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CORPORATE FINANCE

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ABHIJEET CHANDRA
Vinod Gupta School of Management, IIT KHARAGPUR

Lecture 31: Inventory Management - II

CONCEPTS COVERED

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⮚ Order Quantity Problem in Inventory Management

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⮚ Economic Order Quantity (EOQ)

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Inventory Management
Benefits of Holding Inventory
• Stock-outs: the situation that occurs when a firm runs out of inventory. It may lead
to production delays and lost sales. To avoid this, maintain inventory.
• Manage seasonality in demand and supply: customers’ purchases might not match
the production cycles and availability of materials through suppliers. To keep it as

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little uncertain as possible, it is better to have sufficient inventory.

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Alternative approach to hold inventory:

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• Just-in-time (JIT) inventory management: when a firm acquires inventory precisely
when it is needed. In this case, the inventory balance is always (close to) zero.

• How much should we order, in general, if we do not follow JIT?

EOQ: How Much to Order?
• The optimal order quantity for a particular item of inventory, given its forecast
usage, ordering cost, and carrying cost.
• Ordering costs: requisitioning, order placing, transportation, receiving,
inspecting
and storing, administration (constant/mixed).

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• Carrying costs: warehousing, handling, clerical and staff, insurance, depreciation
and obsolescence (varying).

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• Ordering can mean either the purchase of the item or its production.

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EOQ
Minimization of Costs
Total costs

Carrying and shortage costs

Trade-off between Shortage costs
the costs that rise
with the level of CA Carrying costs
(i.e., Carrying
Costs) and the
costs that fall with

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the level of CA
(i.e., Shortage

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Costs)

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CA* Level of CA
EOQ: Assumptions
• Annual consumption of an item known with certainty,
• The rate of usage of an inventory steady over time,
• The order placed to replenish the stocks received at exactly that point in time

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when ‘inventory = 0’.

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• Ordering and carrying costs constant (i.e., do not change frequently).

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EOQ: Derivation
• If usage of an inventory item is at a steady rate over a period of time and there is no
𝑸
safety stock, average inventory (in units) can be expressed as:
𝟐
• Average inventory =

� +
Total inventory costs are the sum of the total carrying costs plus total ordering costs:
�
•
�

= 𝑪the first derivative of above𝟐 equation

𝑶 � with respect to Q and setting the result
• Total inventory cost (T ) �
• Taking

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𝝏𝑻 𝑪
�
equal to zero, we obtain:

𝑺 −𝑶

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=𝟎 𝑸
• Now, solving for Q, we get: 𝝏𝑸 = 𝟐

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𝟐
𝑺
𝑶
𝑸𝟐 𝑪
�
= 𝟐𝑶
𝑸𝟐 = 𝟐𝑶𝑺
𝑸∗ 𝑺�
�
�
=
, then, the optimal quantity
� �
Economic Order Quantity
2(O )
EOQ =
( S )C

• Where,

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• O: ordering costs per order,
S: total usage (in units) of an item of inventory

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•
• C: carrying costs per unit

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EOQ: Graphical representation

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Illustrative Example: EOQ
• The usage of an inventory item is 2,000 during a 100-day planning period,
ordering costs are $100 per order, and carrying costs are $10 per unit per
100 days.
• The EOQ amount, then, is: …….??

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PT
2($100)(2,000)
EOQ =
$10

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• EOQ = 200 units
• With an order quantity of 200 units, the firm would order
(2,000/200) = 10 times during the period under consideration or,
in other words, every 10 days.
Illustrative Example: EOQ
A firm’s inventory planning period is one year. Its inventory requirement for the
period is 1,600 units. Assume that its acquisition costs are Rs. 50 per order. The
carrying costs are expected to be Re. 1 per unit per year for an item.
The firm can produce inventories in various lots as follows:

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• 1,600 units
• 800 units

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• 400 units
• 200 units

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• 100 units
Which of these order quantities is the EOQ?
Illustrative Example: EOQ
(1) (2) (3) (4) (5) (6)
Size of order 1,600 800 400 200 100
(units)
No. of orders 1 2 4 8 16
Cost per order 50 50 50 50 50
(Rs.)
Total ordering 50 100 200 400 800

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costs (Rs.)

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Carrying cost per 1 1 1 1 1
unit (Rs.)

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Avg. inventory 800 400 200 100 50
(Units)
Total carrying 800 400 200 100 50
costs (Rs.)
Total costs (Rs) 850 500 400 500 850
CONCLUSION

• One of the core issues inventory management deals with is how much to
order so that the costs can be minimized.

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• The costs include ordering costs and carrying costs.

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• Economic order quantity addresses the problem of the optimal order quantity
where the total costs of ordering and carrying is minimum.

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REFERENCES

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⮚ Corporate Finance, 2nd ed. (2012), Clayman et al. Wiley

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⮚ Financial Management, 14th ed (2021), Pandey, Pearson

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