DECISION MAKING FOR INVENTORY MANAGEMENT

The discussion of absorption and variable costing makes it clear that inventory can affect
operating income. In addition to the product cost of inventory, there are other types of costs
that relate to inventories of raw materials, work in process and finished goods. For example,
inventory must be bought, received, stored and moved/transferred.

Inventory-Related Costs

When the demand for a product or material is known with near certainty for a given period of
time (usually a year), two major costs are associated with inventory. If the inventory is a
material or good purchased from an outside source, then these inventory-related costs are
known as ordering costs and carrying costs. If the material or good is produced internally, then
the costs are called set-up costs and carrying costs.

1. Ordering costs are the costs of placing and receiving an order. Examples include order
processing costs (clerical costs and documents), the cost of insurance for shipment, and
unloading and receiving costs.

2. Carrying costs are the costs of keeping and storing inventory. Examples include insurance,
inventory taxes, obsolescence, the opportunity cost of funds tied up in inventory, handling
costs and storage space.

If the demand is not known with certainty, then stockout costs exists.

3. Stockout costs are the costs of not having a produce available when demanded by a
customer or the cost of not having a raw material available when needed for production.
Examples are lost sales (both current and future), the costs of expediting (increase
transportation charges, overtime and so on) and the costs of interrupted production (e.g.,
idle workers).

It is important to realize that the purchase price of raw materials is not a part of the total cost
associated with carrying inventory. That price must be paid anyway. Similarly, the product cost
of units produced is not an inventory-related cost.

Traditional Reason for Carrying Inventory

a. To balance ordering or set-up costs and carrying costs.
b. To satisfy customer demand.
c. To avoid shutting down manufacturing facilities because of
 Machine failure
 Defective parts
 Unavailable parts
 Late delivery of parts
d. To buffer against unreliable production processes.
e. To take advantage of discounts.
f. To hedge against future price increases.

Economic Order Quantity: The Traditional Inventory Model

Once a company decides to carry inventory, two basic questions must be addressed:
1. How much should be ordered?
2. When should the order be placed?

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The first question must be answered before the second. Assume that demand is known. In
choosing an order quantity, managers need to be concerned only with ordering and carrying
costs. The formulas for calculating these are as follows:

Total Inventory-Related Cost = Ordering Cost + Carrying Cost

Ordering Cost = Number of Orders per Year x Cost of Placing an Order

Average Number of Units in Inventory = Units in Order / 2

Carrying Cost = Average Number of Units in Inventory x Cost of Carrying One Unit in Inventory

Illustration A: The X Company sells number of automobile brands and proves services after the
sale for those brands from its shop in Davao. Part AG1 is used to repair water pumps. Each year,
10,000 units of Part AG1 are used; they are currently purchased from external suppliers in lots
of 1,000 units. It costs the Part AG1 P25 to place an order, and carrying cost is P2 per part per
year.

Questions:
1. How many orders are placed each year for Part AG1?
2. What is the total ordering cost per year?
3. What is the total carrying cost per year?
4. What is the cost of X Company’s inventory policy for Part AG1 per year?

The Economic Order Quantity

The total cost of the Part AG1 based on the current policy is P1,250. An order quantity of 1,000
with a total cost of P1,250, however, may not be the best choice. Some other order quantity
may produce a lower total cost. The objective is to find the order quantity that minimize the
total cost. The number of units in the optimal size order quantity is called the economic order
quantity (EQO). Since EOQ is the quantity that minimizes total inventory-related costs, a formula
for computing it is as follows:
EQO= √
2 x CO x D
CC

CO – Cost of Placing one order

CC – Cost of Carrying one unit in inventory for a year
D – Annual Demand for the items in units

Illustration: Refer to the data in the previous example.

1. What is the EOQ for Part AG1?

2. How many orders per year for Part AG1 will be placed under the EOQ policy?
3. What is the total annual ordering cost for a year under the EOQ policy?
4. What is the total annual carrying cost for a year under the EOQ policy?
5. What is the total annual inventory-related cost under the EOQ policy?

