EOQ - Expalined

The Economic Order Quantity (EOQ) is the number of units that a company should add to inventory with each order to minimize the total costs of inventory—such as holding costs, order costs, and shortage costs. The EOQ is used as part of a continuous review inventory system in which the level of inventory is monitored at all times and a fixed quantity is ordered each time the inventory level reaches a specific reorder point. The EOQ provides a model for calculating the appropriate reorder point and the optimal reorder quantity to ensure the instantaneous replenishment of inventory with no shortages. It can be a valuable tool for small business owners who need to make decisions about how much inventory to keep on hand, how many items to order each time, and how often to reorder to incur the lowest possible costs.

The EOQ model assumes that demand is constant, and that inventory is depleted at a fixed rate until it reaches zero. At that point, a specific number of items arrive to return the inventory to its beginning level. Since the model assumes instantaneous replenishment, there are no inventory shortages or associated costs. Therefore, the cost of inventory under the EOQ model involves a tradeoff between inventory holding costs (the cost of storage, as well as the cost of tying up capital in inventory rather than investing it or using it for other purposes) and order costs (any fees associated with placing orders, such as delivery charges). Ordering a large amount at one time will increase a small business's holding costs, while making more frequent orders of fewer items will reduce holding costs but increase order costs. The EOQ model finds the quantity that minimizes the sum of these costs.

The basic EOQ relationship is shown below. Let us look at it assuming we have a painter using 3,500 gallons of paint per year, paying $5 a gallon, a $15 fixed charge every time he/she orders, and an inventory cost per gallon held averaging $3 per gallon per year.

The relationship is TC = PD + HQ/2 + SD/Q '� where

• TC is the total annual inventory cost—to be calculated.
• P is the price per unit paid—assume $5 per unit.
• D is the total number of units purchased in a year—assume 3,500 units.
• H is the holding cost per unit per year—assume $3 per unit per annum.
• Q is the quantity ordered each time an order is placed—initially assume 350 gallons per order.
• S is the fixed cost of each order—assume $15 per order.

Calculating TC with these values, we get a total inventory cost of $18,175 for the year. Notice that the main variable in this equation is the quantity ordered, Q. The painter might decide to purchase a smaller quantity. If he or she does so, more orders will mean more fixed order expenses (represented by S) because more orders are handles—but lower holding charges (represented by H): less room will be required to hold the paint and less money tied up in the paint. Assuming the painter buys 200 gallons at a time instead of 350, the TC will drop to $18,063 a year for a savings of $112 a year. Encouraged by this, the painter lowers his/her purchases to 150 at a time. But now the results are unfavorable. Total costs are now $18,075. Where is the optimal purchase quantity to be found.
The EOQ formula produces the answer. The ideal order quantity comes about when the two parts of the main relationship (shown above)—"HQ/2" and the "SD/Q"—are equal. We can calculate the order quantity as follows: Multiply total units by the fixed ordering costs (3,500 × $15) and get 52,500; multiply that number by 2 and get 105,000. Divide that number by the holding cost ($3) and get 35,000. Take the square root of that and get 187. That number is then Q.
In the next step, HQ/2 translates to 281, and SD/Q also comes to 281. Using 187 for Q in the main relationship, we get a total annual inventory cost of $18,061, the lowest cost possible with the unit and pricing factors shown in the example above.

Thus EOQ is defined by the formula: EOQ = square root of 2DS/H. The number we get, 187 in this case, divided into 3,500 units, suggests that the painter should purchase paint 19 times in the year, buying 187 gallons at a time.

The EOQ will sometimes change as a result of quantity discounts offered by some suppliers as an incentive to customers who place larger orders. For example, a certain supplier may charge $20 per unit on orders of less than 100 units and only $18 per unit on orders over 100 units. To determine whether it makes sense to take advantage of a quantity discount when reordering inventory, a small business owner must compute the EOQ using the formula (Q = the square root of 2DS/H), compute the total cost of inventory for the EOQ and for all price break points above it, and then select the order quantity that provides the minimum total cost.

