Inventory Management

Economic order quantity

• Economic order Quantity is that size of the order which gives maximum economy
• In purchasing any item of material.

• In order to determine the economic or optimum order quantity, an analysis of

the various
• Cost associated with the ordering quantity is made.
• This cost may be divided into two parts:

i. Material Acquisition costs &

ii.Material Carrying cost
 ORDERING (OR SET-UP) COST
• Ordering cost is associated with the cost of placing orders for procuring items from outside suppliers
or producing the items setting up of machinery.
• Cost per order generally includes
 Requisition cost of handling of purchase orders, invoices, stationery, payments etc,
 Cost of services include cost of mailing, telephone calls and other follow up actions
 Material handling cost incurred in receiving, inspecting and storing the items included in the
order.
• For practical purposes, ordering (set-up) cost is independent of the size of the order, rather it varies
with the number of orders placed during a given period of time.
• Thus if a large number of orders are placed, more money will be required for procuring the items.

• Ordering cost is calculated as:

 Ordering Cost = (Cost per order or per set-up) * (Number of orders or set-ups
in the inventory planning period)
• When items are produced internally, a set-up cost is incurred and has the same meaning as the
ordering cost. 3
 CARRYING (OR HOLDING) COST
• The carrying cost is associated with carrying (or holding) inventory.

• This cost arises due to many factors which include:

 Storage cost incurred for providing warehouse space to store the products
 Handling cost incurred for payment of salaries to employees to handle inventory
 Insurance cost against possible loss from fire or other form of damage
 Interest paid on investment of capital
 Obsolescence and deterioration costs incurred when a portion of inventory
become either obsolete or is lost or pilfered.
iit is calc on pupa basis because it considers the opportunity cost as well as the variable cost

• Carrying cost can be determined as follows

Carrying Cost = (Cost of Carrying one unit of an item in the inventory for a given
length of time) * (Average number of units of an item carried in the inventory for a
4
given length of time)
 ECONOMIC LOT SIZE MODEL
WITH CONSTANT DEMAND (EOQ)

Calculation of EOQ
EOQ =
√ 2AS
I

‘A’ stands for annual consumption of material in terms of units

‘S’ stands for cost of placing one order including the cost of receiving it
‘I’ stands for interest payment per unit per annum ( or carrying cost per unit per annum)
PRACTICE QUESTIONS

Problem 1

• Annual usage is 1,00,000 units

• Cost of placing one order Rs 50
• Cost of material per unit is Rs 25
• Annual carrying Cost of one unit is 10% of inventory value
• Determine EOQ & Number of orders per annum
PRACTICE QUESTIONS

Problem 2

• A company consumes 50,000 units of a component per year.

• Order receiving & handling costs are Rs. 3 per order while the trucking cost is Rs.
12 per order.
• Interest cost is R. 0.06 per unit per year, Obsolescence cost Rs. 0.004 per unit per
year, Storage cost Rs. 1000 per year for 50,000 units.
• Calculate EOQ
PRACTICE QUESTIONS

Problem 3

• The annual demand for the product is 6400 units. The unit cost is Rs.6 and
inventory
• Carrying cost per unit per annum is 25% of the average inventory cost.
• If the cost of procurement is Rs.75 ,
• Determine EOQ & Number of orders per annum.
Also Calculate Time between two consecutive orders.
PRACTICE QUESTIONS

Problem 4 :
The production department for a company requires 3,600 kg of raw material for
manufacturing a particular item per year. It has been estimated that the cost of placing
an order is Rs. 36 and the cost of carrying inventory is 25% of the investment in the
inventories. The price is Rs. 10 per kg. The purchase manager wishes to determine an
ordering policy for raw material. Calculate :
1. Optimal Lot Size
2. Optimal Order Cycle Time
3. Minimum yearly total cost or Total Inventory Cost
9
PRACTICE QUESTIONS

Problem 5

• A factory required 1500 units of an item per month each costing Rs. 27.
• The cost per order is Rs. 150 and the inventory carrying cost is 20% per unit.
• Find out EOQ.
• Evaluate the 2% price discount offer given by a supplier at an order size of 1200
units.
• Problem 6 :

• A company manufactures a product from a raw materials, which is purchased at

Rs. 60 per kg. The company incurs a handling cost of Rs. 360 plus freight of Rs.
390 per order. The incremental carrying cost of inventory of raw materials is Re
0.50 per kg. per month. In additional the cost of working capital finance on the
investment in inventory of raw materials is Rs. 9 per kg. pa. The annual
production of the product is 1,00,000 units and 2.5 units are obtained from one
kg of raw materials.
Required :
• a. Calculate the economic order quantity of raw materials.
• B. Advise, how frequently should orders for procurement be placed.
• c. If the company proposes to rationalise placement of orders on quarterly
basis, what percentage of discount in the price of raw materials should be
negotiated ?