(^248) Financial Management
But this doesn't give us the optimum size of the inventory order. For finding the minimum
costs we need to find the 'economic order quantity' for the particular item of stock
under review. The effect of the combination of the various items of stock into the total
business inventory will be discussed later.
Inventory Management Techniques
Economic Order Quantity (EOQ)
The economic order quantity is defined as a point where the total costs of restocking
and carrying costs are the lowest.
EOQ is usually calculated by a formula based on differential calculus. Though we will
not derive the formula we need to understand its working.
I P
EOQ^2 FC S
¥
= ¥ ¥
There are four assumptions that we make in the EOQ model:
- Sales can be forecasted perfectly,
- Sales are evenly distributed throughout the year, and
- Orders are received as soon as they are placed.
This set of assumptions mean is pretty restrictive and we will relax these assumptions
slowly. Before we relax these assumptions there are two important things to note about
the EOQ: - Although a mathematically precise EOQ can be calculated, in practice there is
likely to be a range of order quantities within which total costs remain at a low
level. The choice of order quantity within this low-cost range may not significantly
affect the overall financial plan. - The key factor in the calculations is usually the cost of capital (interest on
stockholdings). In times of high interest rates this is likely to outweigh all the other
variables. The inventory holding costs will go up very steeply, and one's conclusion
will be that stockholdings should be kept to the lowest figure possible having
regard to any practical difficulties in obtaining frequent replacement supplies.
Optimum Order Quantity (OOQ)
The last comment above is a reminder that suppliers do not like handling small orders.
The purchase price per unit, therefore, may vary with the size of the purchase order,
and this will require a modification to our EOQ calculation.