Topic 7 – Economic Order Quantity and Reorder Point

Prepared by: Olivo, CPA, MBA

Materials Inventory Management

EOQ/ ECONOMIC ORDER QUANTITY

Objective – to minimize cost

Total Inventory cost = Carrying cost + Ordering Cost

Carrying Cost includes: Ordering Cost includes:

1) Storage Costs 1) Transportation/delivery cost

2) Interest Cost 2) Administrative cost of purchasing
3) Spoilage 3) Cost of Receiving
4) Insurance 4) Cost of Inspecting goods

In order to achieve objective of minimizing cost, companies usually use the EOQ or the Economic Order Quantity /
Economic Lot Size

Assumptions under EOQ:

1) Demand is uniform and known

2) Delivery is perfectly reliable and instant
3) Carrying cost, ordering cost and unit price are constant

Example:

Annual Demand – 4,000 units per year

Carrying cost – P8 per unit
Ordering cost – P100 pesos per order

Case 1 Case 2 Case 3 Case 4 Case 5 Case 6 Case 7

Quantity (order size)
Average Inventory
Total Holding Cost
Frequency of Order
Total Ordering Cost
TOTAL INV COST
*Average Inventory = (Maximum inventory point + Lowest Inventory point) /2
*Holding Cost = Average Inventory * Carrying cost per unit
* Frequency of order = Annual Demand / Oder size
*Order cost = Frequency of Order * Order cost

You can use the table method every time or simply by using formula

EOQ FORMULA:

D = Annual Demand
S = Ordering cost per order
H = Carrying cost per unit
TAKE NOTE: Ordering cost and Carrying cost is equal under EOQ

REORDER POINT

Usual Inventory Management Problem, the quantity on hand must last until the next order is received. Otherwise
known as the Stock-out problem.

Stock out occurs when:

- Demand is greater than expected during the lead time

- The order time exceeds the lead time

Lead time – period between the time the order is placed and received
Normal Time usage – Normal Lead time x Average Usage
Safety stock = (Maximum lead time-Normal lead time) x average usage
ROP (if no SS) = Normal lead time usage
ROP (if w/SS) = SS + Normal lead time usage (or Maximum lead time X Average Usage)

PROBLEM 1 (EOQ)

Happy Traders Incorporated manufactures cellphone cases. Raw materials are bought from local manufacturers.
Happy Traders uses 24,000 units of raw materials evenly throughout the year. The cost of carrying one unit of raw
materials in inventory for one year is P11.52 and the order cost per order is P38.40

Calculate the following:

1) EOQ
2) If Happy Traders buy in EOQ, how much is the order cost?
3) If Happy Traders buy in EOQ, how much is the carrying cost?
4) If the annual demand for the material increases by 44%, the EOQ will increase or decrease by?

PROBLEM 2 (ROP and Safety Stock)

The following information is available for Edgar Corporation’s material

Annual Usage 12,600 units

Working days per year 360 days
Normal lead time 20 days
The units of material are required evenly throughout the year.

1) What is the reorder point?

2) Assume that occasionally, the company experiences delay in the delivery of material, such that the lead
time reaches a maximum of 30 days, how many units of safety stock should the company maintain and
what is the reorder point?

PROBLEM 3 (ROP and Safety Stock)

The following information pertains to CACHING Corporation’s Material X:

Annual Usage 25,200 units

Working days per year 360 days
Normal lead time in working days 30 days
 Safety Stock 1,050 units

The maximum lead time in working days and the reorder point for Material X are ______

PROBLEM 4 (EOQ and Safety Stock)

Using the EOQ Model, CHENG Corporation determined the economic order quantity for their raw materials to be
800 units. To avoid stock-out costs, it maintains 200 units in safety stock. What is CHENG Corporation’s average
inventory of such raw material item?

PROBLEM 5 (EOQ and Safety Stock)

Using the EOQ Model, Tokyo Company computed the economic order quantity for one of the materials it uses in
its production to be 4,000 units. The Company maintains safety stock of 300 units. The quarterly demand for the
material is 10,000 units. The order cost is 200 per order. The purchase price of the material is P2.40. The annual
Inventory carrying cost is equal to 25% of the purchase price.

1) What is the annual inventory carrying cost?

2) The total inventory carrying cost per year is ___________

PROBLEM 6 (ELS / ECONOMIC LOT SIZE)

The following information pertains to AAA Manufacturing Company’s Product X:

Annual Demand 33,750 units

Annual cost to hold one unit of inventory P15

Setup cost (or the cost to initiate a production run P500

Beginning inventory of Product X 0

At present, the company produces 2,250 units of Product X per production run, for a total of 15 production runs
per year. The Company is considering to use the EOQ model to determine the economic lot size and the number of
production runs that will minimize the total inventory carrying cost and setup cost for Product X.

1) At present, the company’s total annual inventory costs is _______

2) If the EOQ model is used, the economic lot size is ________
3) If the EOQ model is used, the number of production runs should be _______
4) If the EOQ model is used, the total annual inventory costs, compared with that under present system, will
increase (decrease) by _________