between fixed quantity or fixed time approaches depends on risking unexpected movement in demand against the costs of administering convenient, scheduled replenishment. The safety stock penalty of fixed re-order cycle methods worsens as stock usage value and demand variability rise. Generally fixed time systems suit stock with stable/predictable demand patterns and low usage values.

 Risk and security.

Most cost benefits arise from attention to stock items of highest usage value where most costs lie (some lower value/usage items may be critical also e.g. key spares). Theft is always a risk even for bricks and JCB ‘s stored on company building sites. Accurate stock records assist with security monitoring (detecting the fit) and control. A two-bin or annual demand system offers little security for high value, important, difficult to supervise items.

 

The Management of Inventory: Overview

Inventory incurs costs, ties up working capital, it consumes space and must be managed in and out. Stocks can deteriorate or get stolen. Most operations, capacity planning and scheduling, depend on inventory. Stocks serve to smooth out timing gaps in the rates of supply and demand. Inventory offers insurance and good planning/control can minimise the associated costs and satisfy efficiency/effectiveness requirements. This is the reason for a just-in-time approach to inventory. Services generally are not stocked nevertheless in car repair services and retail distribution, inventory of support items are components of service transactions. For a central heating installation company, if a fitter has to drive to and queue at a supplier to obtain a minor part – this adds to service costs.

All organisations keep inventories – some trivial, some highly significant. Even the trivial can from another perspective e.g. health and safety take on a different degree of importance. What is trivial to one organisation is important to the next e.g. cleaning materials – trivial in a factory but essential to a supplier of cleaning materials. Spares, stationery, consumables are common inventory to all organisations.

 Inventory values and decisions

Types of stock/inventory

Slack et al. Galloway
  buffer/safety   raw materials
  cycle   finished product
  anticipation   work in progress
  pipeline   consumables
  spares
  strategic stock holding

 Single and multi-stage inventory systems

A retail shop exemplifies a single stage inventory system. Supplier deliveries are taken into stock and sold. For a supermarket there are two stages. The supplier e.g. Nestle will supply, say, a Safeway regional distribution centre that supplies each supermarket. A washing machine manufacturer will transform raw material stocks through several stages with work in progress stock existing between each stage. Finally the whole of a supply network between companies making different ingredients to many products can be charted. Yarn manufacturers supply fabric firms who supply clothing firms. The cloth may be distributed to retailers via regional depots. Quantities of fabric may be sold direct to customers in the “factory shop”.

 Out-of-stock situations

Operations mostly depend on stock. Raw materials shortage in manufacturing means halting production, rescheduling to make something that has raw materials or quick action to secure alternative supply.

Obviously average inventory for a stock item is represented by half the stock. A replenishment delivery is received (Q) and is added to any remaining stock. In an out of stock situation some of it may indeed be allocated already to outstanding (waiting) orders. The stock is now issued to jobs and orders and steadily depletes.

A personal computer assembly line that runs out of memory chips must stop; if  Wimbledon runs out of strawberries they might perhaps change to peaches. If a paper supplier is hit by strike action urgent approaches will be made to other suppliers.

If finished goods are out of stock, or raw materials or consumables shortage affects the customer (“sorry, the soup is off today”) then customers may go elsewhere, orders may be cancelled. Loss of goodwill means that competitors develop a relationship with your customer. All stock outs involve costs.

 

Costs of Inventory

Costs are tied up in the inventory itself and in ordering and carrying the stock.

 Holding costs

– expressed as a % of stock value and may be 15-30 % per annum.

  • cost of capital tied up in inventory (the opportunity cost of money).
  • storage costs: space, equipment, warehouse and stores staff, services etc often 5-10 % of stock value per annum.
  • stock losses/wastage (legitimate or otherwise). Theft, accidental damage, stock exceeding its shelf-life, and stock obsolescence and write-offs. How much depends upon the goods (perishables, rust, aging designs) but the write-off level will usually be greater than zero.

Acquisition/ordering costs

Costs arise from ordering/acquiring goods regardless of the actual value of the goods. In both making to stock and making to order, stock acquisition costs are incurred. Replenishment and purchasing administration paid for. It may take a skilled operator an hour to set up equipment for a new order or scheduled batch. Material may be wasted in the set up process. On completion of the job, equipment must be cleaned and tools put away. The inventory associated set-up costs include labour, material wastage, associated loss of production time collecting or waiting for stores, paperwork and administration. The set-up cost may easily be R350.00 irrespective of the order or batch size.

