Question

What are some inventory ordering costs? Are these costs fixed or variable?

What are the components of total inventory costs?

What is the concept behind the EOQ model?

What is the relationship between total carrying costs and total ordering costs at the EOQ?

What assumptions are inherent in the EOQ model as presented in the chapter?

Answer 1

Some inventory ordering costs are expenses for a purchase order, labor costs for inspection of goods received, labor costs for placing the goods received in stock, etc. These costs are largely fixed as these costs are irrelevant with regards to size of the order and hence are incurred every time an order is placed.

There are two main components of total inventory costs – total inventory carrying costs and total ordering costs. Total inventory carrying costs = average inventory * cost of carrying per unit per annum. Total ordering cost = number of orders * ordering cost per order. Main components of inventory carrying costs are capital cost, storage space cost, inventory service cost and inventory risk cost.

The concept behind the EOQ model is that the quantity of inventory that should be ordered be such that the total cost of inventory i.e. carrying cost + ordering cost is minimized. EOQ model is based on the concept of 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. EOQ model helps in computing an appropriate level of reorder point in which it is ensured that there is instantaneous replenishment of inventory with no shortages.

The relationship between total carrying costs and total ordering costs at the EOQ is that: total carrying costs = total ordering costs.

The assumptions of EOQ model are:

• Demand is constant
• Total demand is known in advance
• Ordering cost is constant
• Unit price of inventory is constant
• Delivery time is constant