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

(^754) © The McGraw−Hill
Companies, 2002
The Economic Order Quantity Model
The economic order quantity (EOQ) model is the best-known approach for explicitly es-
tablishing an optimal inventory level. The basic idea is illustrated in Figure 21.4, which
plots the various costs associated with holding inventory (on the vertical axis) against
inventory levels (on the horizontal axis). As shown, inventory carrying costs rise and re-
stocking costs decrease as inventory levels increase. From our general discussion in
Chapter 19 and our discussion of the total credit cost curve in this chapter, the general
shape of the total inventory cost curve is familiar. With the EOQ model, we will attempt
to specifically locate the minimum total cost point, Q*.
In our discussion that follows, an important point to keep in mind is that the actual
cost of the inventory itself is not included. The reason is that the totalamount of inven-
tory the firm needs in a given year is dictated by sales. What we are analyzing here is
how much the firm should have on hand at any particular time. More precisely, we are
trying to determine what order size the firm should use when it restocks its inventory.
Inventory Depletion To develop the EOQ, we will assume that the firm’s inventory
is sold off at a steady rate until it hits zero. At that point, the firm restocks its inventory
back to some optimal level. For example, suppose the Eyssell Corporation starts out to-
day with 3,600 units of a particular item in inventory. Annual sales of this item are 46,800
units, which is about 900 per week. If Eyssell sells off 900 units of inventory each week,
then, after four weeks, all the available inventory will be sold, and Eyssell will restock by
ordering (or manufacturing) another 3,600 and start over. This selling and restocking
CHAPTER 21 Credit and Inventory Management 727

FIGURE 21.4

Costs of Holding

Inventory

Size of inventory

orders (Q)

Cost of holding

inventory ($)

Total costs of holding inventory

Restocking

costs

Carrying costs

Q*

Optimal size

of inventory order

Restocking costs are greatest when the firm holds a small quantity of inventory.

Carrying costs are greatest when there is a large quantity of inventory on hand.

Total costs are the sum of the carrying and restocking costs.