Practice Test on EOQ

1. Q31b – September 2016

Nesud Co has credit sales of $45 million per year and on average settles accounts with trade payables
after 60 days.

One of its suppliers has offered the company an early settlement discount of 0·5% for payment within
30 days.

Administration costs will be increased by $500 per year if the early settlement discount is taken. Nesud
Co buys components worth $1·5 million per year from this supplier.

From a different supplier, Nesud Co purchases $2·4 million per year of Component K at a price of $5 per
component.

Consumption of Component K can be assumed to be at a constant rate throughout the year. The
company orders components at the start of each month in order to meet demand and the cost of
placing each order is $248·44. The holding cost for Component K is $1·06 per unit per year.

The finance director of Nesud Co is concerned that approximately 1% of credit sales turn into
irrecoverable debts. In addition, she has been advised that customers of the company take an average
of 65 days to settle their accounts, even though Nesud Co requires settlement within 40 days.

Nesud Co finances working capital from an overdraft costing 4% per year. Assume there are 360 days in
a year.

Required:

(b) Evaluate whether Nesud Co should adopt an economic order quantity approach to ordering
Component K. (6 marks)

Required:

(b) Evaluate whether Nesud Co should adopt an economic order quantity approach to ordering
Component K. (6 marks)
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Formulae & tables

Marking guide

Annual demand = 2,400,000/5 = 480,000 units per year

Each month, Nesud Co orders 480,000/12 = 40,000 units

Current ordering cost = 12 x 248·44 = $2,981 per year

Average inventory of Component K = 40,000/2 = 20,000 units

Current holding cost = 20,000 x 1·06 = $21,200 per year

Total cost of current ordering policy = 2,981 + 21,200 = $24,181

Economic order quantity = (2 x 248·44 x 480,000/1·06)0·5 = 15,000 units per order

Number of orders per year = 480,000/15,000 = 32 orders per year

Ordering cost = 32 x 248·44 = $7,950 per year

Average inventory of Component K = 15,000/2 = 7,500 units

Holding cost = 7,500 x 1·06 = $7,950 per year

Total cost of EOQ ordering policy = 7,950 + 7,950 = $15,900

On financial grounds, Nesud Co should adopt an EOQ approach to ordering Component K as there is a
reduction in cost of $8,281.

2. Q3a – December 2013

You could see this question fully worked through if you join the classroom

C2c. Dec 13 Q3A

Plot Co sells both Product P and Product Q, with sales of both products occurring evenly throughout the
year.
Product P

The annual demand for Product P is 300,000 units and an order for new inventory is placed each month.
Each order costs $267 to place. The cost of holding Product P in inventory is 10 cents per unit per year.
Buffer inventory equal to 40% of one month’s sales is maintained.

Product Q

The annual demand for Product Q is 456,000 units per year and Plot Co buys in this product at $1 per
unit on 60 days credit. The supplier has offered an early settlement discount of 1% for settlement of
invoices within 30 days.

Other information

Plot Co finances working capital with short-term finance costing 5% per year. Assume that there are 365
days in each year.

Required:

Calculate the following values for Product P:

(i) The total cost of the current ordering policy; (3 marks)

(ii) The total cost of an ordering policy using the economic order quantity; (3 marks)
(iii) The net cost or saving of introducing an ordering policy using the economic order quantity.
(1 mark)

(i) Cost of current ordering policy

Ordering cost = 12 x 267 = $3,204 per year

Monthly order = monthly demand = 300,000/12 = 25,000 units

Buffer inventory = 25,000 x 0•4 = 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 0•1 = $2,250 per year

Total cost = 3,204 + 2,250 = $5,454 per year

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

EOQ = ((2 x 267 x 300,000)/0•10)0•5 = 40,025 or 40,000 units per order

Number of orders per year = 300,000/40,000 = 7•5 orders per year

Order cost = 7•5 x 267 = $2,003

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 0•1 = $3,000 per year

Total cost = $2,003 + $3,000 = $5,003 per year

(iii) Saving from introducing EOQ ordering policy = 5,454 – 5,003 = $451 per year