Inventory Management Quiz

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.

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.

If safety stock is 50 units, the receipt of an order should increase the inventory to 250. That amount will decline to 50 just prior to the receipt of the next order.

Thus, the average inventory would be the average of 250 and 50 [(250 + 50) ÷ 2], or 150 units

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

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

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.

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.

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

Quantity discounts are not a factor in the EOQ formula.

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.

This statement is least likely to explain an increase in current assets from last July to this July.

If the corporation was a seasonal company with traditionally higher activity in the summer months, it would budget similar amounts for each summer in expectation of the high activity.

The sudden increase in current assets for the following summer would not be explained by the fact that they are a seasonal company.

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.

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.

The reorder point is the inventory level at which an order should be placed.

It can be quantified using the following equation:

Reorder point = (Average weekly demand × Lead time) + Safety stock

                             = [(12,000 units ÷ 50 weeks) × 5 weeks] + 1,500 units

                              = 1,200 units + 1,500 units

                               = 2,700 units

Safety stock cannot protect against the entry of new competitors.

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.

A company maintains safety stocks to protect itself against the losses caused by stockouts.

These can take the form of lost sales or lost production time.

Safety stock is necessary because of the variability in lead time and usage rates.

As the variability in lead time increases, a company will tend to carry larger safety stocks.

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].