FM – May 2021 – L2 – Q5a – Inventory Management

Calculate the Economic Order Quantity (EOQ) and related inventory costs for Adom Furniture Ltd.

Question

a) Adom Furniture Ltd is a reputable producer of office desks. A key material that is used in the production of office desks is processed wood boards. The company produces 200,000 units of office desks annually. The production of one unit of office desk requires three units of the processed wood board. The current production level and requirements will apply going forward.

Currently, the company buys 100,000 units of the processed wood board whenever it runs out of wood. The cost price of a processed wood board is GH¢120. It costs GH¢1,000 to place an order to replenish the inventory of processed wood board. On average, it costs GH¢10 to hold one processed wood board per annum.

The company has been financing each round of inventory purchase with short-term borrowing from a bank. The loan is typically granted for three months at an annual nominal interest rate of 24%. The bank charges a loan processing fee of 1.5% of the principal, which is paid upfront. The local distributor of the processed wood board is now willing to sell the product on credit terms 2/10 net 30.

Required:

i) Compute the optimal quantity of the processed wood board the company should order whenever it places an order. (3 marks)

ii) Compute the optimal number of orders to place. (2 marks)

iii) Compute the average costs associated with the current purchase plan of 100,000 units per order and the cost if the optimal quantity is ordered instead. (4 marks)

Answer

i) Computation of the Optimal Quantity (Economic Order Quantity – EOQ):

Where:

$D$ = Annual demand = 200,000 x 3 = 600,000 units
$C_0$ = Ordering cost = GH¢1,000
$C_H$ = Holding cost = GH¢10
This means the company should order 10,954 units to minimize costs associated with inventory.(3 marks)
ii) Computation of the Optimal Number of Orders:

(2 marks)

iii) Computation of Average Inventory Costs:

For the current purchase plan (100,000 units per order):

For the optimal order quantity (10,954 units per order):

Thus, the company would save costs by ordering the optimal quantity.

(4 marks)