Page 176 - DMGT409Basic Financial Management

Unit 10: Inventory Management

Inventory holding cost is based on average inventory. Notes

Ordering costs are constant.

All demands for the product will be satisfied (no back orders are allowed).
EOQ Formula

EOQ can be obtained by adopting two methods (a) Trial and Error approach and (b) Short cut
or Simple mathematical formula. Here for calculation of EOQ we have adopted simple short cut
method. The formula is
2 AO
EOQ =
CC
Where: A = Annual usage,

O = Ordering cost per order
CC = Carrying cost per unit
CC = Price per unit x Carrying cost per unit in percentage

The above simple formula will not be sufficient to determine EOQ when more complex cost
equations are involved.
!

Caution EOQ is applicable both to single items and to any group of stock items with
similar holding and ordering costs. Its use causes the sum of the two costs to be lower than
under any other system of replenishment.

Example: A company purchases a component of a product at the rate of ` 50 per piece.
The annual consumption of that component is 25,000 pieces. If the ordering cost is `230 per order
and carrying cost is 20 per cent per annum, what would be the EOQ?
Solution: Annual usage – 25,000 units; Cost of placing and receiving one order – ` 230;

Cost of materials – ` 50 per unit; Annual carrying cost of one unit – 20 per cent of inventory
value

Example: XYZ Company buys 75,000 glass bottles per year. Price of each bottle is `0.90.
Cost of purchase is ` 100 per order; Cost of holding one bottle per year is ` 0.20. Bank interest is
15 per cent including a charge for taxes and insurance. Find out EOQ quantity.
Solution: Annual usage – 75,000 units; Cost of placing and receiving one order – ` 100
Cost of bottle – ` 0.90 per bottle; Annual carrying cost of one bottle – `0.20 per bottle

* Inventory carrying cost = ` 0.20 + [Re.0.90 x 0.15] = `0.335

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