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Inventory analysis techniques for generation, transmission and distribution cooperatives of the rural electric system.

Rural electric utilities have significant amounts of money invested in plant materials inventories, and we incur considerable expenses to order and carry this inventory, as well as incurring opportunity costs. While participating in the 1991-92 Management Intership Program, the authors developed the inventory models explained in this article and possible applications for the models, with the purpose of improving our ability to effectively and efficiently manage inventory.

Introduction

The investigation of inventory analysis for distribution cooperatives and cooperatives that provide generation and transmission services was selected as an appropriate field of study by the MIP working group for several specific reasons. First, for all cooperatives, inventories of materials and supplies are both appropriate and necessary to the provision of cost-effective electric service. Second, the character and level of inventory would be presumed to be variable as a function of the activity performed by any one cooperative, including the character of service provided, the ecological and atmospheric environment of each cooperative, the seasonality of operating and construction activity, and transportation considerations for receipt of materials and cost of acquisition.

The contributors to this analysis are employed by utilities that display each of the varied activities involved in generation, transmission and distribution of electricity by cooperatives. In addition, the participants have variations in climatic conditions that may affect construction activity and are dispersed, in some cases centralized (e.g., Kentucky), near transportation headquarters (e.g., Oregon) or isolated (e.g., Alaska), which may affect inventory acquisition and carrying costs.

Each cooperative participant may be subject to unique conditions, yet is faced with the same fundamental problem--the means by which to evaluate inventory decisions and the cost-effectiveness of decisions made in regard to acquisition and retention of supplies. By this study of inventory analysis techniques, a common system applicable to a variety of cooperatives will be developed and performance measures established that provide reasonable identification of the effectiveness of inventory controls.

A model for evaluating inventory carrying costs and the level of acquisition for optimum economics will be developed for materials relevant to the specific utility activities associated with distribution service and provision of generation and transmission services, followed by a discussion of measures of performance and assessments of success in inventory policy.

The Nature of the Problem

All electric utilities, whether providing generation, transmission or distribution services are faced with similar considerations with regard to electric plant. Electric utilities invest in plant to provide electric service and must respond to service requirements by construction of facilities, maintenance and repair of those facilities, and the replacement of facilities as required to maintain a given level of service continuity and reliability. To effectively provide electric service, the utilities must be able to respond to plant installation and maintenance requirements while minimizing the total cost of service. To provide the appropriate level of responsiveness to service demands, a certain amount of construction and maintenance materials must be available to the workforce on an on-going basis, while other materials, that may not be immediately required upon demand, should be either readily accessible or available on a given schedule. The problem under consideration in inventory analysis techniques may be described simply as the determination of the amount of particular materials to maintain, when to place material orders, and the economic consequences of carrying material stocks.

For the generating cooperative, construction requirements may overshadow maintenance in terms of total dollars of materials, yet on-going maintenance of installed plant has a much greater impact on continuity and service reliability than construction (at a given level of load). For a utility concentrating on generation activity, the stock of maintenance materials, and an assessment of how often certain materials may be required, will provide the foundation of the inventories, the value of which may be compared against lost sales, or lost opportunities for sales. For a utility primarily engaged in transmission activity, the same would be generally expected to hold. However, for the distribution cooperative involved in on-going service extensions while providing appropriate maintenance of installed plant, both types of materials must be considered in the equation to varying degrees; load growth expectations and remaining useful life of plant previously installed will each contribute to the determination of economic inventory levels.

While an infinite supply of materials may be maintained, prudence would dictate that needs should be met at the lowest economic cost. Likewise, zero materials may be maintained, but the economic consequences of delays or expedition costs must be controlled as well. A proper balance of economics and reliability must be achieved.

Theoretical Background

Much effort has been spent in the development of inventory techniques for manufacturing that may be transferred to a service industry such as electric utilities. The literature of production process, operations research, and accounting and taxation is replete with references to inventory issues (see, for example, Managing and Accounting for inventories by Janis, et. al, or Handbook of Inventory Management by Janson) that describe the underpinnings of techniques for inventory policy development. The basics for manufacturing or distribution of products may be readily transferred to electric utilities by modification of considerations to those unique to the industry. The majority of the following is courtesy of Janis, et al.

The major, and underlying issue, is the control of investment in inventories, the major determinants of which are: (1) the level of sales or output, as defined by construction materials requirements: (2) the length and technical nature of the production process; and (3) the durability or perishability of the product.

Given an appropriately flexible and timely identification of forecasted needs, the ordering point for additional stocks is that level of inventory at which additional materials are required to maintain a given level of production. The economic ordering quantity (EOQ) is the number of units that should be obtained when the ordering point is reached.

