Question

With the EOQ model, the holding cost ($/year/unit) can be represented by a constant value [H] or [CI] that is the purchase cost per item [C] multiple by a constant index [I] to determine the holding cost. What is the key different between them? Which is the better one? Why?

Answer 1

Economic Order Quantity (EOQ) :

EOQ is the ideal quantity which a company should purchase to minimize inventory cost such as holding cost, shortage costs and order costs. This production sheduling model was developed by S Ford.W. Harris in 1913. It is a measurement used in the field of operation, logistic and supply management. It determines the volume and frequency of orders required to satisfy a given level of demand by minimizing the cost per order.

EOQ model: It assumes that the demand is constant and that inventory is depleted at a fixed rate untill it reaches zero. At this point the inventory tries to reach its beginning level and since the model assumes instantaneous replenishment, there is no inventory shortage or associated cost. The cost of inventory under the EOQ model involves a trade off between inventory holding cost and order cost. They are of various kinds like

1. Economic Producrion Quantity(EPQ) 2. Quantity Discount Model 3. Planned Shortage with Back orders

Holding cost:

Holding cost refers to the total cost of holding inventory which includes ware housing goods, materials and supplies. It also includes rent, insurance, security and utility in case of rented space but if the space is our own then it includes building and inventory insurance, opportunity cost, depreciation and taxes. It also includes opportunity cost. The holding cost per unit is expressed as the cost per unit multiplied by the interest rate. Holding inventory has its own cost which can be in the form of direct cost incurred by financing the storage of inventory.

Purchase cost: Purchase cost is the variable cost of goods. It equals to purchse unit price multiplied by annual demand quantity. They are the costs incurred for acquiring stocks and the cost associate for the acquisition of the stock when they reach a stage for storage or operation  

Benefits of Holding cost - According to my view Holding cost is the better one and points are as under:

(1) The cost of holding stock includes the money we have spent in purchasing the stock as well as storage and insurance. The benefits include having enough stock in hand to meet the demand of customer.

(2) This can lead to increased sale, new customers, new investors, improved cash flow, increased customer confidence etc.

(3) It includes the total cost of stock like capital and opportunity cost, depreciation, rent, taxes, insurance etc

(4) It tends to increase in companies that takes advantage of volume, discount, since they buy in large quantity which can be stored for many days.

(5) The aggregate amount of holding cost is used in the EOQ calculation, which attempts to balance ordering cost and usage level to arrive at the optimam quantity of an inventory item to purchase.