PLT COLLEGE, INC.
COST ACCOUNTING (W 3-6; F 3-5)
Determination of Optimum Purchase Quantities
Businesses Where Effective Inventory Management is
Critical
Effective inventory management is significant for most
businesses even for those which do not sell any
physical products. The smooth running and
productivity of our business is very much dependent
upon how effectively we manage various inventory
items we use or sell.
Key Decisions for Effective Inventory Management
Key decisions include: what to order, how much to
order, when to order and when to schedule delivery.
Objectives of Effective Inventory Management
Overall speaking, effective inventory management is
aimed at having the right items or products at the right
locations at the right time.
That said, the companies face a dilemma: Holding too
much inventory ties up precious cash (meaning, we
could have invested the cash into other and more
profitable paths but it was “tied up” into the unsold
inventory); Having too little inventory is risky as we may
run out of stock to meet the demands of our
customers, therefore, we incur lost profit.
There are costs linked either way; to carry inventory,
we invite warehousing costs, costs of capital tied up in
inventory, costs of keeping precise records and more.
We also run the risks of obsolescence.
On the other hand, if we do not have enough
inventory, we can have stock-outs, back orders, lost
sales, disturbance to production, extra freight
(delivery/shipping fee) costs and more.
So effective inventory management means striking
the right balance between having too much inventory
and having too little of it, while minimizing the costs to
the business.
The Path to Effective Inventory Management
In order to achieve effective inventory management,
businesses must start by having sound inventory
policies (ex: policies about safety stocks, lot sizing,
record keeping and more). Businesses must also strive
to perfect their forecasts to determine the future
demands for the various inventory items that ae
necessary to run the business.
nikki g // (っ◕‿◕)っ♥
The EOQ/ELS Model
This is a deterministic model (which means it is a model
which incorporates assumptions concerning certainty
of some kind; the assumed values are what the values
most likely be in real-life).
The goal of the Economic Order Quantity (Economic
Lot Size) model is to determine the order-quantity
(production) which will yield the lowest average
inventory cost.
Assumptions of the EOQ Model:
 Demand is not seasonal and is evenly
distributed throughout the time period
 The cost of holding a unit of inventory is
constant within the year
 The cost of ordering/producing a batch
inventory is fixed per order/production
 There is no limit as to the storage
 There are no bulk discounts
Ordering the EOQ (Producing the ELS) yields the lowest
cost of inventory, which means ordering (producing)
a number higher or lower than the EOQ/ELS will entail
more costs for the company.
That being said, EOQ/ELS yields total carrying costs
(TCCs) and total ordering costs (TOCs) which are equal
(ex: At EOQ, total carrying costs amounted to 15,500;
it means that even without further computation, total
ordering costs must also be 15,500).
Other Info:
Annual Demand – it is the customer demand rate of
the item assumed to be known and constant at a rate
D units/year
Safety Stock – it is the extra stock or buffer stock or
minimum stock. This is kept to take care of fluctuations
in demand and lead time. Maintaining more safety
stock reduces the chances of stock-outs. But at the
same time, it increases carrying costs
Reorder Point – it reflects the level of inventory that
triggers the placement of an order for additional units.
In determining the ROP, the following factors must be
at hand:
1. Demand-Quantity of inventory used or sold at
each day (Daily usage)
2. Normal Lead time – the days it takes for an
order to arrive when an order is placed
3. Safety Stock
Maximum Lead Time – an abnormality in the number
of days it takes for an order to arrive (Ex: normally,
goods ordered are received after 10 days (NLT), but
for a few orders, it takes about 15 days for it to arrive
(MLT))
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