Page 195 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes 4. Expressions for the ordering cost and the holding cost as a function of the order quantity
are required
5. The average inventory level with constant demand and instantaneous replenishment will
be one-half the order quantity
6. The holding cost is assumed to be directly proportional to the average inventory level
7. The ordering cost is assumed to be constant for each order

8. The demand rate is level and constant from one time period to the next
9. The number of orders per year will be the annual demand divided by the order quantity.

Annual Usage

Expressed in units, this is generally the easiest part of the equation. You simply input your
forecasted annual usage.

Order Cost

Also known as purchase cost or set up cost, this is the sum of the fixed costs that are incurred each
time an item is ordered. These costs are not associated with the quantity ordered but primarily
with physical activities required to process the order.

For purchased items, these would include the cost to enter the purchase order and/or requisition,
any approval steps, the cost to process the receipt, incoming inspection, invoice processing and
vendor payment, and in some cases a portion of the inbound freight may also be included in
order cost. It is important to understand that these are costs associated with the frequency of the
orders and not the quantities ordered. For example, in your receiving department the time spent
checking in the receipt, entering the receipt, and doing any other related paperwork would be
included, while the time spent repacking materials, unloading trucks, and delivery to other
departments would likely not be included. If you have inbound quality inspection where you
inspect a percentage of the quantity received you would include the time to get the specs and
process the paperwork and not include time spent actually inspecting, however if you inspect a
fixed quantity per receipt you would then include the entire time including inspecting, repacking,
etc. In the purchasing department you would include all time associated with creating the
purchase order, approval steps, contacting the vendor, expediting, and reviewing order reports,
you would not include time spent reviewing forecasts, sourcing, getting quotes (unless you get
quotes each time you order), and setting up new items. All time spent dealing with vendor
invoices would be included in order cost.

Carrying Cost

Also called Holding cost, carrying cost is the cost associated with having inventory on hand. It
is primarily made up of the costs associated with the inventory investment and storage cost. For
the purpose of the EOQ calculation, if the cost does not change based upon the quantity of
inventory on hand it should not be included in carrying cost. In the EOQ formula, carrying cost
is represented as the annual cost per average on hand inventory unit. Below are the primary
components of carrying cost.
Interest: If you had to borrow money to pay for your inventory, the interest rate would be part
of the carrying cost. If you did not borrow on the inventory, but have loans on other capital
items, you can use the interest rate on those loans since a reduction in inventory would free up
money that could be used to pay these loans. If by some miracle you are debt free you would
need to determine how much you could make if the money was invested.

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