Introduction to Corporate Finance

18: Cash Conversion, Inventory and Receivables Management

ABC System

A company, using the ABC system, segregates its inventory into three groups, A, B and C. The A items

are the most costly inventory items, and the B group consists of items accounting for the next largest

investment. The C group typically consists of a large number of items accounting for a small dollar

investment. Separating inventory into A, B and C groups allows the company to determine the level

and types of inventory control procedures needed. Control of the A items should be most intensive

because of the high dollar investments involved; the B and C items are subject to correspondingly less

sophisticated procedures.

Basic Economic Order Quantity (EOQ) Model

A popular tool for determining the optimal order quantity for an inventory item is the economic order

quantity (EOQ) model. This model could be used to control the company’s big-ticket inventory items, such

as those included in the A group of an ABC system. The EOQ model considers order costs and carrying

costs and determines the order quantity that minimises their total. Derived from a formal economic

model, the economic order quantity for a given inventory item is given as

Eq. 18.2

SO

C

EOQ=

2

where

S = inventory usage per period (typically one year)

O = order cost, a fixed cost associated with placing and receiving an order

C = carrying cost, a variable cost associated with holding an item in inventory.

Total cost of inventory equals the sum of the fixed cost of placing each order and the variable cost of holding

each item in inventory. Assuming that inventory usage is constant, the larger the order quantity, EOQ,

the fewer orders placed and, therefore, the lower the total order cost. But placing larger orders raises the

average inventory, and therefore results in higher total carrying cost. So the EOQ mathematically balances

the trade-off between decreasing total order costs and increasing total carrying costs, and calculates the

order quantity that minimises the total of these two competing costs (as in Figure 18.2 on page 632).

example

Auchenflower Producers currently uses 16,000
units of an expensive inventory item each year. The
company estimates its order cost to be $500 per
order, and carrying cost for this item to be $100
per unit per year. Auchenflower wishes to estimate
the optimal quantity in which to order this item. By
substituting S = 16,000, O = $500, and C = $100 into

Equation 18.2, we calculate the EOQ for this item as:

EOQ

21 6,000 $500

$100

= 160 ,000 400 units

××

==

By ordering this item in quantities of 400 units,

Auchenflower Producers will minimise its total

inventory cost for this item.

Reorder Points and Safety Stock

The simple EOQ model just presented assumes that inventory is instantaneously replenished precisely

at the time the inventory is exhausted. This model implies perfect certainty with regard to the rate of

ABC system

An inventory control system

that segregates inventory

into three groups – A, B and

C. A items require the largest

dollar investment and the

most intensive control, B

items require the next largest

investment and less intensive

control and C items require the

smallest investment and least

intensive control

economic order quantity

(EOQ) model

A common tool used to

estimate the optimal order

quantity for big-ticket items

of inventory. It considers

operating and financial costs

and determines the order

quantity that minimises overall

inventory costs

total cost

The sum of the order costs

and the carrying costs that is

minimised using the economic

order quantity (EOQ) model

order cost

The fixed dollar amount per

order that covers the costs of

placing and receiving an order;

used in calculating the EOQ

carrying cost

The variable cost per unit of

holding an item in inventory

for a specified period of time.

Used in calculating the EOQ