Average Investment in Inventory

Hello Sir,

This question was asking the average investment in inventory of chemical X
does it mean that we have to calculate the average inventory as when we calculate the average inventory for the annual holding cost .

Secondly ,in a broader expression what does the investment in working capital mean?

Thanks

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Q

(a) In relation to Purdy Co’s potential change of supplier:

(i) Calculate the total annual costs relating to Chemical X for both the current and potential suppliers;                

(7 marks)

(ii) Calculate the value of the average investment in Chemical X inventory for both the current and potential suppliers; and

(2 marks)

(iii) Recommend, with justification, whether Purdy Co should change its supplier.

This scenario relates to five requirements.

Purdy Co uses 5 million litres of chemical X per year in its plastic manufacturing business. Chemical X costs Purdy Co $2.50 per litre per year to store and each order requires a quality check that costs Purdy Co $400 per order to perform.

Purdy Co currently purchases chemical X from a local supplier at a cost of $3.00 per litre. It uses the economic order quantity (EOQ) model to determine order size and carries a safety inventory of five days’ usage to protect against variations in lead time demand.

Purdy Co has recently been approached by a company offering to supply chemical X at a cost of $2.25 per litre, if it will order in quantities of 1 million litres. The new supplier’s credit terms are the same as the current supplier. Purdy Co estimates that its storage cost per litre and its quality check cost per order will be unchanged if it accepts this offer and that it will have sufficient storage space to cope with larger orders. However, it will need to increase its safety inventory to 15 days’ usage if it accepts the new supplier’s offer.

Purdy Co is under pressure from its bank to reduce its overdraft and its finance director is interested in the effect of the new supplier’s offer on chemical X costs, working capital investment and the cash operating cycle.

Purdy Co operates for 365 days per year.