Executive Summary
The optimum level of parts that needs to be ordered and kept would depend upon a lot of factors – both at macro and micro levels. At the former levels, it would first be needed to assess present economic climate the industry, in which the business is passing through, whether depression, boom, recessionary or inflationary. During periods of depression and recessionary cycle, demand for goods and services get lowered, there is lesser demand and therefore, production may also suffer, since finished goods need to find markets, and not simply decay in the stores of the businesses, incurring storage and insurance costs. Further it is also seen that other macro economic factors could be seen in terms of Government policies, tax structures and tariffs, regulatory measures and market conditions, including overall demand for products. Construction industries are booming the world over, since more and more people, especially younger people, are opting to buy their own houses, rather than spend money on rented apartments. With the boom in construction industries, all ancillary industries like building materials including cement, bricks, tiles, paints and varnishes, interior decoration, etc. receive a boost.
The micro economic factors that impact upon manufacturing industries would be in terms of financial position of industry, location, track record, management profile, availability of raw materials, skilled labor and cost factors impacting upon business. Therefore, it is necessary to make a complete and comprehensive analysis of the entire costing aspects including Annual demand for products, fixed ordering costs, variable or semi-variable carrying costs, etc., before embarking on the best quantitative analysis. Economic analysis is based on assumptions which may or may not hold well in long run.
Definition
“Economic ordering quantity (EOQ) is defined as the optimal quantity of order that minimizes total variable costs required to order and hold inventory.” (Wu, 2005). Thus, it is seen that EOQ could be defined as maximum quantity of products that could be ordered within minimum variable costs at that level of ordering and holding Inventory. In other words, EOQ could be seen to be the meeting point between inventories holding & carrying costs and order processing costs.
In this case, inventory carrying costs could be fixed in nature and are as follows:
- Rates & Taxes.
- Insurance.
- Product obsolescence costs.
- Storekeeper’s salary.
- Interest costs.
- Administrative costs for holding inventories.
The aspects of semi-variable overheads in connection with inventories could be:
- Warehouse lighting and heating expenses.
- Stationery and executive costs attributable to invoice processing.
- Freight charges.
Factors or Costs
The variable expenses could be as follows:
- Ordering and requisitioning costs.
- Receiving, scrutiny and storing expenses.
- Fuel expenses on carriage.
- Defectives and losses arising in stores- spillages, damages and spoilages.
The factors that may seem important for other questions but not for this determination could be seen as:
- Dividend payouts and issue of rights or bonus shares,
- Carriage on Sales,
- Trade Discounts on Purchases,
- Selling and administrative cost factors having no relevance to Stores inventory or carrying costs,
- Returns on total assets (ROA ) and Returns on common equity holdings (ROE).
Implicit costs are Sales Taxes and Octroi Duties that form part of purchase price, Fuel charges on carriages and trade discounts which are reduced from total purchase costs.
Explicit costs are: Insurance, Obsolescence costs and storage losses that occur in stores.
Table 1: Showing Economic Analysis of Cost Factors in Eoq
Measurement
The two main elements that impinge upon economic ordering quantity, or in other words how much to buy and stock are the fixed procuring and ordering costs and also carrying inventory and. In terms of measurement the actual costs in dollar terms have to be assessed and quantified. For instance in the case of stationary costs for processing invoices, the actual amounts spend would constitute its measurement and quantifiable values. Other labor costs associated with receiving orders could be said to be like – ordering costs, freight inward charges on materials coming into stores, accepting goods into stores, arranging stacking and inspection, returning defectives, entering into Goods Received inventory and Bin Cards, stores records, etc.
Again, there are carrying costs of inventory. While stocks of raw materials, finished goods, etc, lie in stores and warehouses, they incur costs like insurance, storages costs, obsolescence, loss in values due to evaporation, (in the case of fluids ) changes in conditions caused by oxidization and exposure to heat, moisture or cold. These are valued at actual in terms of purchases costs + proportionate attributable costs.
For the economic point of view, the Economic Ordering Quantity (EOQ) could be considered to be a quantified measurement of carrying costs, inventory and demand for the product.
TOTAL COSTS = PR + CR/Q + PFQ/2
Where:
- P = Purchase cost per unit
- R = Forecasted monthly usage
- C = Fixed Cost per order
- Q = Number of units (Quantity)
- F= Annual stock holdings per year
Q = √2 CR/PF
Considering the following example where the:
- Annual Demand Forecast for Product A = 5200 Cases
- Fixed ordering costs = $10/order
- Purchase Cost per case = $2/case
- Annual Stock Holding costs=20% of value of invoice/year
- Applying the formulae Q = √2 CR/PF
Or Q = √2 (10) (5200)/ (2) (.20)
Or Q= √ 104,000/.40
Or Q = 510 cases.