The purchasing order processing costs include receiving the goods, delivery for large or small orders and invoice processing. Precise costs per ordered unit are often elusive, but the staff and overhead costs are significant. In actual terms R400.00 may be incurred to initiate and process one purchase order.

Ad hoc purchasing must be compared with long-term contracts involving regular deliveries perhaps with just-in-time supply or amounts that the operation can “call off” from a supply agreement over, say, a quarter. There are costs in

  • researching and negotiating the supply contract (this requires expenses of its own given the specialist nature. A whole team may be involved with travel and hotel costs)
  • processing each consignment (packaging, bill of lading, insurance, transport, planning etc).

 Basic Inventory Mathematics

Stock control mathematics are very straightforward and relate to the identification of re-order levels, calculation of economic order quantities, safety and service levels and so on. Generally the input and output sides of the inventory management system are separated and it is assumed that

on the supply side

– receipts go straight into available stock without delay.

on the demand side

– issues from stock are in small amounts relative to total usage e.g. if 2,500 boxes of computer paper are used per annum, they are issued/distributed to departments in lots of twenty or less, rather than say five issues of 500. A materials requirements planning approach is more suited for occasional, large discrete issues.

Calculation of economic order quantity seeks to reconcile ordering and holding costs for an optimum order size. Costs of holding stock and ordering/acquiring it are involved. We need to evaluate whether safety stock and service/availability levels are needed and we need data on lead time and demand. The mathematics involve arithmetic and a basic understanding of normal distribution and standard deviation.

 Inventory Control Systems

It is important to understand systems of inventory management. As demand and lead times vary we can order fixed quantities of stock at variable times or order variable quantities at fixed times. Each has implications for safety stock, operational responsiveness, the level of risk involved given variable demand and supply and security. Many factories will use a two-bin replenishment system. Stock records systems, computerised more often than not today, provide move detailed control over stock levels, issues and receipts. They are essential to stores management. The data content and flows of such systems are needed by just-in-time methods.

We must be aware also that “the records say we have 5 in the warehouse but only three can be found and one of these is damaged”.

 Pareto (ABC) Analysis

Pareto analysis (a.k.a. ABC analysis or 80/20 rule) can be used to classify stock groups. Stock items are ranked in descending order of usage value, and plotted on a cumulative frequency curve. it is common to find that 20% of items account for 80 % of usage value, the next 30% has 15% of value. The final 50% have 5% of value.

ABC or Pareto analysis points the way to where control efforts are best directed. Judgment is needed on critical inventory items or security matters that Pareto analysis in itself does not reveal.

 4.2 The risk associated with the management of fixed assets in a business unit is identified and quantified in terms of probability and severity.

Immovable Asset Management

 Immovable Asset Management involves the process of planning and monitoring the immovable assets during their useful lives in an institution. Good asset management is critical in both the public and private sector, particularly given the fact that assets exist to support the delivery of programs or services; a link has to be established between program delivery and assets, corporate objectives are translated into program objectives, delivery strategies, outputs and outcomes. Assets within a program are one of the inputs utilized to enable program outcomes; therefore if assets do not contribute effectively towards program delivery, they should not be acquired, held or used.

 Life Cycle Process

 

Users of Infrastructure

 

  • Department of Education
    • Schools, School hostels etc.
  • Department of Health
    • Hospitals, health facilities, nurses homes etc.
  • Department of Public Works
    • Government buildings, Offices for government institutions
  • Department of Provincial & Local Government
    • Municipalities
      • Water treatment plants, Reservoirs, Pump stations, Power stations, roadways etc.

Guiding Legislation and documents

  •  MFMA / PFMA
    • Asset Register
    • Accountability
  • GIAMA
    • Rationale
    • Framework
  • GAMAP Best Practice Manual
    • GAMAP 113 Property, Plant and Equipment
  •  
  4.3 A system for managing stock in a business unit is applied with reference to ensuring sufficient stock, control of costs and the value of the stock.

