Inventory Management Quiz

The cost of carrying a unit of inventory can be calculated as follows:

  Invoice price $400

+ Freight and insurance on shipment 20

= Per-unit purchase cost $420

Times: cost of capital × 25%

= Opportunity cost $105

+ Insurance on inventory 15

Per-unit carrying cost = $120

Determining the appropriate level of safety stock involves a complex probabilistic calculation that balances

1. the variability of demand for the good,
2. the variability in lead time, and
3. the level of risk the firm is willing to accept of having to incur stockout costs.

Thus, the only one of the items listed that does not affect the level of safety stock is reorder costs.

Carrying costs are incurred to hold inventory. Examples include such costs as warehousing, insurance, the cost of capital invested in inventories, inventory taxes, and the cost of obsolescence and spoilage.

Shipping costs and the initial cost of the inventory are the purchase costs.

If the corporation makes the special purchase of 6 months of inventory (180,000 cases ÷ 30,000 cases per month),

the average inventory for the 6 month period will be $900,000 [(180,000 × $10) ÷ 2].

If the special purchase is not made, the average inventory for the same period will be the average monthly inventory of $180,000 [(30,000 × $12) ÷ 2].

Accordingly, the incremental average inventory is $720,000 ($900,000 – $180,000),

and the interest cost of the incremental 6 month investment is $32,400 [($720,000 × 9%) ÷ 2].

The lead times does not affect the EOQ; it just means the order should be placed four days earlier.

Inventory costs consist of four categories: purchase costs, order or set-up costs, carrying (holding) costs, and stockout costs.

Carrying costs include storage costs for inventory items plus opportunity cost (i.e., the cost incurred by investing in inventory rather than making an income-earning investment). Examples are insurance, spoilage, interest on invested capital, obsolescence, and warehousing costs.

Inventory carrying costs are incurred to hold inventory. Examples include the costs of storage, insurance, security, inventory taxes, depreciation or rent of warehouse facilities, obsolescence and spoilage, and the opportunity cost of inventory investment.

Inspection costs are not related to the length of time inventory is held. They are costs of taking delivery and are best classified as ordering costs.

A just-in-time (JIT) inventory management system limits the output of each manufacturing operation to the demand of the next operation.

Shipment of raw materials from vendors are scheduled to arrive “just in time” to be used in the production process.

Inventory storage is considered a nonvalue adding activity, and raw materials on hand are thus kept to a minimum.

Safety stock cannot protect against the entry of new competitors.

A manufacturer can use the EOQ model by substituting production set-up costs for ordering costs. Set-up costs are the manufacturer’s equivalent of ordering costs. The result is sometimes referred to as the economic batch quantity.

Carrying costs include storage costs, handling costs, insurance costs,interest on capital invested, and obsolescence.

Quantity discounts are not a factor in the EOQ formula.

A firm’s economic order quantity is a function of demand, carrying costs, and ordering costs. A decrease in carrying costs permits a company to carry more inventory at the same cost and thereby reduce stockout costs.

Fixed cost per order is in the numerator of the EOQ fraction. An increase results in an increase in the EOQ.

Relaxing the credit policy for customers will lead to increased sales because more people will be eligible for more credit.

As sales increase, purchase orders will increase to accommodate the higher sales levels.

The optimal level of inventory is affected by the factors in the economic order quantity (EOQ) model and delivery or production lead times. These factors are the annual demand for inventory, the carrying cost, which includes the interest on funds invested in inventory, the usage rate, and the cost of placing an order or making a production run. The current level of inventory has nothing to do with the optimal inventory level.

One of the underlying assumptions of the EOQ model is that delivery times are predictably consistent.

Other assumptions are that sales are perfectly predictable and that usage is constant.

The basic EOQ model assumes that the same fixed quantity is ordered at each reorder point, purchasing costs are unaffected by the quantity ordered, purchase order lead-time is known with certainty, and adequate inventory is always maintained to avoid stockouts.