Question

QUESTION 3

HIT Co demands 120,000 units of cogs a year. Every month, the company pays £200 to place an order with its supplier. Each cog costs £7.50 and the annual holding cost is £1.00 per unit. The company maintains a buffer stock of cogs, which is sufficient to meet demand for 10 working days.

Required:

a) What is the annual cost of inventory for HIT under the current ordering policy?

b) Ignoring the bulk discount, what is the optimal ordering policy? Evaluate the net benefit if it is adopted.

c) This year, the supplier informs HIT that there is a discount of 3.6% on orders of 30,000 units or more. If HIT orders that much, there is no need for holding buffer inventory any more but the annual holding cost per unit will increase to £2.20. Should the company accept the bulk purchase discount? Explain your answer using numerical evidence.

d) As a small business, HIT uses Baumol model to manage cash. Define Baumol model and explain the benefits and limitations of using the model for cash management purpose.

Answer 1

(a) Annual cost of inventory for HIT under the current ordering policy

Total Inventory Cost is the sum of the carrying cost and the ordering cost of inventory.

  

where,

C =Carrying cost per unit per year = £ 1
Q =Quantity of each order =  120,000 /12 = 10,000 units
F =Fixed cost per order = £ 200
D =Demand in units per year = 120,000

Therefore Annual cost of inventory = £ 7400

Here it is assumed that the inventory level is maintained throughout the year.

(b) Economic Order Quantity

Economic order quantity (EOQ) is the ideal order quantity a company should purchase to minimize inventory costs such as holding costs, shortage costs, and order costs.

D = 120,000 units

S = £ 200 per order

H = £ 1

therefore economic/ optimal order quantity = 6928 units

Net benefit if it is adopted = Annual cost of inventory would be reduced to £ 6928

(c) Should the company accept the bulk purchase discount

Situation 1 : ( current ordering policy)

Annual Cost of inventory = £ 7400

Material Cost per annum = 7.5 * 120,000 = 9,00,000

So total cost = £ 9,07,400

Situation 2 : (if the company accept the bulk purchase discount)

Annual Cost of inventory = 2.2*(30,000/2) + 200*(120,000/30,000) = £ 33,800

Material Cost per annum = (7.5 - 0.27) * 120,000 = 8,67,600

So total cost = £ 9,01,400

So from the above calculations it is clear that the company should accept the bulk purchase discount and save £ 6000

(d) Baumol model for managing cash

Baumol model of cash management trades off between opportunity cost or carrying cost or holding cost & the transaction cost Most firms try to minimise the sum of the cost of holding cash and the cost of converting marketable securities to cash. Baumol’s cash management model helps in determining a firm’s optimum cash balance under certainty. As per the model, cash and inventory management problems are one and the same.

There are certain assumptions that are made in the model. They are as follows:

1. The firm is able to forecast its cash requirements with certainty and receive a specific amount at regular intervals.

2. The firm’s cash payments occur uniformly over a period of time i.e. a steady rate of cash outflows.

3. The opportunity cost of holding cash is known and does not change over time. Cash holdings incur an opportunity cost in the form of opportunity foregone.

4. The firm will incur the same transaction cost whenever it converts securities to cash. Each transaction incurs a fixed and variable cost.

Benifits of the Baumol model

The Baumol model enables companies to find out their desirable level of cash balance under certainty.

Limitations of the Baumol model

1. It does not allow cash flows to fluctuate.

2. Overdraft is not considered.

3. There are uncertainties in the pattern of future cash flows.