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Sir, I did not take the paper f2 and so the EOQ calculation is new to me.
Could you please tell me about the cost of money being tied up in inventory and how do we calculate it and if it was given in the exam question which will be added to holding cost calculation in EOQ?
[Question]
Purchase Price = $10; Annual Demand = 10,000; Reorder cost = $6; Holding cost = $0.6; Cost of Capital = 10%[Answer]
EOQ = sqrt (2 x 10,000 x $6) / 0.60 = 448 unitsCost of Reorder (10,000 / 448) x $6 = $134
Cost of Holding (448 / 2) x $0.6 + (10,000 / 2) x ($10 x 10%) = 3134.4
Total cost = $5268.4Here we have put the cost of interest lost on inventory tied in the Cost of Holding calculation.
BUT below is the way where we have put the cost of interest in EOQ calculation. So which one is the correct way?EOQ = sqrt (2 x 10,000 x $6) / 0.60 + ($10 x 10%) = 274 units
Cost of Reorder (10,000 / 274) x $6 = $219
Cost of Holding (274 / 2) x $0.6 + (10,000 / 2) x ($10 x 10%) = $6417
Total cost = $5301.2What is the correct way of doing the arithmetic of money being tied up in inventory in EOQ calculation? Please explain.
It is the second way.
The holding cost per unit is the interest tied up in inventory (here 10% x $10) plus any other holding costs (here $0.60).
However you calculation of the holding cost per year is wrong. The average inventory is 274/2, and the holding cost per unit is (10% x $10) + 0.6 = $1.60. So the annual holding cost is 274/2 x $1.60 = $219.
(You should have known that you were wrong, because at the EOQ the annual order cost is equal always to the annual holding cost!).
You may not have taken Paper MA, but I explain this in my free Paper FM lectures 🙂
Thank you for your answer. It was great stress to me and yes I watched your lecture
I am attempting a past exam question Dusty Co from Sept-Dec 2019 where we are told to calculate EOQ but, the examiner hasn’t included the interest cost of 3% in the EOQ calculation and I wonder why!?
This is how I calculated, can you please just correct me here too?
EOQ = sqrt (2 x 1500,000 x $252) / 0.21 + ($14 x 3%) = 34,641 units
Cost of Reorder (1500,000 / 34,641) x $252 = $10,912
Cost of Holding (34,641 / 2) x ($0.21 + $0.42) = $10,912
EOQ total inventory management cost = $21,824I know that there might be a difference between my answer and the examiner’s because of the finance cost saving on a reduced overdraft in his answer but the calculation of mine above is all good. correct?
Secondly, I wanna ask you that Finance cost (i.e. cost of interest) will be added to both the EOQ formula calculation & in the calculation of Cost of Holding (just like the above); It is up to US whether we should use finance cost in the calculation or not (just like the examiner doesn’t take finance cost in any of the calculation in his answer) if we don’t take finance cost then we don’t take them in either of the EOQ formula or Cost of Holding calculation. True?
The examiner should have included the financing cost in the holding cost (and notes in his answer that doing this would have got the full marks).
Therefore, my answer in the previous post is correct?
And I asked you this too!
I wanna ask you that Finance cost (i.e. cost of interest) will be added to both the EOQ formula calculation & in the calculation of Cost of Holding (just like the above); It is up to US whether we should use finance cost in the calculation or not (just like the examiner doesn’t take finance cost in any of the calculation in his answer) if we don’t take finance cost then we don’t take them in either of the EOQ formula or Cost of Holding calculation. Correct?
Secondly, the examiner hasn’t included the finance cost in the total inventory cost of $16,149 under current policy whereas I think that he should have been done so, what do you say? That would get the full marks too?
The answer in your first post is not correct for the reason I explained in my reply.
The answer in your second post is correct. It is not “up to us” what we do – the finance cost should be included and normally is included in the examiners answers. He forgot to include it in the answer to this question by mistake, which is why the note is added.
When the finance cost is included in the EOQ calculation (as it should be) then obviously it should be included in the calculation on the total holding cost.
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