Entity needs to maintain inventory at appropriate level keeping balance in contrasting factors inventory levels e.g if large amount of inventory is ordered ordering cost is reduced but opportunity cost is much increased , money tied could be used for other profitable investments. So keeping all factors in mind entity needs appropriate models to be used for inventory management to save from irrelevant costs , help profits to boost up
Let’s study different systems showing to manage inventory in best ways. Prominent methods include:
EOQ Formula
EOQ Without Discounts
Example
Acompany utilizes 5000 units per year,
Purchase price of each unit is $2,
Cost of placing order (ordering cost) =$10
Holding cost =10% of unit cost
Find
- EOQ
- Total Co
- Total Ch
SLOUTION
=√2.10.5000/ 10%* 2
707.10
Annual Ordering Cost
D/ EOQ * Co per unit
= 5000/707.10*10
$14.14
Annual Holding Cost
EOQ/2*Ch per unit
=707.10/2* 0.2
=$71
EOQ with dicounts
In case of purchase of large quantities, supplier offers discounts So its necessary to calculate EOQ considering those discounts, so can decision can be regarding acceptance or rejection of those large orders with discounts(keeping in mind high holding costs for large quantities order)
STEPS TO FOLLOW
- Calculate EOQ in normal circumstances(without discounts)
- Calculate total COSTS without discounts on basis of EOQ calculated
- Now calculate total costs on basis of large orders quantities(with discounts)
- In case of more than one offers, calculate costs with each offer and choose the best one
EXAMPLE # 1 ACCA DEC 2010
WQZ Co is considering making the following changes in the area of working capital management
It has been suggested that the order size for Product KN5 should be determined using the economic order quantity model (EOQ).WQZ Co forecasts that demand for Product KN5 will be 160,000 units in the coming year and it has traditionally ordered 10% of annual demand per order. The ordering cost is expected to be $400 per order while the holding costis expected to be $5·12 per unit per year. A buffer inventory of 5,000 units of Product KN5 will be maintained, whether orders are made by the traditional method or using the economic ordering quantity model.
SOLUTION
Cost of the current ordering policy
Order size = 10% of 160,000 = 16,000 units per order
Number of orders per year = 160,000/16,000 = 10 orders per year
Annual ordering cost = 10 x 400 = $4,000 per year
Holding cost ignoring buffer inventory = 5·12 x (16,000/2) = $40,960 per year
Holding cost of buffer inventory = 5·12 x 5,000 = $25,600 per year
Total cost of current policy = 4,000 + 40,960 + 25,600 = $70,560 per year
Cost of the ordering policy using the EOQ model
Order size = (2 x 400 x 160,000/5·12)0·5 = 5,000 units per order
Number of orders per year = 160,000/5,000 = 32 orders per year
Annual ordering cost = 32 x 400 = $12,800 per year
Holding cost ignoring buffer inventory = 5·12 x (5,000/2) = $12,800 per year
Holding cost of buffer inventory = 5·12 x 5,000 = $25,600 per year
Total cost of EOQ policy = 12,800 + 12,800 + 25,600 = $51,200 per year
Change in costs of inventory management by using EOQ model
Decrease in costs = 70,560 – 51,200 = $19,360
EXAMPLE #2 ACCA DEC2012
KXP Co orders 15,000 units per month of Product Z, demand for which is constant. There is only one supplier of Product Z and the cost of Product Z purchases over the last year was $540,000. The supplier has offered a 2% discount for orders of Product Z of 30,000 units or more. Each order costs KXP Co $150 to place and the holding cost is 24 cents per unit per year. KXP Co has an overdraft facility charging interest of 6% per year
Calculate whether the bulk purchase discount offered by the supplier is financially acceptable and comment
on the assumptions made by your calculation.
