Question

Ewert Company sells a Product P with sales occurring evenly throughout the year. The annual demand for Product P is 300,000 units and an order for new inventory is placed each month. Each order costs KES 40,000 to place. The cost of holding Product P in inventory is KES 15 per unit per year. Buffer (safety) inventory equal to 40% of one month’s sales is maintained.

Required:

Calculate the following values for Product P:

i. The total cost of the current ordering policy.

ii. The total cost of an ordering policy using the economic order quantity.

iii. The net cost or saving of introducing an ordering policy using the economic order quantity.

Answer 1

Answer:-

(i) Cost of current ordering

Ordering cost = 12 month × Each order Cost

Ordering cost =12 × KES 40,000 = KES 480,000 per year

Monthly order = monthly demand = 300,000/12 = 25,000 units
Buffer inventory = Monthly order x 40% of one month sale

Buffer inventory = 25,000 x 40% = 10,000 units
Average inventory excluding buffer inventory = 25,000/2 = 12,500 units
Average inventory including buffer inventory = 12,500 + 10,000 = 22,500 units
Holding cost = 22,500 x KES 15 = KES 337,500 per year

Total cost = 480,000 + 337,500 = KES 817,500 per year

(ii) Cost of ordering policy using economic order quantity (EOQ)

EOQ  = ((2 × order cost × Annual demand) /cost of holding) ^0.5

EOQ =((2 x KES 40000 x 300,000)/KES 15)^0.5 = 40,000 units per order

Number of orders per year = 300,000/40,000 = 7•5 orders per year
Order cost = 7•5 x KES 40000 = KES 300,000

Average inventory excluding buffer inventory = 40,000/2 = 20,000 units
Average inventory including buffer inventory = 20,000 + 10,000 = 30,000 units
Holding cost = 30,000 x KES 15 = KES 45,000 per year

Total cost = KES 300,000 + KES 45,000 = KES 345,000 per year

(iii) Saving from introducing EOQ ordering policy = KES 817,500 – KES 345,000= KES 472,500 per year