 Stock Control Mathematics

 Quantity discounts

The order cost is spread over more items (larger batches) with discounts! But there are higher holding costs

  • orders arrive in one batch with a known lead time arriving just as stock is exhausted.
  • some order placement/receiving costs are independent of order quantity, others are dependent.
  • economies or diseconomies of scale do not apply to holding stock (assumption = holding costs are a fixed % of stock value). Order quantities should not exceed shelf-life expectations, room for storage or what is affordable (eg. at the end of a year – a school or hospital department may buy small (retail) quantities, as the budget is depleted).
  • someone can buy 10000 in error when usage is in 10’s.
  • EOQ assumes good information on variable costs e.g. we know that by placing few big orders, R950.00 per order, say, can be saved or that with smaller quantities the opportunity cost of tied up capital and associated warehouse space costs are saved. But such data on actual costs may be at best a good estimate. This is less of a problem as EOQ is not very sensitive to error so long as the magnitude of the cost/demand data is reasonably accurate.

 Safety stock and service levels

We may run out of stock because of a re-supply delay or higher than anticipated usage. If we can predict demand then we merely place EOQ orders on time. The figure shows the predictable, timely re-ordered stock movements.

But we risk a stock-out with unpredictable demand, usage and resupply so introducing a safety or buffer stock reduces the risks of variable demand/lead time.

Lead time

– the time between a replenishment need arising and new deliveries being ready for use. It includes e.g. time to

  • detect then authorise replenishment
  • establish supplier contact and complete admin/paperwork
  • obtain, produce and have the goods delivered
  • goods inwards/receiving and quality checking time

Service Levels

Rather than guarantee 100% stock availability for any foreseeable need, inventory managers would normally agree an inventory service level (% probability of stock availability to meet demand). This mediates the estimated costs of stock-outs with the cost of carrying a safety reserve. If demand and lead times are normally distributed, the safety stock formula is:

Safety stock levels

Calculating safety stocks requires understanding of demand and lead time. Assuming that these are normally distributed then

Safety stock = ( L Dv+D 2Lv )

  • L = mean lead time, D = mean demand (in the lead time) Lvar = variance of lead time, Dvar = variance of demand

and

  • For a safety stock level in a service agreement, an Sdev (standard deviation) value of 1.6 gives 95% stock availability and 2.3. gives 99%.

The controllable aspects of lead time should be investigated. It is seldom that normally distributed and improved control over the length and variability of lead time will reduce the need to maintain safety stocks.

 Serving items from stock

In order to serve materials from stock, replenishment must occur to replace materials that have been issued or are known to have future requirements.

Economical order quantity EOQ

For every item an economical reorder quantity EOQ can be calculated, that will lead to the lowest total cost of ordering and stockholding. The calculation of the EOQ is based on general economical conditions such as consumption, cost of ordering and cost of holding the item in stock.

However, the EOQ calculation does not include considerations such as maximum stockable quantity, limited shelf-life, dimensions of the material other than the consumption unit, or difficulties in obtaining the material. When the item is re-ordered, other constraints such as the supplier’s minimum, and multiple, are included in the re-order quantity.

Reorder point ROP

Re-ordering of items takes place whenever the available stock quantity drops below a certain level, the re-order point (ROP). This reorder point ROP represents the buffer quantity of items required to ensure that material requests will continue to be served, during the time between the ordering of new material and the arrival of the ordered new material. The time between the moment a proposition for re-ordering of new material and the availability in stock of the ordered new material is the so-called re-ordering delay or lead-time.

The re-order point ROP is calculated as the sum of 2 components

 

* A stock reserve or buffer stock quantity SR which is based on the normal average expected consumption during the lead-time.

* An extra quantity, the so-called safety or security stock SS, to ensure that the item is available up to the pre-defined required service level, even when the re-ordered material arrives later then expected, or the fluctuations in demand during the lead-time cause the demand to be larger then expected.

The safety stock is the most important component of the re-order point. The average stock value is determined for a large part by the safety stock. Good safety stock ensures a high service level.

 Reorder cycle and lead-time

The lead-time of the re-order cycle is composed of the following components:

  1. Review time needed to confirm a replenishment proposal.
  2. Time needed to process and send an order.
  3. The supply time or delivery time, defined as the time needed for the supplier to deliver the requested materials after the order has been received. This time includes assembling or manufacturing, when needed.
  4. Inspection and entering the item to stock.

Both the stock reserve SR and the safety stock SS quantity components of the reorder point ROP are very dependent on the delivery time and the reliability of the supplier.

If the delivery time changes, this will highly influence the re-order point and thus the moment of re-ordering.

Serving material requests by direct delivery from the supplier

Economical considerations such as short delivery time of the supplier, or low demand frequency of expensive items may lead to the decision not to keep the items available in stock, but to handle requests for these items only by direct delivery of the item from the supplier. Direct ordering for non-stocked items can be handled electronically by electronic data interchange EDI or normal ordering by purchase orders.