The level of stock maintained includes consideration of (1) the basic, or underlying, level; (2) the safety stock providing for margins of error in estimation or failure of the "just-in-time" delivery system; and (3) anticipatory stock (the basis for EOQ).

Ordering, or set-up costs, constitute the direct acquisition costs of inventory for either the sum of the inventory products or any individual item. Generally, the economic ordering quantity will reflect ordering costs specific to the placement of any particular order by the purchasing entity.

Carrying costs reflect the economic impact having acquired the items and holding the stock of inventory. These include:

* the investment cost including interest on borrowed funds and transportation

* storage or warehousing costs

* insurance against loss

* depreciation of materials, if any

* obsolescence of materials

* opportunity costs such as lost sales or inability to meet new load demands, interruption of service, purchase discounts, and alternative investment opportunities

The fundamental determinants of performance of a given inventory program include the impacts of space requirements and the financial impact of carrying particular levels of inventory, taking into consideration:

1. the magnitude of the financial commitment

2. inventory as a percent of the total assets, and changes over time as a function of replacement or expansion requirements

3. safety and reliability requirements

4. success in obtaining materials "just-in-time" to minimize operating expenses and inconvenience

For the electric utility, as in other economic activities, the issue of appropriate inventory levels is the establishment of an optimum quantity for overall service considerations at the lowest possible cost by weighing such factors as the cost of lost service, the variability in demand levels, and the variability of replenishment cycles.

These issues will be examined in the context of specific materials identified by actual utility requirements and forecasted needs.

Economic Carrying Charges and Economic Ordering Quantity

As stated earlier, the carrying costs reflect the economic impact of investing and holding inventory. The specific parameters of carrying cost are unique to any particular cooperative, and must be evaluated accordingly.

The factors that contribute to the total carrying charge, detailed as to utility-specific conditions, include the following:

Investment cost. The inventory may be held and acquired through short-term borrowings which generally carry higher interest charges than long-term funds, or may be acquired with long-term borrowings as a prepurchase of construction materials. A consideration in the choice of the rate to estimate would include the seasonality of the acquisitions, the financial characteristics of the company (such as the availability of draws, cash on hand, and debt acquisition capability). For the purposes of this analysis, the Cooperative Finance Corporation's short-term borrowing rate is used in the model to represent an average expected borrowing cost for a distribution cooperative and CoBank's rate for a generation and transmission cooperative.

Storage costs. The storage or warehousing costs should be applied for the value of land and buildings precluded from other productive uses as a result of retention of stocks. The value generally would include an allocation of building costs, manpower to move and maintain the materials, and associated expenses. To the extent that storage is outdoors, the minimum cost would be manpower. The costs are best allocated on the basis of dollar value, rather than volume, since volumetric allocations would assign inordinate amounts to transmission and distribution materials exposed to weather. For the purposes of this analysis, the cost would be assigned on a percentage basis across all dollars of inventory.

Insurance. Since the materials considered for inventory analysis are generally confined, the insurance loss potential is limited to replacement due to materials damage from weather, inadvertent destructive forces, or other force majeure. This factor can be allocated to inventory based on percentages of total plant subject to the insurance requirements. For the purposes herein, it is assumed that insurance for destructive losses is a percent of the total dollar value of inventory.

Depreciation. Certain materials may be subject to depreciation as a result of acquisition in advance of installation. However, except for special materials treated specifically, cooperatives do not depreciate materials until such materials are placed into service. For an unregulated business, the value of depreciation should be taken into account immediately upon receipt of the materials. Since most cooperatives are subject to the REA regulations or used and useful regulatory policies, depreciation is not considered a cost of carrying inventory. Under that condition, obsolescence of materials may have a greater significance than depreciation.

Obsolescence. Generally, for the electric utility, business, obsolescence is a lesser problem than for other industries, but should be anticipated in an inventory assessment mode Materials for distribution and transmission of electricity are of longer life than may be the case for rapidly changing technologies. For generation equipment, the same may not hold, particularly for materials inventories for plant refurbishments that are delayed for a variety of reasons. For the purpose of this analysis, obsolescence is not considered for cooperative inventories.

Opportunity costs. Although opportunity costs are potentially of significant value, and should be incorporated in evaluations of inventory, the assessment of lost sales or inability to meet load demands is beyond the scope of this investigation. Similarly, the interruptions of service due to lack of materials availability, although significant from a customer service perspective, vary widely between cooperatives. The value should be considered in implementation of the models developed at any one cooperative.

The loss of purchase discounts, on the other hand, may be a significant consideration in evaluating the efficacy of multiple utility or regional inventory sharing. In that instance, a credit or debit should specifically be applied to the carrying charges of a particular item, or applied generally, if purchase discounts would otherwise be unavailable. This value would be specific to each utility or combination of utilities.

