Page 197 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes By substituting the variable just defined into above equation, the following expression is obtained:
Total costs = (Number of orders per year × Cost per order) + (Average inventory × Annual
carrying cost per unit)

Or, in algebraic terms,
Total cost = (D/Q × S) + (Q/2 × C)
The EOQ is the value of Q that minimizes the total costs given in equation. The standard procedure
for finding this value of Q involves calculus. The optimal solution, or EOQ, is equal to the
following:

Q* = 2 SD/c
Another item of information that sometimes is useful for planning purposes is the optimal
length of one inventory cycle; that is, the time between placements of orders for the item. The
optimal length of one inventory cycle, T*, measured in days, is equal to the economic order
quantity, Q*, divided by the average daily demand, D/365 (assuming 365 days per year), as
follows
T* = Q*/D/365
This equation can be rewritten as follows:
T* = 365 × Q*/D

Example: Let us work out an example to understand the EOQ Model and on fixed order
quantity policies:
A company, ABC Ltd., for one of its class 'A' items, placed 8 orders each for a lot of 150 numbers,
in a year. Given that the ordering cost is ` 5,400.00, the inventory holding cost is 40 percent, and
the cost per unit is ` 40.00. Find out if the company is making a loss in not using the EOQ Model
for order quantity policies.

What are your recommendations for ordering the item in the future? And what should be the
reorder level, if the lead time to deliver the item is 6 months?
'D' = Annual demand = 8 × 150 = 1200 units

'P' = Unit purchase cost = ` 40.00
'S' = Ordering Cost = ` 5400.00
'F' = Holding Cost = 40%

Using the Economic Order Equation:
Q* = (2DS/H) = 2DS/FP = EOQ

= (2 * 5400 *1200)/(0.40 * 40)

Minimum Total Annual Cost: TVC (Q*) = FPQ*

= 900 × 0.40 × 40
= ` 14,400.00
The Total Annual Cost under the present system = TVC (Q) = DS/Q + HQ/2
= ` (1200 × 5400/150 + 0.40 × 40 × 150/2)

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