 

Exceptional large non-recurrent demands

Occasionally, material requests for exceptionally large quantities will disturb the servicing of material requests for normal quantities.

Exceptional requests handling

Correct handling of these non-recurrent or infrequent exceptional requests is very important. The penalties in costs and service level can be very high if these exceptional large demands are not correctly identified and handled.

Serving a demand for an exceptionally large quantity from stock will generally lead to stock-out, and backorders for the normal requested quantities.

In order to avoid this the material requests for an exceptional large quantity can be handled by a special order.

The infrequent or non-recurrent requests for exceptionally large quantities often originate from capital projects, where these material requests are planned well in advance. The non servicing of these planned materials on the requested delivery date, may disturb the project planning.

Exception threshold level

Requests for exceptional large quantities are identified by comparison of the requested quantities with a so-called exception threshold level.

If the demanded quantity is larger than this threshold level the request will be considered as an exceptional demand.

Occasionally a request for an exceptional quantity of an item can be served normally from stock, without endangering serving of the normal requests for the item. This is the case when after serving the exceptional quantity at least one re-order point is left.

Handling of requests for exceptional large quantities involves:

*    Check if serving the exceptional quantity from stock will disturb the normal stock keeping.

*    If the exceptional quantity can not be served from stock, a special order is created for the material request with a delivery date, such that the delivery date of the material request can be met. Notify requester if this date can not be met.

 Exceptional requests and safety stock

If the historical exceptionally large requests are not correctly identified for the statistical calculations, they will dominate the normal statistical requests.

The statistical domination of the normal requests by the exceptionally large non-recurrent demands may result in very high stock values caused by unnecessary high security stocks.

NOTE: Careful definition of the exceptional threshold value is very important: it has a direct influence on:

* The actual stock operations

* The service level

* The stock value

Logical constraints

The stockholding, reordering and exceptional handling of items are controlled by a number of logistics parameters: the reorder point, economical order quantity and exception threshold level. These logistics parameters are calculated based on a mathematical model, representing an approximation of the real world, and statistical information from a number of sources such as historical consumption, material needs of future capital projects, and the estimates of the various costs of the steps and processes involved. However, the values calculated for the logistic parameters can never be more accurate than the model involved and the information used. The statistical standard model based on historical consumption will normally give very satisfactory results in 95% percent of the cases. However, in exceptional non-standard situations the normal statistical information (historical consumption) may be insufficient and lead to unsatisfactory results, e.g. in cases like:

*    You are informed by the supplier that the delivery time (supply time) for a given item or range of items will change.

e.g. your supplier is not stocking the item anymore in the future, or there is a temporary production failure.

*    The product is technically sensitive: a new version is due after a certain date, or the old version is not valid anymore after a particular date (e.g. computers, calendars, agendas, etc.).

*    There is a certain duration of life, limiting the shelf-life of the product (e.g. ink, markers, medicines, etc.).

*    There is a non-statistical, expected growth, which is known to happen in the future.

*    The dimensions of the requested piece of raw material may be more important than the quantity requested as criterion if this request can be satisfied from a given unit of raw material or not. For raw materials the statistical reorder point quantity may not be very meaningful as a means to express if a given request can still be served from this quantity or not (see picture).

The dimensions of the requested piece of material may be such that the request can only be served from a complete stock unit of the material.

 

If a minimum level is defined of at least one whole stock unit, the serving of a material request is ensured. If the price of the material is low, the minimum level can be taken consisting of several untouched units.

In order to cope with special situations, such as raw materials, limited shelf-life, change of delivery time, etc. additional information can be entered in the form of logical constraints

* item shelf-life

* New version date

* Maximum stockable quantity

* Supplier delivery time + valid date

* Lot quantity

* Minimum level

* Exceptional threshold level for direct delivery

* Expected growth factor + valid date

 

These logical constraints will influence the moment and quantity of the reorder proposition, or the handling of the material request.

