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A company currently places 40 orders of inventory per year, ordering 2,000 units each time, but is to change to an ordering system based on the economic order quantity (EOQ) model.
Its ordering costs are $75 per order. Units cost $8 each and the company’s cost of finance is 10% per annum. Other costs of holding inventory amount to $0.70 per unit.
Calculate the quantity that would be ordered using the EOQ model:
1,549 units
2,000 units
2,828 units
4,140 unitsShould we include finance costs when calculating holding costs for EOQ or no?
Regarding the finance costs, the formula for EOQ does not explicitly include finance costs.
However, finance costs can be considered as part of the holding cost per unit if they are CLEARLY related to the cost of holding inventory.
In this case, if the finance costs are CLEARLY & directly related to the inventory holding, they can be included in the calculation of the holding cost per unit.
Only do if clearly identified…….If it says something along the lines that the cost of tying up money in inventory, could have been used to earn interest or could result in interest expenses – say if the company is overdrawn. Why? Including finance costs in the holding costs for a company could provide a more accurate reflection of the total cost of holding inventory.
However, it is important to note that the decision to include finance costs ultimately depends on the specific context and requirements of the question.
Sir, how is (2 x 80,000 x $75) / $0.70)^0.5 = 2828? Isn’t it 4140?
Also, in Dusty co, holding costs did not include finance costs when calculating EOQ
So which approach should we follow in the exam?I just checked the answer and its 2828 and they included the finance costs by taking (purchase price 8 *10%=0.8) therefore total holding costs = $1.5. This question was from the Pre Dec 2021 mock exam.
Now I’m really confused!
So sorry your confused
Well let’s seeAnnual demand (D) = 40 orders x 2,000 units per order = 80,000 units
Ordering cost per order (Co) = $75
Holding cost per unit (Ch) = $0.70 +$ 0.8 ( 10% * 8)
Plugging these values into the formula:
EOQ = ((2 x 80,000 x $75) / ($0.70 + $0.80) EOQ = 2,828 units
So in answer to your question this one did include it!!
This proves that if it’s in the question it means include it!
I am very tired I must apologise
If I have confused youGreat thanks a lot! Just want to know why dusty co excluded finance costs when calculating EOQ…the inconsistency is what is confusing me 🙁
The question asks for the current cost and then eoq
The thing is when you have eoq you are saving on inventoryAnnual holding and ordering costs of the current inventory management system
Each current order is 1,500,000/12 = 125,000 units per order
Average inventory = 125,000/2 = 62,500 units
Current holding cost = 62,500 x 0·21 = $13,125 per year
Current ordering cost = 12 x 252 = $3,024 per year
Current total inventory management cost = $13,125 + $3,024 = $16,149 per yearFinancial effect of adopting EOQ model
EOQ = (2 x 252 x 1,500,000/0·21)0·5 = 60,000 units/order
Number of orders = 1,500,000/60,000 = 25 orders per year
Average inventory = 60,000/2 = 30,000 units
Holding cost = 30,000 x 0·21 = $6,300 per year
Ordering cost = 25 x 252 = $6,300 per year
EOQ total inventory management cost = $6,300 + $6,300 = $12,600 per yearThen you compare the two
Reduction in total inventory management cost = $16,149 – $12,600 = $3,549 per yearSo what does that do for your business?
Reduction in average inventory
So you don’t buy as much inventory= (62,500 – 30,000) x $14 pu
= $455,000The overdraft will decrease by the same amount.
Finance cost saving = 455,000 x 0·03 = $13,650 per year
Overall saving = $3,549 + $13,650 = $17,199
This is like what I was referring to
Do you understandMy advice is don’t worry about it anymore
If in the exam it isn’t clear in a written question
State your assumptions
It will be marked as OFR which means you only loose the marks for that small part move on…….
Everything else is marked Own Figure Rule
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