Compute the economic order quantity, Financial Management

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Q. Compute the economic order quantity?

TNG has a current order size of 50000 units

Average number of orders per year = demand/order size = 255380/50000 = 5·11 orders

Annual ordering cost = 5·11 * 25 = $127·75

Buffer stock held = 255380 × 28/365 = 19591 units

Average inventory held = 19591 + (50000/2) = 44591 units

Annual holding cost = 44591 × 0·1 = $4459·10

Annual cost of current ordering policy = 4459·10 + 127·75 = $4587

We need to compute the economic order quantity:

EOQ = ((2 × 255380 × 25)/0·1)0·5 = 11300 units

Average number of orders per year = 255380/11300 = 22·6 orders

Annual ordering cost = 22·6 × 25 = $565·00

Average inventory held = 19591 + (11,300/2) = 25241 units

Annual holding cost = 25241 × 0·1 = $2524·10

Annual cost of EOQ ordering policy = 2524·10 + 565·00 = $3089

Saving compared to current policy = 4587 - 3089 = $1498

(c)

Annual credit purchases = 255380 × 11 = $2809180

Current payables = 2809180 × 60/365 = $461783

Payables if discount is taken = 2809180 × 20/365 = $153928

Reduction in payables = 461,783 - 153,928 = $307,855

Finance cost increase = 307855 × 0·08 = $24628

Discount gained = 2809180 × 0·01 = $28091

Net benefit of taking discount = 28091 - 24628 = $3463

The discount is monetarily acceptable.

An alternative approach is to compute the annual percentage benefit of the discount.

This is able to be done on a simple interest basis

(1/(100 - 1)) × (365/40) = 9·2%

On the other hand the equivalent annual rate can be calculated

(100/(100 - 1))365/40 - 1 = 9·6%

Both methods point out that the annual percentage benefit is greater than the current cost of short-term debt (8%) of TNG and therefore can be recommended on financial grounds.


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