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Money tied up in Inventory

Forums › Ask ACCA Tutor Forums › Ask the Tutor ACCA FM Exams › Money tied up in Inventory

  • This topic has 5 replies, 2 voices, and was last updated 1 year ago by John Moffat.
Viewing 6 posts - 1 through 6 (of 6 total)
  • Author
    Posts
  • August 27, 2021 at 1:33 pm #633131
    Natasha1996
    Member
    • Topics: 34
    • Replies: 22
    • ☆☆

    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 units

    Cost 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 = $5268.4

    Here 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 = $5301.2

    What is the correct way of doing the arithmetic of money being tied up in inventory in EOQ calculation? Please explain.

    August 27, 2021 at 3:30 pm #633143
    John Moffat
    Keymaster
    • Topics: 56
    • Replies: 51560
    • ☆☆☆☆☆

    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 🙂

    August 27, 2021 at 4:29 pm #633150
    Natasha1996
    Member
    • Topics: 34
    • Replies: 22
    • ☆☆

    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 = $21,824

    I 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?

    August 28, 2021 at 10:16 am #633214
    John Moffat
    Keymaster
    • Topics: 56
    • Replies: 51560
    • ☆☆☆☆☆

    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).

    August 28, 2021 at 10:28 am #633218
    Natasha1996
    Member
    • Topics: 34
    • Replies: 22
    • ☆☆

    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?

    August 28, 2021 at 10:53 am #633232
    John Moffat
    Keymaster
    • Topics: 56
    • Replies: 51560
    • ☆☆☆☆☆

    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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