The total cost of inventory, however, includes the costs of placing the order, considered as set-up, or ordering costs. Set-up costs include allocations of manpower, equipment, communications facilities, and other factors that impact acquisition of materials. In the absence of down payment requirements or deposits that require cash or cash equivalents, the only real ordering costs experienced by cooperatives would be manpower. For long lead time materials, some financial impact would occur, presumably on the basis of the acquisition cost. One assumed value would be 10 percent for orders exceeding $500,000, which is assumed herein.

The total costs of inventory are the sum of the carrying charges and the ordering costs. Since ordering costs decline as a function of the quantity ordered, and carrying costs increase as a function of the number of units of a particular item that are obtained, the total costs of the inventory will be minimized when an appropriate quantity is obtained dt any given point in time.

The most economic number of units, taking into consideration the item requirements, the costs of ordering, and the carrying costs may be identified by the attached graph, entitled economic ordering quantity. The formulation of economic ordering quantity, in effect, balances the components of the total carrying and acquisition costs of the inventory. The total cost is minimized by that number of orders placed, at a particular level than results is the lowest average cost. A graphical representation of the total cost is illustrated in Appendix A.

The economic ordering quantity reflects the needs of the productive process while remaining within the economic parameters of the cooperative, the expected turnover of specific items, and the obsolescence of the supplies and equipment held in stock.

Model Description and Development

The inventory model was prepared on LOTUS 1-2-3 by the work group to include input details specific to any particular cooperative. The input files of materials and specifications may be modified to accommodate a wide range of alternative inventory conditions and requirements.

File Structure and Names

There are two Lotus 123 version 2.2 spreadsheets for evaluating the economic order quantity. They are named Vern1.wk1 (Appendix B) and Vern2.wk1 (Appendix C). Vern1 is for a distribution Cooperative and Vern2 is for a Generation and Transmission Cooperative.

File Input

The input values are entered the same for both spreadsheets. All cells that are not for input are protected.

The top of each sheet has the formula for the economic order quantity. The first input section of input is for the unit cost anti the annual usage from prior years. The carrying costs are the next to be entered. Dollar values should be entered as whole numbers (no cents). Percent values should be entered as decimal values (example: 8% is entered as 0.08).

Set up costs are entered next. The values are divided into two sections. The first is values that are per unit dependent. An example is the time it takes to set tip files on each individual distribution transformer. The second section values are dependent upon the quantity ordered. An example of your total set up cost is the same if you order 10 machine bolts or 100. The first value entered is the set up time necessary for each unit. The next value is the loaded cost of labor for setting up the units. The set up cost thai is non-quantity dependent is then entered. The loaded cost of this function is then entered.

The final section of values to enter are al the very bottom of each spreadsheet. The lead time for each item is entered in days. The minimum package size is also entered.

Output

The output is in two sections at the bottom of the sheet. The values used in the economic order quantity are repeated and the economic order quantity is calculated.

The package size and the economic order quantity are used to calculate the number of orders and the size of orders placed during the year.

Applications

The inventory model was applied to materials and inventory specifications (such as carrying cost details) applicable to cooperatives at which study group members are employed. Scenario 1 relates to certain items applicable to any distribution cooperative while Scenario 2 relates to specific generation and transmission activities.

The model and output for the two scenarios follows.

Inventory Performance Evaluation

Inventory performance considers whether the investment in acquiring and holding inventory is appropriate in meeting the service needs while minimizing the total financial commitment. Measures of performance include turnover rate and proportion of assets.

Inventory turnover answers the question of whether inventory levels are increasing or decreasing over time. Turnover is sometimes referred to as inventory velocity and is calculated by dividing annual sales in dollars by average inventory measured in dollars.

REA Form 7, Part g, Line 3, for distribution cooperatives shows the Ratio of Inventory Turnover. The resulting figure provides a relatively useful measure of how many times per year average inventory turns over. The average turn for distribution cooperatives in the United States is 1.25. Some have indicated that the turnover rate should be on the order of 2.0 (financial auditors, for example, at Umatilla Electric Cooperative Association, recommend a level of at least 2.0).

As a simplified example of turnover, assume that a cooperative's yearly usage of meters was at a cost of $50,000 and that inventory on hand is calculated to be $10,000. Then, the number 01' inventory "turns" per year would be ($50,000/$10,000) and equal to 5.0. This result could be stated in one of two ways:

1. average inventory turns five times per year, or

2. on the average, an item of inventory stays on the shelf for a period of time equal to one-fifth of a year, or 10.4 weeks.

While more inventory turns per year are commonly associated with more effective inventory management, service sometimes suffers if the result is the unavailability of inventoried items, when needed for service requirements and the significance of the level as a portion of the utilities total financial requirements.

