Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VII. Short−Term Financial

Planning and Management

21. 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