Introduction
Inventories, presented on a company’s statement of financial position, are classified as current assets and are an essential part of the firm’s working capital. One way to define inventory is as follows:
‘items held for sale or consumption (e.g., raw materials) during the business’ operating cycle.’
Working capital management is a vital function for any finance director or manager. Holding goods in stock has a cost, such as warehousing, handling, insurance, ordering, or delivery costs. That is why many decision models are used to manage inventories. One of the commonly used concepts is the economic order quantity (EOQ), which is described by Atrill & McLaney (2019) as [1]:
‘model [which] is concerned with determining the quantity of a particular inventory item that should be ordered each time.’
The EOQ considers two fundamental costs associated with inventory management: ordering costs and holding costs. If a business did not need stock, it would not have to pay for the storage facility or the warehouse personnel. Therefore, the fewer inventory levels a company holds, the smaller holding costs it incurs. As a result, management may decide towards ordering smaller quantities of goods needed for production on a more frequent basis. This policy, however, would increase the cost of placing an order. Essentially, the EOQ model seeks to calculate the optimum size of a purchase order to balance both of these cost elements [1]. Atrill and McLaney provide the formula for calculating the EOQ in their book Management Accounting for Decision Makers, 9th edition:
Economic Order Quantity (EOQ)
Figure 1 shows the correlation between ordering and holding costs and how they relate to the average quantity of inventories held. We can establish that the more stock is held, the higher the holding costs are (purple line) while ordering costs (dark blue line) decrease gradually. Therefore, it is fair to say that holding and ordering costs have an inverse correlation or negative relationship. As a result, the EOQ seeks to establish Point E, where ordering costs and handling costs equal each other, resulting in the lowest total cost.
Figure 1. The relationship between the ordering costs and holding costs graphically presented. Source: Atrill & McLaney (2019). Management Accounting for Decision Makers, 9th edition. Available at: https://ereader.perlego.com/1/book/810718/492
The EOQ model implies a significant assumption. That is, the stock is depleted evenly over time. In practice, many companies are likely to use the inventories either for production or direct sale in varying quantities throughout the year as the demand fluctuates. This is a case for entities selling products that tend to be more prevalent in a specific season, e.g., an ice cream manufacturer will probably sell more ice cream in the summer than in the cold winter season.
Activity 1.
Bookstar Ltd, a British publisher of academic textbooks, has a current policy to order 10,000 units when the inventory level falls to 3,500 units (known as the buffer stock). Forecast demand during the next year is 62,500 units. The cost of placing and processing an order is £125, while the cost of holding a unit in storage is £0.50 per unit per year. Both costs are expected to be constant during the next year. Orders are received two weeks after being placed with the supplier.
Number of orders per year: 62,500 / 5,590 = 11 per year
The economic order quantity model helped establish that Bookstar Ltd should place an order of 5,590 units for a particular item 11 times a year to balance the costs of ordering and holding inventories. This model, however, has several limiting assumptions that must be considered:
Proctor (2012) suggests that the EOQ is of limited practical use as any calculations of ordering and holding costs are mainly estimates and averages [2].
No buffer inventory is required when using the EOQ model. Many companies will ensure to stock some level of buffer inventory if there is a sudden or unexpected increase in demand. The lack of buffer inventory may disrupt and limit sales in a company if one runs out of its stock.
There a no discounts for bulk purchases.
As previously mentioned, the EOQ model suggests that the demand is constant over the period and does not change through seasonality. This is perhaps, the most important factor to consider when making EOQ calculations as it is unlikely for most companies to receive an even demand for their products over a period, e.g., a year.
References
[1] Atrill, P., McLaney, E. (2019). Management Accounting for Decision Makers. 9th edition. Pearson: Harlow
[2] Proctor, R. (2012). Managerial Accounting. 4th edition. Pearson. Available at: https://www.perlego.com/book/811180/managerial-accounting-pdf