Question

ZETA Ltd is a manufacturing company that uses material QUEE in its manufacturing process. On an annual basis, ZETA Ltd uses 127,690 units of material QUEE in production. The material is bought form a wide range of suppliers at an average price of K38 per unit. Because supply for material QUEE is uncertain, ZETA Ltd maintains safety inventory that is sufficient to satisfy usage for 12 days. The material is consumed at an even rate and the cost of placing an order is K50 per order while the cost of storage is K0.10 per unit per annum. Current ordering policy Currently, the company places orders of 20,000 units each of material and this policy has been in place for over five years. However, ZETA Ltd has recruited a new Procurement Officer and a new Finance Manager who have replaced those who have now left the company. Proposal 1 The newly recruited Procurement officer has proposed to change this ordering policy to the use of the economic order quantity model. She has explained that the use of the economic order quantity model would result in some cost savings as a better order size would be used. Proposal 2 The newly recruited finance manager has information that one of the suppliers of the material has proposed to offer a quantity discount of 1.5% for orders of 50,000 units and more. The finance manager has therefore proposed that the order size should be increased to 50,000 units per order.

ZETA Ltd has a working year of 365 days.

Required:

(a) Calculate the total annual cost, including the purchase cost for:

(i) The current ordering policy (ii) The ordering policy based on proposal 1 (iii) The ordering policy based on proposal 2 [12 Marks]

(b) Based on the computations in part (a) above, explain whether ZETA Ltd should continue with the current ordering policy or should change to the ordering policy based on either proposal 1 or proposal 2. [3 Marks]

(c) Explain five (5) limitations of the economic order quantity model. [5 Marks]

[TOTAL: 20 MARKS]

Answer 1

(a)

I)

Current
Cost per Unit	38 K
Required Material	127690
Safety Stock	4198
Order Quantity	20000
Purchase Cost	5,011,745 K
Cost to place order	330 K
Holding cost	1,000 K
Total Cost	5,013,075 K

II)

EOQ (Proposal 1)
Required Material	127690
Safety Stock	4198
Ordering cost/order	50 K
Holding cost/unit	0.10 K
EOQ	11484
Average Inventory	5742
Orders per Year	11
Purchase Cost	5,011,745 K
Ordering Cost	574 K
Holding Cost	574 K
Total Cost	5,012,893 K

III)

Proposal 2
Cost per Unit	38 K
Required Material	127690
Safety Stock	4198
Order Quantity	50000
Purchase Cost	4,936,569 K
Cost to place order	132 K
Holding cost	2,500 K
Total Cost	4,939,201 K

(b)

ZETA Ltd should change the ordering policy to proposal 2 to save costs and increase profit. EOQ method reduces the holding cost but increases the ordering cost because of the increase in the number of orders.

As the supplier is willing to give a discount for orders above 50,000, it is better for the company to reduce the cost of the material by doing so. Reduction in the number of orders helps to reduce the ordering cost drastically even if the holding cost is very high. Reduction in purchase cost and ordering cost makes the 2nd proposal better.

(c)

1. Complicated Math Calculations - The EOQ model requires a good understanding of algebra, a disadvantage for small business owners lacking math skills.

2. Based on Assumptions - The EOQ model assumes steady demand of a business product and immediate availability of items to be re-stocked. It does not account for seasonal or economic fluctuations. It assumes fixed costs of inventory units, ordering charges and holding charges. This inventory model requires continuous monitoring of inventory levels.

3. EOQ orders will not meet the minimum order quantity (MOQ) requirements of your suppliers

4. EOQ assumes immediate availability of stock

5. All items in your warehouse are not of equal value - In many businesses, some items will be more profitable than others and some will cost more to sell than others. The EOQ model, however, treats all inventory items the same, regardless of their value to the business.