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kj_nyc
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Posted: 29 Aug 2009 at 15:44 \| IP Logged

Becker Question CPA-04835

Which of the following inventory management approaches orders at the point where carrying costs equate nearest to restocking costs in order to minimize total inventory cost?

a. Economic order quantity.
b. Just-in-time.
c. Materials requirements planning.
d. ABC.

Explanation
Choice "a" is correct. The economic order quantity (EOQ) method of inventory control anticipates orders at the point where carrying costs are nearest to restocking costs. The objective of EOQ is to minimize total inventory costs. The formula for EOQ is:

E = sq root( 2*S*O / C)

E Order size (EOQ)
S Annual Sales (in units)
O Cost per Purchase Order (primarily production set-up costs)
C Carrying cost per unit

I don't understand how the formula shows that the EOQ happens at the point where carrying costs are nearest to restocking costs? Can someone please explain?

annoyings
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Posted: 30 Aug 2009 at 19:33 \| IP Logged

http://en.wikipedia.org/wiki/Economic_order_quantity

You can see a derivation of the formula there. If you have experience
with calculus, it should make some sense and perhaps bring back bad
memories. If not, it probably will not help much.

Either way, knowing where the formula comes from is beyond the
scope of the CPA exam. It is interesting, though.

kj_nyc
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Posted: 30 Aug 2009 at 22:41 \| IP Logged

Yes, I did find see that site and found a couple other sites as well - basically the formula is derived by minimizing total inventory costs (purchase, ordering and carrying costs) with respect to order quantity. I still don't see how it follows that at this minimum, carrying costs are close to restocking costs. Both are supposed to be at a minimum, but I don't see how they must be equal or close??

annoyings
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Posted: 31 Aug 2009 at 14:01 \| IP Logged

Well, I suppose finding the minimum total cost by taking the derivative,
setting it equal to zero and solving for Q is the correct way to go. When
we do this, we are finding Q such that the sum of the derivatives of
ordering and holding costs are equal to zero. This does not mean that
ordering and holding costs are equal, though.

For fun, let's take the ordering and holding costs, set them equal to zero,
and solve for Q.

CD/Q = HQ/2

2CD = HQ^2

Q^2 = 2CD/H

Q = sqrt(2CD/H)

We end up with the same formula. This implies that the quantity which
minimizes total cost also causes ordering and holding costs to be equal.

kj_nyc
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Joined: 05 Jun 2009
Location: United States
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Posted: 31 Aug 2009 at 15:38 \| IP Logged

Thanks, annoyings, that worked out very nicely!

I also got an email from someone who explained it as well, and I finally came across this course site with some useful materials
http://www.cob.sjsu.edu/devinc_w/
The chapter 19 powerpoint pp. 18-21, especially the graph on page 21, makes it very clear.

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