Therefore, in the above case it is economically quantified that the number of units of product that need to be purchased and placed in shelf is 510 units.
However, this is based on certain assumptions that may, or may be applicable on the long run in terms of no lead time between placing of orders and receipt of goods, annual demand remaining constant throughout the year, other costs remaining constant (which may or may not remain constant due to market pressures, competition, demand and supply forces, etc ) Therefore it needs to be seen that EOQ would have to take account of impinging economic and market factors as and when they occur, without which the analysis may not be practicable applicable.
Analysis
It is now necessary to consider the following aspects also:
Opportunity costs
This would be in terms of results whether these costs could be more beneficially used for other purposes, or investments, and the comparative study of whether these costs could earn better revenues and returns if used for other opportunities
For a company, it could decide whether to invest in additional stocks, or invest the same for purchase of Plant and Machinery for enhancing production. The management needs to weigh the relative costs and benefits of each investment to arrive at a plausible decision.
Invariably, management investment decisions carry opportunity costs analysis.
Owner supplied costs
This refers to costs that inure, in the case of ownership business where certain costs are borne the owners, and not by the business as such. Thus, it could be seen that owner supplied costs technically form part of the corpus of owner and not the business entity.
Equity capital
The funds that are needed for formation and progression of the company are amassed through public issue in the case of publicly funded companies. Promoters have the option whether to go in for equity or preference issues for amassing funds for carrying on business. Equity capital carries voting rights, albeit not eligible for fixed dividends over the years of shareholdings whereas preference shareholders having fixed yearly dividend without participation in management. Equity capital is important from the economics point since Returns on Equity (ROE) holdings denotes economic health of the company and increasing ROE denotes satisfactory economic growth. Equity capital also assumed economic importance since, unlike loans and borrowings, it needs to be paid back only after the final dissolution of the company, and the company could retain equity capital till its final liquidation after all liabilities are met
Demand Supply equilibrium
It is seen in our analysis that forces of demand and supply are at the root of all economic activities. There may develop conditions under which the demand and supply forces are equal or at equilibrium, where the amount of goods being supplied is equal to its demand. Under such conditions, the suppliers are getting the right prices for their goods while buyers are getting their required products at desirable prices. Graphically represented it could be as follows:
In the case of EOQ it is assumed that the forces of demand and supply are stable in the short period and thus there are no volatile movements of prices of product(Economics Basics: Demand and supply, 2008).
Marginal Analysis
In economic parlance, the marginal cost could be seen in terms of the additional costs for producing an extra unit. While fixed costs remain constant in the short run, (they change in long run) marginal costing fluctuates with increase or decrease in level of production. In this case, if the management wish to increase the quantum of economic order quantity from present 510 units, it would be necessary to take up a marginal analysis in terms of whether the increase would be beneficial from the business economics perspective, in terms of additional savings with minimum costs. If the marginal analysis does not provide positive outcomes, it need not be applied empirically.
Summary
It is seen from the above deliberations that the decision for deciding the optimum number of units to be carried in stock is a management decision, although it would also need economic analysis for its basis and efficacy. There are several tools that guide management to enhance profits, reduce cost and render beneficial results that augur well for the future growth and development of business enterprises, especially in the present context of high competitiveness and limited resources. It is also necessary that tools could be better utilized and improved for current applications and also future forecasting. Managerial economics is the study of economics for management decision making based on assumptions and probability that may or may not hold in future. This could be vitiated by internal changes in the management structure itself, governmental policies, tax structures or a plethora of other reasons, implicit or explicit, significant or non – significant. However, it is necessary that managerial economics need to adapt to situations and make good use of potential information to chalk out a clear and cogent Plan of Action for management to pursue and promote.
While economics serves little theoretical purposes, when it is lend for managerial decision making, it is capable of providing the basis for powerful and strategic decision making based on current estimation of future forecasting and planning.
Learning
Inventory controls in manufacturing and trading organizations assume great importance since they are directly linked with profits and returns to stakeholders. The main issue would be in terms of how to get the best inventory system working for the organization with least costs and outflows. This could be done by using scientifically tested and proven tools such as EOQ. It inculcates inventory discipline and provides the management with clues on how best to use inventory resources given the fact that availability, quality and management of inventory are key issues which cannot be compromised under any circumstances.
By the application of economic tools in inventory controls combined with ABC analysis perpetual stock taking, determination of minimum, maximum and reordering levels, and exercising a strong and watchful control over inventory both quantitatively and qualitatively, it is believes that a major area of management concern could be effectively served for common benefit.
References
Wu, Sabrina. (2005). Economic Order Quantity: The definition of EOQ. 2008. Web.
Economics Basics: Demand and supply. (2008). Investopedia. Web.