Page 247 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 11: Inventory Management

A third approach is to calculate the optimum order size mathematically using a method called Notes
the Economic Order Quantity (EOQ) model, which yields the optimum order quantity with a
single set of calculations. The model is:
2
EOQ =

Where, A = Annual usage units
S = Ordering cost per order
C = Inventory carrying cost per unit per annum

Notes The EOQ model rests on the several important assumptions:
1. There is a known constant demand.

2. Ordering costs are known and remain constant.
3. Carrying costs are known and remain constant.
4. Production and inventory capacity is unlimited.

Example: SWT Company, which is open Monday through Friday except for a 2-week
vacation period and 10 holidays. The firm operates a total of 240 business days a year. Below is
given the demand and cost data for its most expensive steel belted radial tyre.
Avg. daily demand 50; Selling price 95/tyre
Cost 60/tyre; Ordering cost 500/order

Carrying cost 20 per cent of unit cost
A = 50 tyres a day × 240 business days = 12000
S = Cost of ordering is 500 per order,
C = 20% × 60 i.e., 12 per unit

2 1200 500


Hence EOQ =
60 × 0.2
1000,000 = 1000 tyres
Hence, Economic Ordering Size is 1000 tyres

A 12000 units
Number of order =  12 orders
EOQ 1000 units/order
A 12000 × 500 per oder
Ordering Cost =  S =  6000
EOQ 1000 units per order

Carrying cost is function of average amount of inventory on hand multiplied by the carrying
cost rate. The average inventory on hand is the order size divided by 2.

EOQ 1000 units
Average inventory = =  500 units
2 2

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