SOLUTION
Cost of current inventory policy
Cost of materials = $540,000 per year
Annual ordering cost = 12 x 150 = $1,800 per year
Annual holding cost = 0·24 x (15,000/2) = $1,800 per year
Total cost of current inventory policy = 540,000 + 1,800 + 1,800 = $543,600 per year
Cost of inventory policy after bulk purchase discount
Cost of materials after bulk purchase discount = 540,000 x 0·98 = $529,200 per year
Annual demand = 12 x 15,000 = 180,000 units per year
KXP Co will need to increase its order size to 30,000 units to gain the bulk discount
Revised number of orders = 180,000/30,000 = 6 orders per year
Revised ordering cost = 6 x 150 = $900 per year
Revised holding cost = 0·24 x (30,000/2) = $3,600 per year
Revised total cost of inventory policy = 529,200 + 900 + 3,600 = $533,700 per year
Evaluation of offer of bulk purchase discount
Net benefit of taking bulk purchase discount = 543,600 – 533,700 = $9,900 per year
The bulk purchase discount looks to be financially acceptable. However, this evaluation is based on a number of unrealistic assumptions. For example, the ordering cost and the holding cost are assumed to be constant, which is unlikely to be true in reality. Annual demand is assumed to be constant, whereas in practice seasonal and other changes in demand are likely.
| Materials: | ||||
| 1)Re-Order Level: | Maximun Usage * maximum Lead Time | |||
| OR | ||||
| Safety Stock + Lead Time Consumption | ||||
| 2)Minimum Level: | ROL-(Average Usage*Average Lead Time) | |||
| 3)Maximum level: | ROL+ROQ-(Minimum Usage*Minimum Lead Time) | |||
| 4)Average Level: | 1/2(Maximum Level+Minimum Level) | |||
| OR | ||||
| Minimum Level + 1/2 ROQ | ||||
| 5)Danger Level: | Minimum Usage Rate * Minimum Lead Time | |||
| OR | ||||
| Average Usage Rate * Minimum Lead Time | ||||
| OR | ||||
| Minimum Usage Rate * Average Lead Time | ||||
| 6)EOQ/ROQ | Sq Root of √ 2AB/C | |||
| A-Annual consumption | ||||
| B-Buying Cost | ||||
| C-Carrying Cost Per Annum. | ||||
| 7)Associated Cost | (No of Orders*Buying Cost)+(Average Inventory*Carrying Cost) | |||
| 8)Material T/O Ratio | Consumption / Average Stock | |||
| 9)Average Stock | 1/2(Maximum Stock+Minimum Stock) | |||
| 10)Contribution | Sales – Variable Cost | |||
| 11)COGS | Variable Cost + Fixed Cost | |||
| 12)Wilson’s Model | Buying Cost = Carrying Cost = 1/2 of Associated Cost | |||
| 13)Normal Lead Time Consumption | Average Lead Time * Average Consumption | |||
IMPORTANT FORMULAE OF MATERIALS
Re-Order Level:
“Minimum level set by entity at which order is made “
Maximum Usage * maximum Lead Time (IN CASE OF WITHOUT SAFETY STOCK)
OR
Safety Stock + Lead Time Consumption
Normal Lead Time Consumption
“Time lap between placement of order and delivery of order at warehouse by supplier”
Average Lead Time * Average Consumption
Minimum Level:
ROL-(Average Usage*Average Lead Time)
Maximum level:
ROL+ROQ-(Minimum Usage*Minimum Lead Time) (absolute maximum inventory)
ROL+ROQ-(Average Usage*Average lead Time) (Normal maximum inventory)
Average Level:
1/2(Maximum Level+ Minimum Level)
OR
Minimum Level + 1/2 ROQ
Danger Level: Minimum Usage Rate * Minimum Lead Time
OR
Average Usage Rate * Minimum Lead Time
OR
Minimum Usage Rate * Average Lead Time
EOQ/ROQ Square Root of √ 2D.Co/Ch
Material T/O Ratio Consumption / Average Stock
Average Stock 1/2(Maximum Stock+ Minimum Stock)