MAC3701 Application Of Management Accounting Techniques SUMMARY STUDY NOTES 2022. STUDY UNIT 1 PLANNING AND CONTROLLING INVENTORY
Cost of holding inventory is expensive –
capital is needed to create suitable infrastructure (factory, staff, computers, stationery etc)
and cash flow also needed f...
Cost of holding inventory is expensive –
capital is needed to create suitable infrastructure (factory, staff, computers, stationery etc)
and cash flow also needed for operational activities of entity. Investment in inventory and
inventory infrastructure is committed fixed costs which are managed over medium to long-
term.
Because of high costs and risks of holding inventory entity should keep inventory levels as
low as possible – also because any stock item has to be paid for.
Inventory Control
Basic Objective of inventory control is to release capital for more productive use.
For every type of item held in inventory, two questions must be asked:
1. When to order (When should a replenishment order be placed)
2. How much to order (what is the order quantity Q)?
Total cost = Purchase + Ordering + Carrying + Shortage
2. Demand
Customer's demand, size of demand, rate of demand and pattern of demand is
important
Size of demand = no. of items demanded per period
Can be deterministic (Static or dynamic) or probabilistic (governed by discrete
or continuous probability distribution)
The rate of demand can be variable or constant
Pattern reflects items drawn from inventory -instantaneous (at beginning or
end) or gradually at uniform rate
, 3. Order Cycle
The time period between placements of two orders having two types of review
systems:
Continuous review
Periodic review
4. Time Horizon
The period over which inventory level will be controlled ...can be finite or
infinite.
5. Lead Time
The time between ordering a replenishment and receiving into inventory ...can
be deterministic- constant or variable or probabilistic
6. Stock Replenishment
The rate at which items are added to the inventory... an be instantaneous or
uniform rate
Economic Order Quantity
The economic order quantity (EOQ) is the quantity that minimizes the sum of these two costs.
It is based on the following assumptions:
1. The demand for the item is constant and known with certainty.
2. There are no upper or lower limits on the order quantity (lot size).
3. Stockouts are not permitted.
4. There are no quantity discounts.
5. Lead time and supply are known with certainty; lead time is constant.
6. Order quantities for individual items are made independently.
If we define
C - total annual (period) cost
S - fixed cost of placing an order
D - annual (period) demand
H - annual (period) unit cost of holding inventory
2SD
EOQ
H
Answers the question “how much to order”
Example
ABC Ltd. is engaged in sale of footballs. Its cost per order is $400 and its carrying cost unit is
$10 per unit per annum. The company has a demand for 20,000 units per year. Calculated
the order size, total orders required during a year, total carrying cost and total ordering cost
for the year.
Solution
EOQ = SQRT(2 × 20,000 × 400/10) = 1,265 units
Annual demand is 20,000 units so the company will have to place 16 orders (= annual
demand of 20,000 divided by order size of 1,265). Total ordering cost is hence $64,000 ($400
multiplied by 16).
Average inventory held is 632.5 ((0+1,265)/2) which means total carrying costs of $6,325 (i.e.
632.5 × $10).
The EOQ is used as part of a 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. The EOQ provides a model for calculating s the
appropriate reorder point and the optimal reorder quantity to ensure the instantaneous
replenishment of inventory with no shortages. It can be a valuable tool for small business
owners who need to make decisions about how much inventory to keep on hand, how many
items to order each time, and how often to reorder to incur the lowest possible costs.
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