College of the Immaculate Conception

INSTITUTE OF HIGHER STUDIES

Department of Management, Accountancy, Technology, and Entrepreneurial Studies

MS 1806: INVENTORY MODEL

INVENTORY COSTS1

There are three basic costs associated with inventory: carrying (or holding) costs, ordering costs, and
shortage costs.
CARRYING COSTS
Carrying costs are the costs of holding items in storage. These vary with the level of inventory and
occasionally with the length of time an item is held; that is, the greater the level of inventory over time, the higher
the carrying cost(s). Carrying costs can include the cost of losing the use of funds tied up in inventory; direct storage
costs, such as rent, heating, cooling, lighting, security, refrigeration, record keeping, and logistics; interest on loans
used to purchase inventory; depreciation; obsolescence as markets for products in inventory diminish; product
deterioration and spoilage; breakage; taxes; and pilferage. Carrying costs are normally specified in one of two ways.
The most general form is to assign total carrying costs, determined by summing all the individual costs mentioned
previously, on a per-unit basis per time period, such as a month or a year. In this form, carrying costs would
commonly be expressed as a per-unit peso amount on an annual basis (for example, P10 per year). Alternatively,
carrying costs are sometimes expressed as a percentage of the value of an item or as a percentage of average
inventory value. It is generally estimated that carrying costs range from 10% to 40% of the value of a manufactured
item.

ORDERING COSTS
Ordering costs are the costs associated with replenishing the stock of inventory being held. These are
normally expressed as a peso amount per order and are independent of the order size. Thus, ordering costs vary
with the number of orders made (i.e., as the number of orders increases, the ordering cost increases). Costs incurred
each time an order is made can include requisition costs, purchase orders, transportation and shipping, receiving,
inspection, handling and placing in storage, and accounting and auditing.
Ordering costs generally react inversely to carrying costs. As the size of orders increases, fewer orders are
required, thus reducing annual ordering costs. However, ordering larger amounts results in higher inventory levels
and higher carrying costs. In general, as the order size increases, annual ordering costs decrease and annual carrying
costs increase.

SHORTAGE COSTS
Shortage costs, also referred to as stock-out costs, occur when customer demand cannot be met because
of insufficient inventory on hand. If these shortages result in a permanent loss of sales for items demanded but not
provided, shortage costs include the loss of profits. Shortages can also cause customer dissatisfaction and a loss of
goodwill that can result in a permanent loss of customers and future sales. In some instances the inability to meet
customer demand or lateness in meeting demand results in specified penalties in the form of price discounts or
rebates. When demand is internal, a shortage can cause work stoppages in the production process and create delays,
resulting in downtime costs and the cost of lost production (including indirect and direct production costs).
Costs resulting from immediate or future lost sales because demand could not be met are more difficult to
determine than carrying or ordering costs. As a result, shortage costs are frequently subjective estimates and many
times no more than educated guesses.
Shortages occur because it is costly to carry inventory in stock. As a result, shortage costs have an inverse
relationship to carrying costs; as the amount of inventory on hand increases, the carrying cost increases, while
shortage costs decrease.

INVENTORY MANAGEMENT
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Managers have long recognized that good inventory control is crucial. Basically, managers attempt to solve
the dual problems of maintaining sufficient inventory to meet demand for goods and at the same time incurring the
lowest inventory holding cost by making the best possible decisions with respect to the following:
1. How much should be ordered when the inventory for a given item is replenished? (the proper quantity
of inventory to order)
2. When should the inventory for a given item be replenished? (the proper time to order the quantity)

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Traditional inventory management techniques are based on old production processes that include purchase
of materials, receipt of materials, materials warehousing, materials issuances to production, materials pre-production
inspection, conversion processes, quality inspection of units produced, finished goods warehousing, pre-shipment
inspection and delivery to customers.

