COST ACCOUNTING & CONTROL

Accounting for Materials

Inventory Models
Inventory models are usually devised to minimize the costs associated with inventory while maintaining certain level
of inventories needed to sustain smooth operations.

Components of Inventory Costs

 Carrying Costs: This cost increases with order size or quantity of inventory on hand.
Example: Storage costs, insurance on inventory, normal spoilage, record keeping cost

 Ordering Costs: This cost decreases with order size or quantity of inventory on hand.
Example: Delivery costs, administrative costs – inspection, purchasing and receiving, quantity discount lost, handling
costs

Economic Order Quantity (EOQ)

EOQ refers to the number of units that should be placed every order to economize on the sum of ordering costs and
carrying costs.

EOQ = 2CN where: C = Cost per order

K N = Annual demand in units
K = Carrying cost per unit

At EOQ, a firm incurs the lowest total inventory costs computed as follows:

Total Costs = Carrying Costs + Ordering Costs

= EOQ (K) + N (C)

2 EOQ

Average inventory is computed as follows:

 No safety stock: EOQ/2
 With safety stock: EOQ/2 + safety stock
 If EOQ is not available: (Beginning inventory + Ending inventory) ÷ 2

Assumptions & Limitations of EOQ Analysis

1. Annual determinable demand for inventory is spread evenly throughout the year.
2. Lead time does not vary and each order is delivered in a single delivery.
3. The unit cost of the units ordered is constant; thus, there can be no quantity discounts.

Illustration:

Ward Company requires 40,000 units of materials for its P100-signature product. The materials, which are purchased from
outside suppliers, will be used evenly throughout the year. The cost to place one order is P20, while the cost to carry the
units of materials in inventory for one year is P0.40.

Required:
1. The optimal order quantity.
2. The number of times the company should place orders within a year.
3. The average inventory.
4. Total ordering and carrying costs.

1) EOQ
√2 x P20 x 40,000
P0.40

= 2,000 units

2) No. of orders = N / EOQ

= 40,000 / 2,000
= 20 orders

Frequency of orders = 360 days / No. of orders

= 360 / 30
= every 18 days
 3) Average inventory = EOQ/2
= 2,000 / 2
= 1,000 units

4) Total ordering costs = No. of orders x Cost per order

= 20 orders x P20
= P400

Total carrying costs = Average inventory x CC/unit

= 1,000 units x P0.40
= P400

Total costs = TOC + TCC

= P800

@ 4,000 units:

Total costs = TOC + TCC

TOC = (40,000/4,000) x P20

= 10 orders x P20
= P200

TCC = (4,000/2) x P0.40 P1,000

= 2,000 x P0.40
= P800

@ 1,000 units:

Total costs = TOC + TCC

TOC = (40,000/1,000) x P20

= 40 orders x P20
= P800

TCC = (1,000/2) x P0.40 P1,000

= 500 x P0.40
= P200

Illustration:

Based on an EOQ analysis, the optimal order quantity of Kiros Company is 3,000 units. Annual inventory carrying costs equal
30% of the average inventory level. The company pays P5 per unit to buy the product and P112.50 to place an order. The
monthly demand for the product is 5,000 units.

Required:
1. Annual inventory carrying cost. 2,250
2. Annual inventory ordering costs. 2,250
3. Total inventory costs. 4,500

1) TCC = Ave. inventory x CC/unit

= (3,000/2) x P1.50
= P2,250

2) TOC = No. of orders x CPO

= (60,000/3,000) x P112.50
= P2,250

3) TC = TCC + TOC
= P4,500
The Concept of Reorder Point

Order (Reorder) Point is the inventory level (in units) that automatically calls for placing a new order.

DATE OF ORDER RECEIPT OF ORDER (Normal) RECEIPT OF ORDER (delayed)

X----------------------------------------X---------------------------X
1/1/22 1/11/22 1/16/22
---------------Normal LT------------ ----Additional LT-----
10 days 5 days
---------------------------Maximum LT-------------------------
15 days

Safety stock = ALT x Daily demand

= 5 days x 100/day
ROP (w/o SS) = 500 units
= Daily demand x NLT
= 100 units x 10 days
= 1,000 units

ROP (w/ SS) = NLT usage + SS

= 1,000 units + 500 units
= 1,500 units

OR; = Daily demand x MLT

= 100 units x 15 days
= 1,500 units

Assuming:
Daily usage/demand 100 units

w/ safety stock
Reorder point
w/o safety stock

When is the perfect time to place an 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, or
 The order time exceeds the anticipated lead time.

LEAD TIME is the period from the time an order is placed until such time the order is received.
 Normal (Average) Lead Time – this refers to the usual delay in the receipt of ordered goods.
 Maximum Lead Time – this 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
Or; maximum lead time x average usage

Illustration:

Laguna Company purchases 7,500 units of bleaching soap per annum. The average purchase lead time is 7 working days.
Maximum lead time is 10 working days. The company works 300 days per year.

Required:
1. How many units should Laguna maintain as safety (buffer) stock? 75
2. What is Laguna’s reorder point for bleaching soap? 250

1) SS = ALT x Daily demand

= (10 – 7) x (7,500/300)
= 3 days x 25 units/day
= 75 units
 2) ROP (w/ SS) = MLT usage
= 10 days x 25
= 250 units

EOQ applied to production operations

When applied to production operations, the EOQ formula is used to compute the Economic Lot Size (ELS)

ELS = 2CN where: C = Set-up cost

K N = Annual production requirement
K = Carrying cost per unit

Illustration:

Kupo Bookstore publishes a book about accounting. Set-up cost is P10. Kupo prints 675 copies of the book evenly throughout
the year. The optimal production run (economic lot size) is 30.

How much is the unit carrying cost? P15

30 = √ 2 x P10 x 675
?

30 = √ 13,500
?

30² = 13,500
?

900 = 13,500
?
? = 15