Question

We are managing the inventory and one of the items is very important for us, so we have to calculate the best quantity to order. Consider following data related to this inventory item:

-      D = quantity over 1 year = 350,000 units

-      U = unit cost = 3 Euro

-      WACC = 10%

-      S = Order cost = 150 Euro

-      Orders have to contain multiples of 500 units

1.    Draw the different variable costs in a graph starting from Q = 10 to Q = 1000

2.    Calcualte the theoretical EOQ

3.    Determine the actual order quantity based on the information above

Answer 1

The different variable costs and their formula

Holding cost = HQ/2

Ordering cost = DS/Q

Here H = 0.1U

1. The graph of these values from 10 to 1000 at the interval of 50 is shown below. At this point we are ignoring the constraint of minimum order quantity of 500 units. However, the range of quantity from 10 to 1000 does not reach the EOQ level.

2. The theoretical EOQ is calculated by

EOQ = SQRT (2DS/H)

EOQ = SQRT (2*350000*150/(0.1*3)) = 18708.28 or 18708 units.

3. Now we actually cannot order 18708 units as we need to order in multiples of 500. Thus we need to consider the nearby values that are divisible by 500 and has the minimum cost. The ideal thing to do is to calculate the total variable cost at 18500 and 19000. The two nearest values that are multiples of 500. The total cost using the formulas above are

At 18500 = $5612.83

At 19000 = $5613.15

Given the slight advantage, we should select 18500 as the actual order quantity.