For example, say that the painter can order 200 gallons or more for $4.75 per gallon, with all other factors in the computation remaining the same. He must compare the total costs of taking this approach to the total costs under the EOQ. Using the total cost formula outlined above, the painter would find TC = PD + HQ/2 + SD/Q = (5 × 3,500) + (3 × 187)/2 + (15 × 3,500)/187 = $18,061 for the EOQ. Ordering the higher quantity and receiving the price discount would yield a total cost of (4.75 × 3,500) + (3 × 200)/2 + (15 × 3,500)/200 = $17,187. In other words, the painter can save $875 per year by taking advantage of the price break and making 17.5 orders per year of 200 units each.
EOQ calculations are rarely as simple as this example shows. Here the intent is to explain the main principle of the formula. The small business with a large and frequently turning inventory may be well served by looking around for inventory software which applies the EOQ concept more complexly to real-world situations to help purchasing decisions more dynamically.

Economic Order Quantity (EOQ)

Economic order quantity (EOQ) is the order quantity of inventory that minimizes the total cost of inventory management.

Two most important categories of inventory costs are ordering costs and carrying costs. Ordering costs are costs that are incurred on obtaining additional inventories. They include costs incurred on communicating the order, transportation cost, etc. Carrying costs represent the costs incurred on holding inventory in hand. They include the opportunity cost of money held up in inventories, storage costs, spoilage costs, etc.

Ordering costs and carrying costs are quite opposite to each other. If we need to minimize carrying costs we have to place small order which increases the ordering costs. If we want minimize our ordering costs we have to place few orders in a year and this requires placing large orders which in turn increases the total carrying costs for the period.

We need to minimize the total inventory costs and EOQ model helps us just do that.

Total inventory costs = Ordering costs + Holding costs

By taking the first derivative of the function we find the following equation for minimum cost

EOQ = SQRT(2 × Quantity × Cost Per Order / Carrying Cost Per Order)

Example

ABC Ltd. is engaged in sale of footballs. Its cost per order is $400 and its carrying cost unit is $10 per unit per annum. The company has a demand for 20,000 units per year. Calculate the order size, total orders required during a year, total carrying cost and total ordering cost for the year.

Solution

EOQ = SQRT(2 × 20,000 × 400/10) = 1,265 units

Annual demand is 20,000 units so the company will have to place 16 orders (= annual demand of 20,000 divided by order size of 1,265). Total ordering cost is hence $64,000 ($400 multiplied by 16).

Average inventory held is 632.5 ((0+1,265)/2) which means total carrying costs of $6,325 (i.e. 632.5 × $10)

Inventory Controlling - Step by Step Procedure

Controlling Inventory

Controlling inventory does not have to be an onerous or complex proposition. It is a process and thoughtful inventory management. There are no hard and fast rules to abide by, but some extremely useful guidelines to help your thinking about the subject. A five step process has been designed that will help any business bring this potential problem under control to think systematically thorough the process and allow the business to make the most efficient use possible of the resources represented. The final decisions, of course, must be the result of good judgment, and not the product of a mechanical set of formulas.

STEP 1: Inventory Planning

Inventory control requires inventory planning. Inventory refers to more than the goods on hand in the retail operation, service business, or manufacturing facility. It also represents goods that must be in transit for arrival after the goods in the store or plant are sold or used. An ideal inventory control system would arrange for the arrival of new goods at the same moment the last item has been sold or used. The economic order quantity, or base orders, depends upon the amount of cash (or credit) available to invest in inventories, the number of units that qualify for a quantity discount from the manufacturer, and the amount of time goods spend in shipment.

STEP 2: Establish order cycles

If demand can be predicted for the product or if demand can be measured on a regular basis, regular ordering quantities can be setup that take into consideration the most economic relationships among the costs of preparing an order, the aggregate shipping costs, and the economic order cost. When demand is regular, it is possible to program regular ordering levels so that stock -outs will be avoided and costs will be minimized. If it is known that every so many weeks or months a certain quantity of goods will be sold at a steady pace, then replacements should be scheduled to arrive with equal regularity. Time should be spent developing a system tailored to the needs of each business. It is useful to focus on items whose costs justify such control, recognizing that in some cases control efforts may cost more the items worth. At the same time, it is also necessary to include low return items that are critical to the overall sales effort.

If the business experiences seasonal cycles, it is important to recognize the demands that will be placed on suppliers as well as other sellers.

