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Is it correct that we have to deduct interest cost from Holding cost?
If yes, then why do we have to account for interest cost into holding cost?
I know that to hold inventory for long period will cost the company because company has to pay rent for warehouse for holding inventory etc BUT do we have to pay interest for holding any inventory?
Secondly, There is a past exam Dusty Co (Sep/Dec 2019) where i am unable to calculate the overdraft calculation & its impact on overall cost saving.
I have done everything else EoQ calculation correctly such as below but stuck at the Finance cost calculation under all 3 policies of inventory management.
Total cost under Current Policy = $16149
Total cost under EOQ = $12600
Total cost under Bulk discount = $27762Please help me with these issues. Thanks 🙂
We do not deduct interest from the holding cost.
Although the examiners answer just has the holding cost of $0.21, he makes it clear in a note to his answer that you would also have got full marks by adding on the interest cost (though obviously the figures would have been different).
As far as your second question is concerned, then as the average inventory increases or decreases then so to the overdraft will increase or decrease to finance it (just as we are always doing in questions on the management of receivables). Given that the interest rate is 3% it will mean more or less interest payable on the overdrawn amount.
Since there is a reduction in average inventory from (62500 units to 30,000 units under EOQ model) then there will a saving of interest on overdraft.
reduction in average inventory = (62,500 – 30,000) x $14 = 455,000
saving of interest on overdraft = 455,000 x 3% = $13,650If there weren’t the reduction in average inventory then we would be paying interest on total inventory such as
Average Inventory = 62,500 x $14 = 875,000
Interest on overdraft = 875,000 x 3% = $26,250BUT you did not clear that why do the interest increases as the average inventory increases or vice versa (what is the reason?)
If the average inventory increases then the finance for the increase will come from the overdraft and therefore there will be more. interest payable on the overdraft (and vice versa if the average inventory decreases).
Have you watched all my free lectures on the management of working capital?
Did I calculate the interest on overdraft correctly in my previous response? Let me copy here again then you please comment whether I calculate correctly!
Since there is a reduction in average inventory from (62,500 units to 30,000 units under EOQ model) then there will a saving of interest on overdraft.
reduction in average inventory = (62,500 – 30,000) x $14 = 455,000
saving of interest on overdraft = 455,000 x 3% = $13,650Overall saving = $3,549 + $13,650 = $17,199
__________________________________________________________If there weren’t the reduction in average inventory then we would be paying interest on total inventory such as
Average Inventory = 62,500 x $14 = 875,000
Interest on overdraft = 875,000 x 3% = $26,250________________________________________________________
Increase in Average inventory from (62,500 units to 125,000 units under Bulk Order Discount scenario) then there will be an increased cost of interest on overdraft.
(125,000 x 13·93) – (62,500 x 14) = $866,250
Increase cost of interest on overdraft = 866,250 x 3% = $25,988Overall saving = $105,000 – $11,613 – $25,988 = $67,399
________________________________________________________I do not understand why you have asked this because you can see from the examiners answer that your answer is correct 🙂
I want to know here in dusty co finance cost has been increased due to increase in the value of the average inventory .
But as I have been doing other questions they have not mention or done calculations regarding finance cost increase due to the increase in average inventory.I am getting confused whether to take effect of increased finance cost or not as some solutions has taken the effect and some do not.
The question asks you to “calculate the financial effect of EOQ & Bulk order discount” in part (ii) & (iii)
It also says at the end that they have no cash but access to S-T finance is available via an O/D at 3% pa and the current O/D is 550k………So it wants to know if it inc or dec it’s inventory then it’s impact financially – O/DOther questions say
To evaluate whether they should adopt EOQ
Calculate the cost of the current ordering policy and determine what kind of saving is made with EOQ
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