Unit III: Management of Inventory | Financial Management & Economics Finance: CA Intermediate (Old Scheme) PDF Download

 Page 1


 
 
10.64 
FINANCIAL MANAGEMENT  
UNIT-III   
MANAGEMENT OF INVENTORY   
 10.14 INVENTORY MANAGEMENT 
Inventories constitute a major element of working capital.  It is, therefore, important 
that investment in inventory is properly controlled.  The objectives of inventory 
management are, to a great extent, similar to the objectives of cash management.  
Inventory management covers a large number of problems including fixation of 
minimum and maximum levels, determining the size of inventory to be carried, 
deciding about the issues, receipts and inspection procedures, determining the 
economic order quantity, proper storage facilities, keeping check over 
obsolescence and ensuring control over movement of inventories. 
Inventory Management have been discussed in details in chapter 2 (Material) 
Paper 3:Cost and Management Accounting. 
Some illustrations are given just for reference. 
ILLUSTRATION 12  
A company’s requirements for ten days are 6,300 units.  The ordering cost per order 
is ` 10 and the carrying cost per unit is ` 0.26. You are required to CALCULATE the 
economic order quantity. 
SOLUTION 
The economic order quantity is: 
EOQ  = 
26. 0
10 300 , 6 2 ××
= 
26. 0
000 , 26 , 1
= 700 units (approx). 
ILLUSTRATION 13  
Marvel Limited uses a large quantity of salt in its production process.  Annual 
consumption is 60,000 tonnes over a 50-week working year.  It costs ` 100 to initiate 
and process an order and delivery follow two weeks later.  Storage costs for the salt 
are estimated at ` 0.10 per tonne per annum.  The current practice is to order twice 
a year when the stock falls to 10,000 tonnes.  IDENTIFY an appropriate ordering policy 
for Marvel Limited, and contrast it with the cost of the current policy. 
 
Page 2


 
 
10.64 
FINANCIAL MANAGEMENT  
UNIT-III   
MANAGEMENT OF INVENTORY   
 10.14 INVENTORY MANAGEMENT 
Inventories constitute a major element of working capital.  It is, therefore, important 
that investment in inventory is properly controlled.  The objectives of inventory 
management are, to a great extent, similar to the objectives of cash management.  
Inventory management covers a large number of problems including fixation of 
minimum and maximum levels, determining the size of inventory to be carried, 
deciding about the issues, receipts and inspection procedures, determining the 
economic order quantity, proper storage facilities, keeping check over 
obsolescence and ensuring control over movement of inventories. 
Inventory Management have been discussed in details in chapter 2 (Material) 
Paper 3:Cost and Management Accounting. 
Some illustrations are given just for reference. 
ILLUSTRATION 12  
A company’s requirements for ten days are 6,300 units.  The ordering cost per order 
is ` 10 and the carrying cost per unit is ` 0.26. You are required to CALCULATE the 
economic order quantity. 
SOLUTION 
The economic order quantity is: 
EOQ  = 
26. 0
10 300 , 6 2 ××
= 
26. 0
000 , 26 , 1
= 700 units (approx). 
ILLUSTRATION 13  
Marvel Limited uses a large quantity of salt in its production process.  Annual 
consumption is 60,000 tonnes over a 50-week working year.  It costs ` 100 to initiate 
and process an order and delivery follow two weeks later.  Storage costs for the salt 
are estimated at ` 0.10 per tonne per annum.  The current practice is to order twice 
a year when the stock falls to 10,000 tonnes.  IDENTIFY an appropriate ordering policy 
for Marvel Limited, and contrast it with the cost of the current policy. 
 
 
 
