9. Inventory management: using Economic Order Quantity (EOQ) analysis

Smith Limited wishes to improve its working capital management as part of an overall cost cutting strategy to increase profitability. Two areas the company has been considering are working capital funding strategy and inventory management. Smith Limited current follows a policy financing working capital needs as much as possible from long-term sources of finance, such as equity. The company has been considering its inventory management and has been looking specifically at component A.

Current position:

Smith Limited purchases 1,500,000 units of component A each year and consumes the component at a constant rate. The purchase price of component A is US. 14 per unit. The company places 12 orders each year. Inventory of component A in the financial statements of Smith Limited is equal to average inventory of component A.

The holding cost of component A, excluding finance costs is US. 0.21 per unit per year. The ordering cost of component A is US. 252 per order.

Economic order quantity (EOQ):

Smith Limited wishes to investigate whether basing ordering component A on the economic order quantity will reduce costs.

Bulk order discount:

The supplier of component A has offered Smith Limited a discount of 0.5% on the purchase price of component A provided the company orders 250,000 units per order.

Additional information:

Smith Limited has no cash but has access to short-term finance (over draft facility) at an interest cost of 3% per year. This overdraft currently stands at US. 550,000.

Required:

i). Compute the annual holding and ordering costs of Smith Limiteds current inventory management system.

ii). Show the financial effect of adopting the economic order quantity (EOQ) as the basis for ordering inventory.

iii). Show the financial effect of accepting the bulk order discount.

iv. Recommend which option should be selected by Smith Limited based on your answers in i, ii, & iii.