In inventory management items often get ordered in an ‘economic’ order quantity so that the cost per item is at a minimum.
This is seen to be economic because the subsequent issue cost of the item is reduced and the business, operational or project budget therefore records a lower cost. The term ‘economic order quantity’ is often used.
This approach is not economic however in situations where the items are:
- Not used
- Are written down, or
- Where the holding cost ultimately exceeds the procurement saving.
Determining the true economic order quantity for holding inventory requires a consideration of the total company cash cost not just the departmental or project charge.
Case Study
In this manufacturing operation, it was recognized that a special widget was needed as a spare. This item needs to be made to order and the set-up costs for making the widget are such that to buy one widget would cost $2,000. However, once set up, the supplier will provide five widgets for $3,000.
If five widgets are purchased, the purchase cost is be $600 each — an apparent saving of $1,400 over the single widget cost. On the surface, it seems that buying five widgets is a much better option than buying one widget – that is the economic order quantity.
But what if the extra four widgets are not used and are written down as slow moving after, say, 4 years?
The so-called ‘economic order quantity’ approach costs the company the original $3,000 plus the annual cost of holding the extra four widgets in inventory (at a conservative 20% per year this is $2,400 x 20% x 4 years = $1,920). The total cost over the four years could be as high as $4,920.
Therefore, while the operational budget showed only a $600 expense when the first widget was issued by the storeroom, the company actually incurred a total cost of $4,920. Purchasing just a single widget would have only cost the company $2,000.
Furthermore, in the event that the $2,000 widget was thought to be too expensive, then an alternative solution might have been found.
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Posted by: Phillip Slater