Inventory Management Quiz

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

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

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

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

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

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

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

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

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

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

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

The EOQ model is a deterministic model that calculates the ideal order (orproduction lot) quantity given specified demand, ordering or setup costs,and carrying costs.

The model minimizes the sum of inventory carryingcosts and either ordering or production setup costs.

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

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

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

Inventory storage is considereda nonvalue adding activity, and raw materials on hand are thus kept to aminimum.

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

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

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

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

If the corporation was a seasonal company withtraditionally higher activity in the summer months, it would budget similaramounts for each summer in expectation of the high activity.

The suddenincrease in current assets for the following summer would not be explainedby the fact that they are a seasonal company.

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

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

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

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

The cost of shipping inventory is a cost of acquiring, not carrying, it.

The company’s per-gallon carrying cost is $2.40 ($12 purchase price pergallon × 20% carrying cost).

The cost of carrying safety stock is $5,760(2,400 gallons × $2.40),

and the cost of carrying average inventory is$2,400 (1,000 gallons × $2.40).

Thus, total inventory carrying cost is$8,160 ($5,760 + $2,400).

Inventory carrying costs are incurred to hold inventory. Examples includethe costs of storage, insurance, security, inventory taxes, depreciation orrent of warehouse facilities, obsolescence and spoilage, and the opportunitycost of inventory investment.

Inspection costs are not related to the lengthof time inventory is held. They are costs of taking delivery and are bestclassified as ordering costs.