1
Taylor, Bernard W. III (2013). Introduction to Management Science. USA: Pearson Education, Inc.
2
Arao, R.R., et al.(2009). Quantitative Approaches in Decision Making. Sampaloc, Manila: Rex Book Store
3
Agamata, Franklin T. (2014). Management Services: a Comprehensive Guide. Davao City: CERTS Publications
MANAGEMENT SCIENCE page 2

Traditional inventory management focuses on warehousing functions. Materials are purchased and
warehoused. Finished goods are warehoused as well. In this context, traditional inventory models were developed.
 The reorder point method establishes the level of inventory on hand when an order is made.
 The order cycling method or cycle review method established schedules of periodic or regular
review of quantities of inventories on hand to determine the number of units to be ordered and bring
the stock balance at a desired level. The review cycle time (e.g. 15 days, 30-60-90 days, etc.) varies
among companies depending on the types of materials. High value, critical items normally require a
short review cycle. For low value, noncritical items, the usual review cycle time is longer because the
stock-out cost is minimal and procurements are done in large quantities.
 The min-max method sets definable limits in inventory balances. Here the minimum inventory level
serves as the reorder point. It includes the normal quantity to be used from the time an order is placed
up to the time the materials are received (i.e. lead time). The safety stock quantity to minimize the
occurrence of stock-out is also included. The maximum inventory level is the sum of stock out quantity
and the order size.
 One of the practical techniques of min-max method is the two-bin system. Materials are stored in
bins, piles, bundles or specific stocking area. Two bins are used: one contains the quantities to be used
from the date the materials are received up to the time an order is to be placed and the other bin
contains the quantities to be used during the waiting time (lead time) and the safety stock. Once the
first bin is consumed, an order for two (2) bins is automatically placed.

ECONOMIC ORDER QUANTITY MODEL

The most widely used and traditional means for determining how much to order in a continuous system is
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the economic order quantity (EOQ) model, also referred to as the economic lot size model. The function of the EOQ
model is to determine the optimal order size that minimizes total inventory costs. There are several variations of the
EOQ model, depending on the assumptions made about the inventory system.
The model formula is derived under a set of simplifying and restrictive assumptions, as follows:
 Demand is known with certainty and is relatively constant over time.
 No shortages are allowed.
 Lead time for the receipt of orders is constant.
 The order quantity is received all at once.

Methods of Computing Economic Order Quantity5

1. TABULAR METHOD. Under this method, several purchase order quantity alternatives are listed in separate
columns. Total inventory costs, showing both carrying and ordering costs are calculated for each alternative.
The column with the lowest total amount of inventory cost will be the economic order quantity.

Example: Assume that a company has annual inventory demand of 10,000 units with ordering cost of
P10.00 per order and carrying cost of P0.80 per unit

The economic order quantity can be determined by constructing a table as shown below:

(A) (B)=(10,000/A) (C)=(B x P10) (D)=(A/2) (E)=(D x P0.80) (F)=(C+E)

Total
Order Number of Total Ordering Average
Total Carrying Cost Inventory
Size Orders Cost Inventory
Cost
100 100 1000 50 40 1040

200 50 500 100 80 580

300 33 330 150 120 450

400 25 250 200 160 410

500 20 200 250 200 400

600 17 170 300 240 410

700 14 140 350 280 420

800 13 130 400 320 450

900 11 110 450 360 470

EOQ = 500 units (order size where total costs = 400)

4
Taylor, Bernard W. III (2013). Introduction to Management Science. USA: Pearson Education, Inc
5
De Leon, Guillermo M. & De Leon, Norma D. (2014). Cost Accounting. Sampaloc, Manila: GIC Enterprises & Co., Inc.
MANAGEMENT SCIENCE page 3

Total ordering costs and total carrying costs vary inversely. The greater the inventory on hand,
the greater the total carrying costs but the lower the ordering costs. If a small inventory is on hand,
total carrying costs will be lower but more orders will be placed, thus increasing the total ordering
costs. It is the responsibility of management to find the proper inventory policy that keeps the total
inventory costs to a minimum.

2. FORMULA METHOD. This method is easy to use and it produces an exact figures. The formula that can be
used is:

im
EOQ =
where:
EOQ = economic order quantity
C = cost of placing an order
N = number of units required annually
K = carrying cost per unit of inventory

THE CONCEPT OF REORDER POINT6

ORDER (reorder) POINT is the inventory level (in units) that automatically calls for placing a new order.
“When to reorder” is a stock-out problem. The objective is to order at a point in time so as not to run out of
stock before receiving the inventory ordered but not so early that an unnecessary quantity of safety stock is
maintained. When order point is computed, there may be stock-out situation if:
 Demand is greater than expected during the lead time.
 The order time exceeds the anticipated lead time