10.65 
 
MANAGEMENT OF WORKING CAPITAL 
SOLUTION 
The recommended policy should be based on the EOQ model. 
F = ` 100 per order 
S = 60,000 tonnes per year 
H = ` 0.10 per tonne per year 
Substituting : 
2 ×100× 60,000
EOQ = 
0.10
  = 10,954 tonnes per order 
Number of orders per year   = 60,000/10,954 = 5.5 orders 
Re-order level = 2 ×60,000/50  = 2,400 tonnes 
Total cost of optimum policy  = holding costs + ordering costs 
        = (0.1 ×10954)/2 + (100 ×60,000)/10,954 
        = 547.70 + 547.74 = ` 1,095 
To compare the optimum policy with the current policy, the average level of stock 
under the current policy must be found.  An order is placed when stock falls to 
10,000 tonnes, but the lead time is two weeks.  The stock used in that time is 
(60,000 ×2)/50 = 2,400 tonnes.  Before delivery, inventory has fallen to (10,000 – 
2,400) = 7,600 tonnes.  Orders are made twice per year, and so the order size = 
60,000/2 = 30,000 tonnes.  The order will increase stock level to 30,000 + 7,600 = 
37,600 tonnes.  Hence the average stock level = 7,600 + (30,000/2) = 22,600 tonnes.  
Total costs of current policy = (0.1 ×22,600) + (100 ×2) = ` 2,460 per year. 
Advise: The recommended policy should be adopted as the costs are less than the 
current policy (by ` 1,365 per year). 
ILLUSTRATION 14  
Pureair Company is a distributor of air filters to retail stores.  It buys its filters from 
several manufacturers.  Filters are ordered in lot sizes of 1,000 and each order costs 
` 40 to place.  Demand from retail stores is 20,000 filters per month, and carrying 
cost is ` 0.10 a filter per month. 
(a) COMPUTE the optimal order quantity with respect to so many lot sizes? 
(b) CALCULATE the optimal order quantity if the carrying cost were ` 0.05 a filter 
per month? 
(c) COMPUTE the optimal order quantity if ordering costs were ` 10? 
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10.64 
FINANCIAL MANAGEMENT  
UNIT-III   
MANAGEMENT OF INVENTORY   
 10.14 INVENTORY MANAGEMENT 
Inventories constitute a major element of working capital.  It is, therefore, important 
that investment in inventory is properly controlled.  The objectives of inventory 
management are, to a great extent, similar to the objectives of cash management.  
Inventory management covers a large number of problems including fixation of 
minimum and maximum levels, determining the size of inventory to be carried, 
deciding about the issues, receipts and inspection procedures, determining the 
economic order quantity, proper storage facilities, keeping check over 
obsolescence and ensuring control over movement of inventories. 
Inventory Management have been discussed in details in chapter 2 (Material) 
Paper 3:Cost and Management Accounting. 
Some illustrations are given just for reference. 
ILLUSTRATION 12  
A company’s requirements for ten days are 6,300 units.  The ordering cost per order 
is ` 10 and the carrying cost per unit is ` 0.26. You are required to CALCULATE the 
economic order quantity. 
SOLUTION 
The economic order quantity is: 
EOQ  = 
26. 0
10 300 , 6 2 ××
= 
26. 0
000 , 26 , 1
= 700 units (approx). 
ILLUSTRATION 13  
Marvel Limited uses a large quantity of salt in its production process.  Annual 
consumption is 60,000 tonnes over a 50-week working year.  It costs ` 100 to initiate 
and process an order and delivery follow two weeks later.  Storage costs for the salt 
are estimated at ` 0.10 per tonne per annum.  The current practice is to order twice 
a year when the stock falls to 10,000 tonnes.  IDENTIFY an appropriate ordering policy 
for Marvel Limited, and contrast it with the cost of the current policy. 
 
 
 
10.65 
 
MANAGEMENT OF WORKING CAPITAL 
SOLUTION 
The recommended policy should be based on the EOQ model. 
F = ` 100 per order 
S = 60,000 tonnes per year 
H = ` 0.10 per tonne per year 
Substituting : 
2 ×100× 60,000
EOQ = 
0.10
  = 10,954 tonnes per order 
Number of orders per year   = 60,000/10,954 = 5.5 orders 
Re-order level = 2 ×60,000/50  = 2,400 tonnes 
Total cost of optimum policy  = holding costs + ordering costs 
        = (0.1 ×10954)/2 + (100 ×60,000)/10,954 
        = 547.70 + 547.74 = ` 1,095 
To compare the optimum policy with the current policy, the average level of stock 
under the current policy must be found.  An order is placed when stock falls to 
10,000 tonnes, but the lead time is two weeks.  The stock used in that time is 
(60,000 ×2)/50 = 2,400 tonnes.  Before delivery, inventory has fallen to (10,000 – 
2,400) = 7,600 tonnes.  Orders are made twice per year, and so the order size = 
60,000/2 = 30,000 tonnes.  The order will increase stock level to 30,000 + 7,600 = 
37,600 tonnes.  Hence the average stock level = 7,600 + (30,000/2) = 22,600 tonnes.  
Total costs of current policy = (0.1 ×22,600) + (100 ×2) = ` 2,460 per year. 
Advise: The recommended policy should be adopted as the costs are less than the 
current policy (by ` 1,365 per year). 
ILLUSTRATION 14  
Pureair Company is a distributor of air filters to retail stores.  It buys its filters from 
several manufacturers.  Filters are ordered in lot sizes of 1,000 and each order costs 
` 40 to place.  Demand from retail stores is 20,000 filters per month, and carrying 
cost is ` 0.10 a filter per month. 
(a) COMPUTE the optimal order quantity with respect to so many lot sizes? 
(b) CALCULATE the optimal order quantity if the carrying cost were ` 0.05 a filter 
per month? 
(c) COMPUTE the optimal order quantity if ordering costs were ` 10? 
  
 
10.66 
FINANCIAL MANAGEMENT  
SOLUTION 
(a) 4
100
2(20)(40)
 * EOQ = = 
 Carrying costs = ` 0.10 × 1,000 = ` 100.  The optimal order size would be 
4,000 filters, which represents five orders a month. 
(b) 
2(20)(40)
EOQ * = = 5.66
50
 
 Since the lot size is 1,000 filters, the company would order 6,000 filters each 
time.  The lower the carrying cost, the more important ordering costs become 
relatively, and the larger the optimal order size. 
(c) 2
100
2(20)(10)
 * EOQ = = 
 The lower the order cost, the more important carrying costs become relatively 
and the smaller the optimal order size.