A given firm must recognize that if it begins to run out of product in the middle of a busy season, other sellers are also beginning to run out and are looking for more goods. The problem is compounded in that the producer may have already switched over to next season’s production and so is not interested in (or probably even capable of) filling any further orders for the current selling season. Production resources are likely to already be allocated to filling orders for the next selling season. Changes in this momentum would be extremely costly for both the supplier and the customer.

On the other hand, because suppliers have problems with inventory control, just as sellers do, they may be interested in making deals to induce customers to purchase inventories off-season, usually at substantial savings. They want to shift the carrying costs of purchase and storage from the seller to the buyer. Thus, there are seasonal implications to inventory control as

well, both positive and negative. The point is that these seasonable implications must be built into the planning process in order to support an effective inventory management system.

STEP 3: Balance Inventory Levels

Efficient or inefficient management of merchandise inventory by a firm is a major factor between healthy profits and operating at a loss. There are both market-related and budget-related issues that must be dealt with in terms of coming up with an ideal inventory balance:

•      Is the inventory correct for the market being served?

•      Does the inventory have the proper turnover?

•      What is the ideal inventory for a typical retailer or wholesaler in this business?

To answer the last question first, the ideal inventory is the inventory that does not lose profitable sales and can still justify the investment in each part of its whole.

An inventory that is not compatible with the firm’s market will lose profitable sales. Customers who cannot find the items they desire in one store or from one supplier are forced to go to a competitor. Customer will be especially irritated if the item out of stock is one they would normally expect to find from such a supplier. Repeated experiences of this type will motivate customers to become regular customers of competitors.

STEP 4: Review Stocks

Items sitting on the shelf as obsolete inventory are simply dead capital. Keeping inventory up to date and devoid of obsolete merchandise is another critical aspect of good inventory control. This is particularly important with style merchandise, but it is important with any merchandise that is turning at a lower rate than the average stock turns for that particular business. One of the important principles newer sellers frequently find difficult is the need to mark down merchandise that is not moving well.

Markups are usually highest when a new style first comes out. As the style fades, efficient sellers gradually begin to mark it down to avoid being stuck with large inventories, thus keeping inventory capital working. They will begin to mark down their inventory, take less gross margin, and return the funds to working capital rather than have their investment stand on the shelves as obsolete merchandise. Markdowns are an important part of the working capital cycle. Even though the margins on markdown sales are lower, turning these items into cash allows you to purchase other, more current goods, where you can make the margin you desire.

Keeping an inventory fresh and up to date requires constant attention by any organization, large or small. Style merchandise should be disposed of before the style fades. Fad merchandise must have its inventory levels kept in line with the passing fancy. Obsolete merchandise usually must be sold at less than normal markup or even as loss leaders where it is priced more competitively. Loss leader pricing strategies can also serve to attract more' consumer traffic for the business thus creating opportunities to sell other merchandise as well as well as the obsolete items. Technologically obsolete merchandise should normally be removed from inventory at any cost.

Stock turnover is really the way businesses make money. It is not so much the profit per unit of sale that makes money for the business, but sales on a regular basis over time that eventually results in profitability. The stock turnover rate is the rate at which the average inventory is replaced or turned over, throughout a pre-defined standard operating period, typically one year. It is generally seen as the multiple that sales represent of the average inventory for a given period of time.

Turnover averages are available for virtually any industry or business maintaining inventories and having sales. These figures act as an efficient and effective benchmark with which to compare the business in question, in order to determine its effectiveness relative to its capital investment. Too frequent inventory turns can be as great a potential problem as too few. Too frequent inventory turns may indicate the business is trying to overwork a limited capital

base, and may carry with it the attendant costs of stock-outs and unhappy and lost customers.

Stock turns or turnover, is the number of times the "average" inventory of a given product is sold annually. It is an important concept because it helps to determine what the inventory level should be to achieve or support the sales levels predicted or desired. Inventory turnover is computed by dividing the volume of goods sold by the average inventory. Stock turns or inventory turnover can be calculated by the following equations:

Stock Turn = Cost of Goods Sold

Average Inventory at Cost

Stock Turn =              Sales

Average Inventory at Sales Value

If the inventory is recorded at cost, stock turn equals cost of goods sold divided by the average inventory. If the inventory is recorded at sales value, stock turn is equal to sales divided by average inventory. Stock turns four times a year on the average for many businesses. Jewelry stores are slow, with two turns a year, and grocery stores may go up to 45 turns a year.

