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Hi Sir,
May I understand what does cost of finance fit in the calculation of inventory EOQ? I come across a question in the text book, but I don’t understand the solution provided in the book.
Question:
Product’s monthly demand: 10000 units
Purchase price: $10/unit
Company’s cost of finance: 15% pa
Warehouse storage costs per unit pa: $2/unit
order cost per batch: $200Solution:
EOQ = square root (2C0D/Ch) (Sorry, I found the forum doesn’t allow square root symbol)
C0 = $200
D = 120000
Ch = $10 * 15% + $2 [why purchase price should only be multiplied by the cost of finance, but not by (1+15%)? ]
Thank you!The cost of actually buying the units is not relevant because whatever order quantity we choose, the total number of units purchased over the year will stay the same at 10,000 (and so the total cost of buying will stay the same).
However, with different order quantities, the level of average inventory will change. The more the average inventory, the more money will be tied up in inventory and will therefore be costing interest (either because we borrow the money to buy the inventory or because we are using money that could otherwise be earning interest).
The amount of interest it is costing for us to hold one unit in inventory for one year (Ch) is 15% of the purchase price.(If you watch my lecture on Inventory control, you will hear a longer explanation of this)
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Thanks! I am clear now.
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