 Lead time is period from time an order is placed until such time the order is received.
 Normal (Average) lead time refers to the usual delay in the receipt of ordered goods.
 Maximum lead time adds to normal lead time a reasonable allowance for further
delay.
 Normal lead time usage = normal lead time x average usage
 Safety stock = (maximum lead time – normal lead time) x average usage
 Reorder point without safety stock = Normal lead time usage
 Reorder point with safety stock = Normal lead time usage + safety stock
= maximum lead time x average usage

DISCUSSION EXERCISES
(Sources: AICPA/RPCPA/CMA/Various Test banks)

1) Shirley Company requires 40,000 shells for its signature product “Pearly Shirl.” The shells will be used evenly
throughout the year. The cost to place one order is P20 while the cost to carry the shells in inventory for one
year is P0.40.
a. What is the optimal order quantity (EOQ)?
b. How many orders should be placed within the year?
c. What is the average inventory in units?
2) Based on an EOQ analysis, the optimal order quantity is 4,000 units. Annual inventory carrying costs equal 30%
of the average inventory level. the company pays P10 per unit to buy the product and P400 to place an order.
The monthly demand for the product is 5,000 units.
REQUIRED:
a. Annual inventory carrying costs
b. Annual inventory carrying costs
c. Total inventory costs
3) A company has estimated its economic order quantity for Part A at 2,400 units for the coming year. If ordering
costs are P200 and carrying costs are P0.50 per unit per year, what is the estimated total annual usage? 7,200

4) The ordering costs associated with inventory management include

A. Insurance costs, purchasing costs, shipping costs, and spoilage.
B. Obsolescence, setup costs, quantity discounts lost, and storage costs.
C. Purchasing costs, shipping costs, setup costs, and quantity discounts lost.
D. Shipping costs, obsolescence, setup costs, and capital invested.

6
Lee, Charlwin P. (2018). MAS-09: Quantitative Techniques (Regular Handouts). Sampaloc, Manila: ReSA Review School
MANAGEMENT SCIENCE page 4

5) The carrying costs associated with inventory management include

A. Insurance cost, shipping costs, storage costs, and obsolescence.
B. Storage costs, handling costs, interest on capital invested, and obsolescence.
C. Purchasing cost, shipping costs, set up costs, an{ quantity discount lost
D. Obsolescence set up costs, interest on capital invested, and purchasing costs order cost.

6) Which one of the following would not be considered a carrying cost associate with inventory?
A. Insurance costs C. Cost of obsolescence
B. Cost of capital invested in the inventory D. Shipping costs
7) The result of the economic order quantity formula indicates the
A. Annual quantity of inventory to be carried
B. Annual usage of materials during the year
C. Safety stock plus estimated inventory for the year.
D. Quantity of each individual order during the year

8) The purpose of the economic order quantity model is to

A. Minimize the safety stock
B. Minimize the inventory quantities
C. Minimize the sum of the order costs and the holding costs
D. Minimize the sum of the demand costs and the backlog costs

9) A decrease in inventory ordering cost will

A. increase the reorder point.
B. decrease the economic order quantity.
C. have no effect on the economic order quantity.
D. decrease the holding cost percentage.

10) An increase in inventory holding costs will

A. have no effect on the EOQ C. decrease the number of orders issued per year.
B. increase the EOQ D. decrease the economic order quantity
11) The economic order quantity (EOQ) will rise following
A. decrease in annual unit sales
B. An increase in carrying costs
C. An increase in the per-unit purchased price of inventory
D. An increase in the variable costs of placing & receiving an order

12) The elapsed time between placing an order for inventory and receiving the order is
A. Lead time B. Stock out time. C. Reorder point D. Stocking time

13) For inventory management, ignoring safety stock, the valid computation of the reorder point is
A. Economic order quantity
B. Anticipated demand during lead time
C. EOQ multiplied by the expected demand during lead time
D. Square fool of the anticipated demand during lead time
14) The cost of stock-out not include
A. depreciation and obsolescence C. loss of sales
B. loss of customer goodwill D. disruption of production schedules
15) When a specific level of stock is carried for an item in inventory, the average inventory level for that item
A. Is not affected by the safety stock.
B. Increase by the amount of the safety stock
C. Increase by the % the amount of the safety stock
D. Decrease by the amount of the safety stock