If the dollar value of a particular inventory compares favorably with the industry average, but the turnover of the inventory is less than the industry average, a further analysis of that inventory is needed. Is it too heavy in some areas? Are there reasons that suggest more inventories are needed in certain categories? Are there conditions peculiar to that particular firm? The point is that all markets are not uniform and circumstances may be found that will justify a variation from average figures.

In the accumulation of comparative data for any particular type of firm, a wide variation will be found for most significant statistical comparisons. Averages are just that, and often most firms in the group are somewhat different from that result. Nevertheless, they serve as very useful guides for the adequacy of industry turnover, and for other ratios as well. The important thing for each firm is to know how the firm compares with the averages and to deter- mine

whether deviations from the averages are to its benefit or disadvantage.

STEP 5: Follow-up and Control

Periodic reviews of the inventory to detect slow-moving or obsolete stock and to identify fast sellers are essential for proper inventory management. Taking regular and periodic inventories must be more than just totaling the costs. Any clerk can do the work of recording an inventory. However, it is the responsibility of key management to study the figures and review the items themselves in order to make correct decisions about the disposal, replacement, or discontinuance of different segments of the inventory base.

Just as an airline cannot make money with its airplanes on the ground, a firm cannot earn a profit in the absence of sales of goods. Keeping the inventory attractive to customers is a prime prerequisite for healthy sales. Again, the seller's inventory is usually his largest investment. It will earn profits in direct proportion to the effort and skill applied in its management.

Inventory quantities must be organized and measured carefully. Minimum stocks must be assured to prevent stock-outs or the lack of product. At the same time, they must be balanced against excessive inventory because of carrying costs. In larger retail organizations and in many manufacturing operations, purchasing has evolved as a distinct new and separate phase of management to achieve the dual objective of higher turnover and lower investment. If this type of strategy is to be utilized, however, extremely careful attention and constant review must be built into the management system in order to avoid getting caught short by unexpected changes in the larger business environment.

Caution and periodic review of reorder points and quantities are a must. Individual market size of some products can change suddenly and corrections should be made.

Inventory is Money - Introduction to Inventory Management

Introduction to Inventory Management

The term "inventory" refers to the items, goods or materials that are used by a firm for the purpose of production and sale. It also includes the items, which are used as supportive materials to facilitate production function.

There are three basic types of inventory: 

1. Raw Materials (RM)
2. Work-in-Process (WIP)
3. Finished Goods (FG)

Raw materials are the items purchased by firms for use in production of finished product. 

Work-in-progress consists of all items currently in the process of production. This includes semi-finished (SFG) goods also. These are actually partly manufactured products. 

Finished goods consists of those items, which have already been produced but not yet sold. 

Inventory constitutes one of the important items of current assets, which permits smooth operation of production and sale process of a firm. Inventory management is that aspect of current assets management, which is concerned with maintaining optimum investment in inventory and applying effective control system so as to minimize the total inventory cost.

Importance Of Inventory Management

Inventory management is important from the view point that it enables to address two important issues:

1. The firm has to maintain adequate inventory for smooth production and selling activities.

2. It has to minimize the investment in inventory to enhance firm's profitability.

Investment in inventory should neither be excessive nor inadequate. It should just be optimum. Maintaining optimum level of inventory is the main aim of inventory management.  

Excessive investment in inventory results into more cost of fund being tied up so that it reduces the profitability, inventories may be misused, lost, damaged and hold costs in terms of large space and others. At the same time, insufficient investment in inventory creates stock-out problems, interruption in production and selling operation. 

Therefore, the firm may loose the customers as they shift to the competitors. Financial manager, as he involves in inventory management, should always try to put neither excessive nor inadequate investment in inventory. 

The importance or significance of inventory management could be specified as below:

• Inventory management helps in maintaining a trade off between carrying costs and ordering costs which results into minimizing the total cost of inventory.
• Inventory management facilitates maintaining adequate inventory for smooth production and sales operations
• Inventory management avoids the stock-out problem that a firm otherwise would face in the lack of proper inventory management
• Inventory management suggests the proper inventory control system to be applied by a firm to avoid losses, damages and misuses.

***INVENTORY IS MONEY***