BM1913

INVENTORY PLANNING AND CONTROL

Independent vs. Dependent Demand Inventory

Inventory is literally defined as a stock of goods which a business manages to produce products or perform
services. The two (2) general categories of inventory are as follows (Myerson, 2015):
• Dependent demand. This is represented by an item whose demand is linked directly to the
demand or production level of another item. An example of dependent demand inventory
requirements would be tires that go on a bike; the production of one (1) bicycle would require
two (2) tires of a specific size, and thus the demand for the tires is dependent on the number of
bicycles being produced.
• Independent demand. This refers to the inventory requirement for finished goods or a product
available for customers’ consumption or use. An example of independent demand inventory is a
bicycle ready for sale in the market.

Types of Inventory
The four (4) major types of inventory are as follows (Myerson, 2015):
1. Raw materials and components. These are made up of the resources a business uses to produce
its own goods. This category also includes goods used in the manufacturing process, such as
components used to assemble a finished product. For example, the major raw materials needed
to complete a bike are brakes, cables, wheels, tires, and the bike frame.
2. Work in process (WIP). These are materials and parts that have been partially transformed from
raw materials but are not yet finished goods and can include partially assembled items that are
waiting to be completed. For example, a complete bike structure with no brake cables is still
considered as WIP.
3. Finished goods. These are products that are ready to be shipped directly to customers, including
wholesalers and retailers. For example, after adding brake cables to a bike, it can now be
considered as a finished product ready for delivery to the market.
4. Maintenance, repair, and operations (MRO). These are items a business needs to operate, such
as office equipment, packing boxes, and tools and parts to repair equipment. For example,
repairing a bike requires tools such as screwdrivers and pliers.

Costs of Inventory
The following are the different types of costs associated with inventory (Myerson, 2015):
• Carrying costs. These are also known as holding costs. These are costs involved in the acquisition
and storage of inventory items. The components of holding costs are as follows:
o Capital or opportunity cost. The value of this cost depends on current interest rates which
can range from 5% to 25%. Money used to purchase inventory items can be derived from
borrowed capital and internal sources. Capital cost is derived from the interest rates of
borrowed finances while opportunity cost is derived from the return that a money would
generate if it is invested in other things. For instance, the money used to purchase
inventory items would generate a return by investing in facility expansion or equipment
purchase.
o Physical space occupied by the inventory. The value of this cost ranges from 3% to 10%.
This includes building rent or depreciation, utility costs, insurance, and taxes among
others.

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o Handling of inventory. The value of this cost ranges from 4% to 10%. This includes
equipment lease or depreciation, power, and operating costs.
o Pilferage and scrap. The value of this cost ranges from 2% to 5%. The longer the period
an inventory item is stored in the warehouse, the greater the costs associated with
deterioration or obsolescence.

• Ordering costs. These include fixed and variable costs associated with placing an order to
purchase additional inventory. Fixed costs are expenses that are independent of output and are
incurred no matter what, such as rent, building, and machinery among others. Variable costs, on
the other hand, are expenses that vary with output. Generally variable costs increase at a constant
rate relative to number of units produced for manufacturing companies or volume of services
rendered for service-oriented firms. Variable costs may include wages, utilities, and materials
used in production among others. Variable costs associated with purchase orders include
preparing a purchase request, creating the purchase order itself, reviewing inventory levels,
receiving and checking items as they are received from the vendor, and the costs to prepare and
process payments to the vendor when the invoice is received.
• Setup costs. These are costs associated with changing production over, known as setup, which
includes labor and parts as well as downtime. Setup costs involve both fixed and variable costs.
The fixed costs of setups include the capital equipment used in changing over the production line.
The variable costs include the employee costs for any consumable material used in the teardown
and setup. The longer the setup takes, the greater the variable costs.

Economic Order Quantity (EOQ) Model

Economic Order Quantity (EOQ) Model minimizes total inventory costs by optimizing the tradeoffs
between holding and ordering costs. It is the optimal inventory size that should be ordered with the
supplier to minimize the total annual inventory cost of the business. Other names used for economic order
quantity are optimal order size and optimal order quantity (Accounting Information Management, n.d.).

EOQ is established under the following assumptions: ordering cost is constant; rate of demand is known
and spread evenly; lead time is known and fixed; purchase price of the item is constant; replenishment is
made instantaneously; and the entire order is delivered at one time (Myerson, 2015). Rate of demand is
the number of units requested by a customer in a particular time period. Lead time is the period between
the initiation and completion of a production process.

The formula for computing EOQ is:

2𝐷𝐷𝐷𝐷
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄 (𝐸𝐸𝐸𝐸𝐸𝐸) = �
𝐻𝐻
Where:
D - Annual demand in units for the inventory item
S - Setup or ordering cost for each order
H - Holding or carrying cost per unit per year

ILLUSTRATION: Montgomery Corp. desires to determine the optimal order quantity for zippers used in the
production of their famous leather bags. The annual demand for their bags is 80,000 units, cost to place
an order is P1,200, cost per unit is P50, and carrying cost is 6% of unit cost. Find the EOQ, number of orders
per year, ordering cost and carrying cost, and total cost of inventory.

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SOLUTION:
1. Economic Order Quantity (EOQ)

2(80,000)(𝑃𝑃1,200) 𝑃𝑃192,000,000
𝑬𝑬𝑬𝑬𝑬𝑬 = � =� = �64,000,000 = 𝟖𝟖, 𝟎𝟎𝟎𝟎𝟎𝟎
𝑃𝑃50 × 6% 𝑃𝑃3

KEY POINTS: The optimum inventory size that should be ordered by Montgomery Corp. to
minimize the total annual inventory cost of their business is 8,000 units of zippers.

2. 𝑵𝑵𝑵𝑵. 𝒐𝒐𝒐𝒐 𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐 𝒑𝒑𝒑𝒑𝒑𝒑 𝒚𝒚𝒚𝒚𝒚𝒚𝒚𝒚 = 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑⁄𝐸𝐸𝐸𝐸𝐸𝐸 = 80,000⁄8,000 = 𝟏𝟏𝟏𝟏

KEY POINTS: Montgomery Corp. must order zippers 10 times per year.

3. 𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 = 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 × 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑝𝑝𝑝𝑝𝑝𝑝 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦
= 𝑃𝑃1,200 × 10 = 𝑷𝑷𝑷𝑷𝑷𝑷, 𝟎𝟎𝟎𝟎𝟎𝟎
KEY POINTS: Montgomery Corp. has a total ordering cost of P12,000 in a year.

4. 𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 = 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 × 𝐸𝐸𝐸𝐸𝐸𝐸/2

= 𝑃𝑃3 × 8,000/2 = 𝑷𝑷𝑷𝑷𝑷𝑷, 𝟎𝟎𝟎𝟎𝟎𝟎
KEY POINTS: Montgomery Corp. has a total carrying cost of P12,000 in a year.

5. 𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 = 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 + 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐

= 𝑃𝑃12,000 + 𝑃𝑃12,000 = 𝑷𝑷𝑷𝑷𝑷𝑷, 𝟎𝟎𝟎𝟎𝟎𝟎
KEY POINTS: Montgomery Corp. will incur a total inventory cost of P24,000 in a year.

References
Accounting Information Management (n.d.). Economic order quantity (EOQ). Retrieved September 9,
2019, from https://www.accountingformanagement.org/economic-order-quantity
Myerson, P. (2015). Supply chain and logistics management made easy: Methods and applications for
planning, operations, integration, control and improvement, and network design. United States:
Pearson Education, Inc.

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