Inventory Study Guide

📖 Core Concepts Inventory – All goods and materials a business holds for resale, production, or use. Work in Process (WIP) – Items that have started transformation but aren’t finished goods. Safety (Buffer) Stock – Extra units kept above normal levels to protect against demand‑ or supply‑side variability. Cycle Stock – The quantity needed to meet regular demand during a production cycle (excludes safety stock). Reorder Level – Inventory point that triggers a new purchase order. FIFO vs. LIFO – Accounting rules that decide which units are considered sold first; they affect reported cost of goods sold (COGS) and taxes. Inventory Turnover Ratio – Measures how many times inventory is sold & replaced in a year. Just‑In‑Time (JIT) – Production philosophy that creates goods only when needed, minimizing holding costs. Inventory Exposure – The amount of committed stock in the supply chain relative to expected demand and lead times; a risk‑management metric. --- 📌 Must Remember Safety Stock = (Maximum Daily Usage × Max Lead Time) – (Average Daily Usage × Average Lead Time) (simple approximation). Reorder Point (ROP) = Demand during Lead Time + Safety Stock. COGS Formula $$\text{COGS} = \text{Beginning Inventory} + \text{Purchases} + \text{Production Cost} - \text{Ending Inventory}$$ Inventory Turnover $$\text{Turnover Ratio} = \frac{\text{COGS}}{\text{Average Inventory}}$$ FIFO → newest costs stay on the balance sheet; LIFO → oldest costs stay on the balance sheet. Holding Cost includes warehousing, insurance, utilities, and capital cost of tied‑up money. Ordering Cost is incurred each time a purchase order is placed (setup, admin, shipping). Shortage Cost = lost sales + reputational damage + possible loss of customers. JIT Success hinges on reliable suppliers and tight communication; any disruption can halt production. --- 🔄 Key Processes Determining Reorder Level Estimate average daily demand → multiply by lead time → add safety stock. Calculating Safety Stock (basic method) Identify max daily usage & max lead time → compute excess over average usage × average lead time. Performing ABC Analysis Rank items by % of total revenue → classify: A (top 20%), B (next 30%), C (remaining 50%). Choosing Valuation Method Assess inflation environment → FIFO for higher net income; LIFO for tax deferral in rising prices. Implementing JIT Map demand signals → set up kanban or pull system → synchronize supplier deliveries to production schedule. --- 🔍 Key Comparisons FIFO vs. LIFO FIFO: Oldest units sold first → inventory on balance sheet reflects recent (higher) costs. LIFO: Newest units sold first → lower COGS in inflation → lower taxable income. Safety Stock vs. Anticipation Stock Safety Stock: Buffers random demand/supply variation. Anticipation Stock: Built deliberately for known seasonal spikes. Cycle Stock vs. Buffer (Safety) Stock Cycle Stock: Meets regular demand; rotates each production cycle. Buffer Stock: Extra layer on top of cycle stock for uncertainty. Physical Stock vs. Virtual Inventory Physical: Tangible items in warehouses. Virtual: Tracked through information systems; no dedicated storage needed. --- ⚠️ Common Misunderstandings “More inventory = better service.” → Excess inventory raises holding & shortage costs, can become obsolete. “FIFO always yields higher profit.” → In deflationary periods FIFO can actually lower profit vs. LIFO. “JIT eliminates all inventory.” → JIT reduces but never fully removes safety stock; some buffer is still required. “Reorder level = safety stock.” – Wrong; ROP = demand during lead time plus safety stock. --- 🧠 Mental Models / Intuition “The bathtub model” – Think of inventory as water in a bathtub: inflow (purchases/production) fills it, outflow (sales) drains it. Safety stock is the water left at the bottom to prevent the tub from emptying during a surge. “The ladder of risk” – Each extra layer of stock (cycle → safety → anticipation) climbs a rung of cost; the higher you go, the more you pay in holding cost but the lower the stock‑out risk. “FIFO as a conveyor belt” – Visualize items moving on a belt; the first that entered is the first that exits. LIFO is like a stack of plates; you take the top one first. --- 🚩 Exceptions & Edge Cases Perishable Goods – Safety stock must be limited; otherwise spoilage cost outweighs stock‑out risk. Highly Seasonal Items – Anticipation stock may exceed normal safety stock by a large factor. Inflationary vs. Deflationary Environments – Valuation method choice flips impact on net income and tax. Regulatory Restrictions – Certain industries (e.g., pharmaceuticals) may be mandated to keep minimum safety stock levels. --- 📍 When to Use Which Valuation Method: Use FIFO when inventory costs are rising and you want higher reported earnings; choose LIFO for tax deferral in inflationary periods. Stock Type: Deploy anticipation stock for known seasonal peaks; rely on safety stock for unpredictable demand or supply variability. Management Technique: Apply ABC analysis when you have many SKU’s and need to focus effort on high‑value items. Production Approach: Implement JIT only if suppliers have proven reliability and lead times are short; otherwise keep a modest safety buffer. --- 👀 Patterns to Recognize “Spike‑then‑dip” demand curves → likely a cue for anticipation stock. Consistently high inventory turnover (>12/yr) → indicates efficient inventory management, but watch for stock‑outs. Large gap between reorder level and actual order quantity → may signal over‑reliance on safety stock. Sudden increase in shortage cost → often precedes a need to revisit safety stock calculations or supplier performance. --- 🗂️ Exam Traps Confusing Safety Stock with Cycle Stock – exam answers may list safety stock as the “normal demand” quantity; remember cycle stock covers routine demand only. Choosing FIFO in a deflationary scenario – some questions test whether you know FIFO raises COGS when prices fall, lowering profit. Assuming JIT eliminates all holding costs – JIT still incurs minimal safety stock and setup costs; answer choices that claim “zero inventory cost” are wrong. Mixing up Reorder Point and Reorder Quantity – the point triggers the order; the quantity is how much you order (often EOQ). Ignoring the impact of valuation method on tax – LIFO reduces taxable income in inflation; a distractor may claim it always reduces taxes regardless of price trends. ---