Another measure of performance would be inventory as a percent of total assets. The complexity and accuracy of economic ordering quantity and inventory levels such as this are related to the assumptions that are made. Typically, the more that is assumed away in the model, the easier the model is to work with and understand; however, the output of a simple model is often less accurate.

Therefore, other measures of inventory and inventory performance should be explored and monitored over time. For instance, upon completion of implementation of the economic ordering quantity model, the resultant quantity of inventory should be compared with existing stocks as a percent of total assets to evaluate whether inventory decisions have previously been appropriate. Relationships between the level of inventory and operating conditions may vary over time, though such as just prior to a major expansion phase or significant replacement activities.

Conclusion

The investigation of inventory analysis techniques resulted in the development of a model for acquiring inventory items on an economic basis for distribution and generation/transmission cooperatives to minimize total costs. The model may be used generally throughout the industry by modification of input variables to reflect utility-specific conditions. An evaluation of inventory programs may be accomplished by implementing the model, testing the results against current practice, and determining the impact on inventory turnover and total utility investment. The model will assist the utility in meeting service requirements adequately, efficiently, at a the lowest possible cost to the membership in keeping with the goal of adequate and reliable service at the lowest possible cost.

* Deborah Debnam started her utility career at Chugach Electric Association in Anchorage, Alaska, in 1984. She is currently Supervisor of Credit & Collections and Metering Services. Along with the credit and metering duties, Debbie oversees property damage claims both for and against Chugach and conducts small claims proceedings. She is also a member of the Northwest Energy Diversion Council. Debbie completed the Management Internship Program this year.

Debbie's management career began in 1973 when she accepted the position of Credit Manager at Nerland's Home Furnishings in Anchorage, Alaska. In 1976 she moved to Oregon where she owned and operated three retail clothings stores for eight years. During this time she was president of a local merchant's association and was on contract to a shopping mall developer to assist small business tenants with lease negotiations and advertising. Educationally, Debbie attended classes at Clackamas Community College in Oregon and studied accounting and business management through the University of Maryland while living overseas in Yalova, Turkey, and Misawa, Japan.

* Bruce Hall is Manager of Engineering for Umatilla Electric Cooperative Association (UECA). UECA serves approximately 9,200 members in the northeastern Oregon desert. Nearly 40% of UECA's energy sales are directly to irrigation, making it the most heavily irrigation-dependent cooperative in the U.S.

Bruce is responsible for the management of the engineering and materials departments, including the supervision and direction of these departments' staffs. He also directs and coordinates all engineering studies, including long-range plans, system studies, and voltage and fault studies.

Mr. Hall is a graduate of Oregon State University with a B.S. in electrical and computer engineering. Bruce is a licensed engineer and a 1992 graduate of the Management Internship Program.

* Tom Lovas completed the Management Internship Program in May of 1992. He is currently manager of the Planning and Rates Department at Chugach Electric Association, Inc., in Anchorage, Alaska. In that position, he is responsible for load forecasting, generation and transmission system planning, wholesale and retail rates, wholesale power and fuel contracts, regulatory activities and financial forecasting. The department provides financial, engineering and economic analysis in support of Chugach strategic planning.

Mr. Lovas has been employed at Chugach, a provider of generation and transmission services as well as retail distribution of electricity, since 1985. Prior to his current employment, he served as Supervisor of Planning Economics in the engineering department of the Montana Power Company and earlier was an analyst on the staff of the Vice-President, Rates and Valuation, at Pacific Gas and Electric Company. He is a graduate of Washington State University and holds bachelor and master of arts degrees in economics (public utility). Mr. Lovas is a member of the International Association for Energy Economics and the National Association of Business Economists.

* Tim Miller has been with Green River Electric Corporation in Owensboro, Kentucky, since 1978. Tim worked as a line crew groundman, engineering aide and warehouseman before assuming his current position as purchasing agent in 1980. In addition to the purchasing responsibilities, Tim oversees all warehouse and inventory activities, dispatches the company oil spill response team and prepares all paperwork relating to oil spills and disposal of oil-filled equipment.

Tim received his B.S. degree in business administration from Brescia College in Owensboro. Tim has completed Western Kentucky University's Advanced Supervisors Seminar, Kentucky Association of Electric Cooperatives' Supervisory Development Program and Frontline Leadership. He completed the Management Internship Program in May of 1992.
COPYRIGHT 1992 National Rural Electric Cooperative Association
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Title Annotation:includes appendices
Author:Debnam, Deborah; Hall, Bruce; Lovas, Tom; Miller, Tim
Publication:Management Quarterly
Date:Sep 22, 1992
Words:3764
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