Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate Edition
VII. Short−Term Financial
Planning and Management
- Credit and Inventory
Management
© The McGraw−Hill^757
Companies, 2002
This reorder quantity, which minimizes the total inventory cost, is called the economic
order quantity (EOQ). For the Eyssell Corporation, the EOQ is:
Q* [21.16]
2,498 units
Thus, for Eyssell, the economic order quantity is 2,498 units. At this level, verify that
the restocking costs and carrying costs are both $936.75.
6,240,000
(2 46,800) $50
.75
2 TF
CC
730 PART SEVEN Short-Term Financial Planning and Management
economic order quantity
(EOQ)
The restocking quantity
that minimizes the total
inventory costs.
Carrying Costs
Thiewes Shoes begins each period with 100 pairs of hiking boots in stock. This stock is de-
pleted each period and reordered. If the carrying cost per pair of boots per year is $3, what are
the total carrying costs for the hiking boots?
Inventories always start at 100 items and end up at zero, so average inventory is 50 items.
At an annual cost of $3 per item, total carrying costs are $150.
EXAMPLE 21.2
Restocking Costs
In our previous example (Example 21.2), suppose Thiewes sells a total of 600 pairs of boots in
a year. How many times per year does Thiewes restock? Suppose the restocking cost is $20
per order. What are total restocking costs?
Thiewes orders 100 items each time. Total sales are 600 items per year, so Thiewes re-
stocks six times per year, or about every two months. The restocking costs would be 6 orders
$20 per order $120.
EXAMPLE 21.3
The EOQ
Based on our previous two examples, what size orders should Thiewes place to minimize
costs? How often will Thiewes restock? What are the total carrying and restocking costs? The
total costs?
We have that the total number of pairs of boots ordered for the year (T) is 600. The re-
stocking cost (F) is $20 per order, and the carrying cost (CC) is $3. We can calculate the EOQ
for Thiewes as follows:
EOQ
89.44 units
Because Thiewes sells 600 pairs per year, it will restock 600/89.44 6.71 times. The total
restocking costs will be $20 6.71 $134.16. Average inventory will be 89.44/2 44.72.
The carrying costs will be $3 44.72 $134.16, the same as the restocking costs. The to-
tal costs are thus $268.33.
8,000
(2 600) $20
3
2 TF
CC
EXAMPLE 21.4