Question

Discuss the concept of Economic Order Quantity? If a company has too many items in inventory, how would this affect its cash flow. What are some of the ways you would maintain an efficient inventory without running out of items for your customers?

Answer 1

1. Economic Order Quantity -

The purpose of Economic Order Quantity is to minimize the costs associated with ordering and holding inventory to the least. To achieve this purpose, concept of Economic Order Quantity was developed. So basically, Economic Order Quantity is that quantity of inventory ordered which is optimal in terms of least cost of ordering and holding.

It is seen that sometimes, when inventory is ordered in bulk, due to discount offered by vendor, the acquisition cost per order is reduced. But that may lead to more holding cost. So by using Economic Order Quantity concept, optimum quantity of inventory to be ordered can be found out that would minimize the ordering and holding cost.

2. If a company has too many items in inventory, the first major disadvantage is that holding cost of inventory is increased, especially when there is no sales or very less sales.

Another problem is when too much inventory is purchased, a huge amount of cash is blocked, which results in non payment of certain necessary expenses like rent, loan interest etc.

In holding excess inventory, additional costs are also incurred , such as extra transportation, extra rent etc..

3. Some of the ways to maintain an efficient inventory without running out of items for customers -

(A) Conduct research for the recent trends and demand for products. Examine whether according to trend and demand, how much inventory is already available, and how much to be ordered.

(B) Type of inventory is another factor to be checked. For example, in case of FMCG goods, not much inventory should be maintained. And in case of goods which are of daily necessities like toothbrush, comb, high quantity of inventory can be maintained.

(C) To maintain coordination between inventory department and purchase department. Whenever a little inventory is left, inventory department should inform purchase department so that order can be placed on time before no inventory is left.

(D) Introducing softwares that would perform the task of analysing the need for optimum inventory would be very helpful in efficient maintainence of inventory and would also reduce any chance of human errors.

(E) Based on past experience and records, best supplier should be selected based on supplier's price, delivery time, discount offered. No time should be wasted on selecting supplier every year.

(F) Performing audit procedures on inventory management would also help to know whether efficient and effective inventory management policy exists and inventory is maintained adequately.