Introduction to Corporate Finance

ONLINE CHAPTERS

usage and the timing of receipt from suppliers. Assuming a constant rate of usage, a company can easily

estimate a reorder point as follows:

Reorder point = Lead time in days × Daily usage

For example, if Auchenflower Producers uses about 44 units per day (16,000 units per year ÷ 365

days), and if it typically takes the company four days to place and receive an order, then the company

should place an order when its inventory falls to 176 units (four days × 44 units).

To allow for faster-than-anticipated rates of usage and/or delayed deliveries, many companies maintain

safety stocks of inventory. Management determines the size of these stocks by analysing the probabilities

of both increased usage rates and delivery delays. For example, Auchenflower Producers estimates that

a safety stock equal to 2% of its annual usage of the given item will adequately protect against stockouts

due to faster-than-anticipated usage and/or order fulfilment delays. Given that estimate, Auchenflower

will maintain a safety stock of 320 units (0.02 × 16,000 units). A variety of more sophisticated models

are available for setting both reorder points and safety stocks.

finance in practice

SHOULD I BUY IN LARGE QUANTITIES?

The proliferation of superstores and warehouse

clubs causes many individuals and families to buy

large quantities of staple items such as paper

goods, canned food and soft drinks in order to

try to save money. The question is: does buying

in large quantities make sense? This question can

be answered by considering the cost trade-offs

involved, similar to the basic EOQ model.

Let’s assume that the local GoLo offers a box

of 200 garbage bags for $12. You currently buy a

box of 50 similar garbage bags for $6 at the nearby

grocery store every three months (¼ of a year), so

the 200 bags should last you an entire year. Because

you routinely go to both the local grocery shop and

to GoLo, your ‘order costs’, which would be the

transportation costs and the value of your time, are

virtually $0. You won’t have to make a special trip to

either shop. Assuming you have adequate storage

space at home, your holding costs are strictly

financial, and represent the cost of having your

money tied up in garbage bags. Let’s assume you

can earn 4% interest on your savings. Your average

investment in each case would be one-half of the

cost of the purchase as calculated below:

Average investment

GoLo purchase = $12/2 = $6

Nearby grocery shop purchase = $6/2 = $3

The GoLo purchase would therefore cause you

to have, on average, an extra $3 ($6 – $3) invested

in garbage bags. Given that you can earn 4%

on your money, the annual cost of tying up $3 in

garbage bags is $0.12 (0.04 × $3). But by buying

the large quantity of garbage bags at GoLo, you

save $12, the difference between $24 (four $6

purchases at the nearby grocery shop) and the $12

cost of the one-time purchase at GoLo. So does it

make economic sense to incur annual holding costs

of $0.12 to save $12 annually? Clearly, in this case,

the large quantity purchase will save just under $12

per year.