16) In inventory management, the safety stock will tend to increase if the
A. Carrying cost increases C. Variability of the lead time increases.
B. Cost of running out of stock decreases D. Variability of the usage rate decreases
17) When the level of safety stock is increased
A. Lead time will increase C. Carrying costs will decrease.
B. The frequency of stock outs will decrease D. Order costs will decrease
18) J Company sells 20,000 radios evenly throughout the year. The cost of carrying one unit of inventory for one
year is P8, and the purchase order cost per order is P32. What is the economic order quantity?
A. 200 B. 400 C. 283 D. 625

19) The following data relate to inventories for a given year of CD Company:
Economic order quantity 7,500 units
Cost to place one purchase order P75
Total cost to place purchase orders for the year P15,000
MANAGEMENT SCIENCE page 5

Cost to carry one unit for one year P6

The estimated annual usage in units would be
A. 2,250,000 C. 1,250,000
B. 2,000,000 D. 5,525,000
20) One of the products of Nature Health Products sells is a magnetic back support. The ordering costs related to
this product are P12.50 per order. The cost of carrying one item inventory for one year is P16.00. The business
sells 40,000 of this type of product evenly throughout the year. How much is the total ordering costs per year
and total carrying costs per year at the economic order quantity?
Ordering costs Carrying costs
A. P1,562.50 P1,562.50
B. P1,562.50 P2,560.00
C. P2,000.00 P2,000.00
D. P4,000.00 P4,000.00

21) Nini works for a local ceramic company. She just completed her accountancy degree and learned the EOQ model
in one of her easy subjects. She suggested to her employer to adopt it. The company sells 20,000 pieces of
specialty ceramic items each year. Traditionally they have produced these items four times a year, making 5,000
pieces at a time. They carry no safety stock as customers do not mind waiting for orders. The average piece of
ceramic items cost P400 to make and costs the company P20 to carry in inventory for a year. The set up costs
for each production run total P80. The company should
A. adopt EOQ due to savings of P35,675.
B. adopt EOQ due to savings of P42,320
C. continue the existing system due to P38,950 advantage
D. continue the existing system due to P41,820 advantage

22) Pat, lnc. currently places orders for a particular stock item at quarterly intervals. Information concerning this
item is as follows:
Cost of placing an order P10
Annual demand 20,000 units
Purchasing Price per unit P0.50
Carrying cost ratio 20%
What annual cost saving would result if Pat used the economic order quantity for order sizes instead of their
current policy?
A. P80 B. P90 C. P150 D. P240

23) Huron Corporation purchases 60,000 headbands per year. The average purchase lead time is 20 working days,
safety stock equals 7 days normal usage, and the corporation works 240 days per year. Huron should reorder
headbands when the quantity in inventory reaches
A. 5,000 units B. 1,750 units C. 6,750 units D. 5,250 units

24) D & R Corp. consumes 300,000 units of spare part V per year. The average purchase lead-time is 20 working
days while maximum is 27 working days. The company's annual operations cover 240 days allowing for
shutdowns for plant maintenance, holidays and Sundays. The company would like to keep safety stock or extra
stock to guard against stock outs, how much is the safety stock?
A. 25,000 units B. 1,250 units C. 33,750 units D. 8,750 units

25) IRE Manufacturing Corporation uses the standard economic order quantity (EOQ) model. lf the EOQ for Product
Bird Box is 200 units and IRE maintains a 50-unit safety stock for the item, what is the average inventory of
Product Bird Box?
A. 250 units B. 150 units C. 125 units D. 100 units

26) C Enterprises uses 84,000 units of Part 256 in manufacturing activities over a 300-day work year. The usual lead
time for the part is 6 days; occasionally, however, the lead time has gone as high as 8 days. The company now
desires to adjust its safety stock policy. The increase in safety stock size and the likely effect on stock out costs
and carrying costs, respectively, would be
A. 560 units, decrease, increase C. 1,680 units, decrease, increase.
B. 560 units, decrease, decrease D. 2,240 units, increase, decrease
27) As a consequence of finding a more dependable supplier, D Co, reduced its safety stock of raw materials by 80%.
What is the effect of this safety stock reduction on D's economic order quantity?
A. 80% decrease C. 20% increase
B. 64% decrease D. No effect

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