Question

Effect of management evaluation criteria on EOQ model. Computers 4 U is an online company that sells computers to individual consumers. The annual demand for one model that will be shipped from the northeast distribution center is estimated to be 500,000 computers. The ordering cost is $800 per order. The cost of carrying a computer in inventory is $50 per year, which includes $20 in opportunity cost of investment The average purchase cost of a computer is $200.

1. Compute the optimal order quantity using the EGG model.

2. Compute the number of orders per year and the annual relevant total cost of ordering and holding inventory.

3. Assume that the benchmark that is used to evaluate distribution center managers includes only the out-of-pocket costs incurred (that is, managers’ evaluations do not include the opportunity cost of investment tied up in holding inventory). If the manager makes the EGG decision based upon the benchmark, the order quantity would be calculated using a carrying costof$3onot$5G. How would this affect the EGG amount and the actual annual relevant cost of ordering and carrying inventory?

4. What will the inconsistency between the actual carrying cost and the benchmark used to evaluate managers cost the company? Why do you think the company currently excludes the opportunity costs the calculation of the benchmark? What could the company do to encourage the manager to make decisions more congruent with the goal of reducing total inventory costs?

 

Answer 1

Effect of management evaluation criteria on EOQ model

1.

 

2.

 

3.

Thus, the EOQ quantity and total relevant costs are higher if the company ignores holding costs when evaluating managers, but only by about 3%. The square root in the EOQ model reduces the sensitivity of the ordering decision to errors in parameter estimates.

 

4.         

Since managers will choose to order 5,164 computers instead of 4,000, the cost to the company will be $6, 559 ($206,559 - $200,000) higher than it would be if managers were evaluated based upon all carrying costs. Computers 4 U probably does not include the opportunity costs of carrying inventory because it is not tracked by the financial accounting system. The company could change the evaluation model to include a cost of investment in inventory. Even though this would involve an additional calculation, it would encourage managers to make optimal decisions.

Since managers will choose to order 5,164 computers instead of 4,000, the cost to the company will be $6, 559 ($206,559 - $200,000) higher than it would be if managers were evaluated based upon all carrying costs. Computers 4 U probably does not include the opportunity costs of carrying inventory because it is not tracked by the financial accounting system. The company could change the evaluation model to include a cost of investment in inventory. Even though this would involve an additional calculation, it would encourage managers to make optimal decisions.