Assistance (IAS 20)


In some situations, the unit cost of inventory is dependent upon the quantity of inventory. For example, on a bulk purchase, some quantity discount is offered. Quantity discount means that if inventory is purchased in bulk, it is available at a price lower than the normal unit price. In such cases, the cost of inventory affects the decisions regarding when and how much to order. Therefore, in quantity discount model cost of inventory is considered in the inventory models.

Ordering Cost

This is the cost associated with the placement of an order for the acquisition of inventories. The expenses, incurred in the purchase department, are its main constituents. Salary of purchase deptt., postages bills, telephone, stationary and follow-up measure by the purchase department are clubbed together to determine ordering cost.

If in case, a company is producing its own inventory rather than taking it from an outside supplier, then the cost of set-up for making one batch of product is termed as set-up cost. Set-up cost is used when inventory is made within the organization. Similarly, in case of buy situation, we use ordering cost.

Holding Cost or Carrying Cost

Holding costs are incurred due to maintaining an inventory level in the organization. It is due to interest on the held-up capital in inventory, insurance cost, rent, salaries of storage staff, obsolescence, deterioration and pilferage/theft of material, depreciation of material handling equipment, etc. Generally, carrying cost is expressed as a percentage of the inventory value.

Shortages Cost or Stock-out Cost

When there is a stock-out situation, the customer demand is not satisfied. In case of raw material/WIP shortages, the production gets disrupted. This causes loss due to emergency purchase. Unsatisfied customer results in loss of goodwill and lost-sale. The lost-sale may be due to two reasons:

1. The customer may postpone or drop the idea to purchase and

2. The customer may go to another producer of similar product/services.

Operating Policy of Inventory Control

Delivery is instantaneous. Therefore, reordering should be done just at the time inventory stock is zero. This policy has a presumption that lead time is zero. If in case, lead time is known and constant, the order should be placed exactly ahead of lead time so that the instantaneous supply of Q* arrives when the stock depletes to zero.

Sensitivity of EOQ Model

It is important to note that the total cost curve is quite flat near the EOQ zone (Fig.19.3). Slight change in the value of Q is near the EOQ point (i.e., when Q ~ Q*), the change in total cost is insignificant.

If we increase or decrease the EOQ by twice, the increase in total cost is only 25%. Thus, total cost is not very sensitive in the vicinity of EOQ. The physical significance of this observation is quite important. If there is a slight error in deciding the EOQ, the total inventory cost is insignificantly affected.

Now, let us summarize the concept of EOQ. Economic Order Quantity (EOQ) is that size of order which is able to minimize the total cost of carrying inventory and cost of ordering for a given period under the assumption of known and certain demand.

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