Page 196 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Unit 12: Inventory Management

Insurance: Since insurance costs are directly related to the total value of the inventory, you Notes
would include this as part of carrying cost.
Taxes: If you are required to pay any taxes on the value of your inventory they would also be
included.

Storage Costs

Mistakes in calculating storage costs are common in EOQ implementations. Generally companies
take all costs associated with the warehouse and divide it by the average inventory to determine
a storage cost percentage for the EOQ calculation. This tends to include costs that are not directly
affected by the inventory levels and does not compensate for storage characteristics. Carrying
costs for the purpose of the EOQ calculation should only include costs that are variable based
upon inventory levels.

The assumption of the EOQ model yields the saw-toothed inventory pattern shown in Figure 12.1.
The vertical line at the 0, T , T , and T points in time represent the instantaneous replenishment of
1 2 3
the amount of the order quantity, Q, and the negatively sloped lines between the replenishment
points represent the use of the item. Because the inventory level varies between 0 and the order
quantity, average inventory is equal to one-half of the order quantity, or Q/2.
Figure 12.1: Certainty Case of the Inventory Cycle

Avg. inventory = Q/2

T 1 T 2 T 3

Time
This model assumes that the costs of placing and receiving an order are the same for each order
and independent of the number of units ordered. It also assumes that the annual cost of carrying
1 unit of the item in inventory is constant regardless of the inventory level. Total annual inventory
cost, then, are the sum of ordering costs and carrying costs. The primary objective of the EOQ
model is to find the order quantity Q that minimizes total annual inventory cost.

Algebraic Solution: In developing the algebraic form of the EOQ model, the following variables
are defined
Q = The order quantity, in units

D = The annual demand for the item, in units
S = The Cost of placing and receiving an order, or set-up cost
C = The annual cost of carrying 1 unit of the item in inventory
Ordering costs are equal to the number of orders per year which is equal to annual demand, D,
divided by order quantity, Q. Carrying costs are equal to average inventory, Q/2, multiplied by
the annual carrying cost per unit, C.

The total annual cost equation is as follows:
Total cost = Ordering cost + Carrying cost

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