 

The quantity that is proposed to reorder

* Shelf-life (indirect by expected consumption in shelf-life)

* Lot quantity

* Maximum stock

* Expected growth

 

The moment in time on which a proposition for re-ordering is created

* Supplier delivery time (indirect by new reorder point ROP)

* Minimum level

* New version date

* Expected growth

The handling of the material requests

* Exceptional threshold level for direct delivery

 Logical constraints and material flow

 4.4 A plan is designed to minimize the risk associated with fixed assets in a business unit.
  1. The need for GIAMA
  •  Government is confronted with service delivery needs which must be matched with efficient and effective use of resources, including immovable assets.
  • Government’s extensive and diversified immovable assets have a significant impact on the overall macro-economic, socio-political & physical landscape.
  • Decisions on immovable assets have long-term implications and should be based on the full impact of costs over the expected lifespan of such assets.
  • It is therefore imperative that Government’s immovable assets be managed in a uniform, efficient, effective and accountable manner.

 

  1. Legal framework of GIAMA

 

  • The Constitution mandates the National Government to pass legislation for all spheres of government if the purpose is to establish uniformity and to set minimum norms and standards with regard to service delivery.
  • Cabinet mandated the Minister of Public Works to develop an overarching policy framework to govern the management of immovable assets throughout Government and to implement that policy by means of legislation

 

  1. Objectives of GIAMA

 

GIAMA makes it incumbent on all organs of State     to promote Government’s objectives through the management of immovable assets under their control:

  • Promoting accountability, fairness and transparency.
  • Promoting effective, efficient and economic use and maintenance of immovable assets.
  • Reducing the demand for new immovable assets by (inter alia) considering non-asset solutions.
  • Supporting government’s socio-economic objectives including land reform, economic empowerment, poverty alleviation and job creation.
  • Realising the best value for money from the disposal of immovable assets, whilst promoting Government’s socio-economic objectives.
  • Increasing opportunities for partnering with the private sector throughout the life-cycle of immovable assets.
  • Protecting the environment and South Africa’s diverse cultural and historic heritage.
  • Improving health and safety in the working environment.

 

 

  1. Guidelines & Requirements

 

GIAMA legislation will empower the Minister of Public Works to determine immovable asset management guidelines and minimum requirements that will –

  • complement general asset management guidelines issued by National Treasury in terms of the PFMA and MFMA;
  • provide a framework for the management of immovable assets throughout their life-cycle (encompassing strategic planning, acquisition, maintenance & management and disposal
  • assets address the minimum content, format & processes required to compile immovable asset management plans;
  • provide a planning framework for custodians to implement a portfolio management function;
  • provide a framework for measuring the performance of immovable assets; and
  • prescribe the minimum information required to manage immovable.

 

  1. Immovable Asset Management Plans

 

  • Each organ of State (users and custodians) will be required to produce an IAM plan that will form part of the strategic planning and budgeting process of Government.
  • IAM plans must cover all the immovable assets which the organ of State uses or intends to use (State-owned & leased).
  • Where a custodian makes immovable assets available to a user, the custodian and user should jointly conduct the strategic planning process
  • All IAM plans must be submitted to the relevant Treasury annually (on a date to be determined by that Treasury).
  • IAM plans must inform the annual budgetary process and must be revised once budgetary allocations are finalised.
  • Revised IAM plans must be included in the strategic plans of all organs of State.
  • Custodians must assist users by making available information pertaining to the performance of immovable assets allocated to them.

[This would include analyzing such information in a manner                 that would enable users to make informed decisions]

  • Users must provide custodians with a copy of the IAM plans they submit to Treasury.

[Generally, custodians are in a position to view the management of immovable assets from a wider (“whole of government”) perspective than individual organs of State.

The production of custodian IAM plans will enable these “whole       of government” considerations to be taken into account during Governments’ strategic planning and budgetary processes]

  1. Consultation
  •  DPW consulted with all National and Provincial Departments on the draft GIAMA policy and their comments will be incorporated in the revised policy and the GIAMA Bill.

GIAMA

  •  Each organ of state must submit its immovable asset management plan to the relevant Treasury annually.
  • These asset management plans must inform the budget allocation process, and must be revised and included in the strategic plans of organs of state once budgetary allocations are finalised.

The Framework comprises of the following components:

 Strategic Planning

    • Link service delivery strategies with IA’s
    • Analysis of existing IA’s vs IA’s required to meet service delivery requirements
  • Acquisition Planning & Management
    • Additional IA’s
    • Upgrades or Improvements
  • Operation & Maintenance Planning & Management
    • Performance & Condition assessments
    • Prioritised Maintenance Budget
  • Disposal Planning & Management
    • Maximisation of benefits of disposals within financial and other resource constraints
  • Performance Management
    • Monitor & review to ensure compliance & accountability

Asset Management Framework supporting GIAMA