Reorder Point

The EOQ answer the question of how much to order (or produce). Knowing when to place an
order (or set-up for production) is also an essential part of any inventory policy. The reorder
point is the point in time when a new order should be placed (or set up started). It is a function
of the EOQ, the lead time and the rate at which inventory is used. Lead time is the time
required to receive the economic order quantity once an order is placed or a set-up is started.
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To avoid stockout costs and to minimize carrying costs, an order should be placed so that it
arrives just as the last item in inventory is used. Knowing the rate of usage and lead time allows
us to compute the reorder point that accomplishes these objectives:

Reorder Point = Rate of Usage X Lead Time

Illustration B: X Company sells a number of automobile brands and provides service after the
sale for those brands. Part AG1 is used to repair water pumps. Each year, 10,000 units of Part
AG1 are used; they are used at the rate of 40 parts per day. It is five days from the time of order
to the time of the arrival of the order.

Question: Calculate the reorder point.

Safety Stock

If the demand for the part or produce is not known with certainty, a stockout may occur. For
example, if 45 units of the parts were used per day instead of 40, the firm would use 200 parts
after nearly four and a half days. Since the new order would not arrive until the end of the fifth
day, production would be idle for half a day. To avoid this problem, organization often choose to
carry safety stock. Safety stock is extra inventory carried to serve as insurance against changes
in demand. The formula is:

Safety Stock = [Maximum Daily Usage – Average Daily Usage] x Lead Time

Illustration C: Assume data in Illustration B. However, some days, as many as 50 parts are used.
It is five days from the time of order to the time of the arrival of the order.

Question:
1. Calculate the amount of safety stock.
2. Calculate the reorder point with safety stock.

The EOQ model is very useful in identifying the optimal trade-off between inventory ordering
costs and carrying costs. It is also useful in helping to deal with uncertainty by using safety stock.

Exercises:

1. Which one of the following would not be considered a carrying cost associated with
inventory?
a. out-bound shipping costs.
b. insurance costs.
c. storage costs.
d. cost of capital invested in the inventory.

2. When the Economic Order Quantity (EOQ) model is used for a firm that manufactures its
inventory, ordering costs consist primarily of:
a. production set-up.
b. cost of funds.
c. insurance and taxes.
d. storage and handling.

3. Paint Corporation expects to use 48,000 gallons of paint per year costing P12 per gallon.
Inventory carrying cost is equal to 20% of the purchase price. The company uses its inventory

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 at a constant rate. The lead time for placing the order is 3 days, and Paint Corporation holds
2,400 gallons of paint as safety stock. If the company orders 2,000 gallons of paint per order,
what is the cost of carrying inventory?
a. P5,760.
b. P5,280.
c. P8,160.
d. P2,400.

4. Which one of the following is not explicitly considered in the standard calculation of
Economic Order Quantity (EOQ)?
a. Fixed ordering costs.
b. Carrying costs.
c. Level of sales.
d. Quantity discounts.

5. Valley Inc. uses 400 pounds of a rare isotope per year. The isotope costs P500 per pound, but
the supplier is offering a quantity discount of 2% for order sizes between 30 and 79 pounds,
and a 6% discount for order sizes of 80 pounds or more. The ordering costs are P200.
Carrying costs are P100 per pound of material and are not affected by the discounts. If the
purchasing manager places eight orders of 50 pounds each, the total cost of ordering and
carrying inventory, including discounts lost, will be:
a. P12,100.
b. P4,100.
c. P1,600.
d. P6,600.

6. Ferndale Distributors is reviewing its inventory policy with respect to safety stocks of its most
popular product. Four safety stock levels were analyzed and annual stockout costs estimated
for each level.

The cost of this product is $20 per unit, holding costs are 4% per year, and the cost of short-
term funds is 10% per year. What is the optimal safety stock level?
a. 1,000 units.
b. 2,000 units.
c. 1,500 units.
d. 1,250 units.