MBAFT-6205: MANAGEMENT ACCOUNTING
UNIT-I:
MATERIAL COST
Dr. Vinod Kumar
Assistant Professor
Department of Commerce
Sri Venkateswara College
University of Delhi
E-mail Id: drvinod@svc.ac.in
STRUCTURE
1.1 Economic Order Quantity (EOQ)
1.1 Economic Order Quantity
EOQ: It refers to the size of the order which gives maximum economy in purchasing any
material. It is also referred as optimum or standard ordering quantity. It is fixed mainly after
taking into consideration the following costs:
1. Ordering cost: It is the cost of placing an order and securing the supplies. It varies
from time to time depending upon the number of orders placed and the number of items
ordered. The more frequently the orders are placed, and fewer the quantities purchased
on each order, the greater will be the ordering cost and vice versa. It is also known as
“cost of acquiring” inventory.
2. Inventory carrying cost: It is the cost of keeping items in stock. It includes interest on
investment, obsolescence losses, store keeping cost, insurance premium etc. The large
the volume of inventory, the higher will be the inventory carrying cost and vice versa. It
is also known as “cost of holding” inventory.
The cost of acquiring decreases while the cost of holding increases with every increase in the
quantity of purchase lot. A balance is found between two opposing factors and the economic
ordering quantity is determined at a level for which the aggregate of acquiring and holding
costs is the minimum.
The formula of EOQ is:
EOQ = √
1|Page
MBA
A = Annual consumption in units
B = ordering cost or cost of placing an order
C = carrying cost or annual cost of storage of one unit
Question: 1
A, a refrigerator manufacturer purchases 1,600 units of certain component from B. His annual
usage is 1,600 units. The order placing cost is ₹100 and the cost of carrying one unit for a
year is ₹8. Calculate the EOQ, number of orders, time intervals between two orders in a year
and tabulate results.
Solution
EOQ = √
EOQ = √ = 200 units
Annual Orders per Units per Order Average Carrying Total
demand year order placing cost inventory in costs (₹) annual cost
(₹) units (50%
of order
placed)
1600 units 1 1600 100 800 6400 6500
2 800 200 400 3200 3400
3 533 300 267 2136 2436
4 400 400 200 1600 2000
5 320 500 160 1280 1780
6 267 600 134 1072 1672
7 229 700 115 920 1620
8 200 800 100 800 1600
9 178 900 89 712 1612
10 160 1000 80 640 1640
The above table shows that total cost is the minimum when each order is of 200 units.
Therefore, EOQ is 200 units only. Numbers of orders in a year will be 8. The time interval
between two orders will be 12/8 = 1.5 months.
2|Page
MBAFT-6205: MANAGEMENT ACCOUNTING
Question 2
The following information relating to a type of raw material is available:
Annual demand 2400 units
Unit price ₹2.40
Ordering cost per order ₹4
Storage cost 2% p.a.
Interest rate 10% p.a.
Calculate the EOQ.
Solution:
A = 2400 units; B = ₹4; C = 2% + 10% = 12% (0.12×₹2.40) = ₹0.288
The formula of EOQ is:
EOQ = √ = 258 units
Question 3
Your factory buys and uses a component for production at ₹10 per unit. Annual requirement
is 20,000 units. Carrying cost of inventory is 10% per annum and ordering cost is ₹400 per
order. The purchase manager argues that as the ordering cost is high it is advantageous to
place a single order for the entire annual requirement. He also says that if we order 20,000
units at a time we can get 3% discount from the supplier. Evaluate this proposal and make
your recommendations.
Solution:
The formula of EOQ is:
EOQ = √ = 4000 units
No. of orders per annum = 20000/4000 = 5
3|Page
MBA
Total cost at EOQ:
Purchase cost 20000×₹10 ₹2,00,000
Ordering cost 5×₹400 ₹2,000
Carrying cost [(4000/2)×1(i.e.10% of ₹10) ₹2,000
Total cost ₹2,04,000
Total cost of buying in one order of 20,000 units
Purchase cost (20,000×10‒3%) ₹1,94,000
Ordering cost for one order ₹400
Carrying cost [(20,000/2)×9.7×10%] ₹9,700
Total cost ₹2,04,100
As the total cost of buying in EOQ is less than of buying in one order, it is recommended to
buy in EOQ.
Question 4
JP limited manufacturers of a special product, follows the policy of EOQ (Economic Order
Quantity) for one of its components. The component’s details are as follows:
Purchase price per component : ₹200
Annual cost of carrying unit in inventory : 10% of purchase price
Total cost of inventory and ordering p.a. : ₹4000
The company has been offered a discount of 2% on the price of the component provided the
lot size is 2,000 components at a time.
You are required to:
(a) Compute the EOQ.
(b) Advise whether the quantity discount offer can be accepted. [Assume that the
inventory carrying cost does not vary according to discount policy].
(c) Would your advice differ if the company is offered 5% discount on a single order?
Solution:
(a) Computation of EOQ
In order to compute EOQ we need the figure of total annual usage of inventory. This can be
done through the following equation:
Total cost = √
4|Page
MBAFT-6205: MANAGEMENT ACCOUNTING
Annual usage = A; Cost of an order (B) = ₹100; Carrying cost of one unit of inventory (C) =
₹20
₹4000 = √
₹4000 = √
4000 A = 1,60,00,000
A = 1,60,00,000/4000
A = 4000 (Annual consumption is 4,000 units).
The formula of EOQ is:
EOQ = √ = 200 units
(b) Discount offer:
When order size is 2,000 units; the No. of orders per annum = 4000/2000 = 2
If a discount of 2% on the price of the component is available if an order in the lot size of
2,000 components is given, the total cost shall be:
Storage cost [(2000/2)×₹20] = ₹20000
Ordering cost (2×₹100) = ₹200
Total = ₹20200
Less; savings on account of discount (4000×200×2/100) = ₹16000
Net cost = ₹4,200
Since the net cost of ₹4,200 is more than the present cost of ₹4,000, this offer should not be
accepted.
(c) Discount offer on a single order of 4,000 components:
The total cost shall be:
Storage cost [(4000/2)×₹20] = ₹40000
Ordering cost (1×₹100) = ₹100
Total = ₹40100
Less; savings on account of discount (4000×200×5/100) = ₹40000
Net cost = ₹100
5|Page
MBA
Since the net cost of ₹100 is much less than the present cost of ₹4,000, this offer should be
accepted.
Example 5
Blacksmith Co. buys in lots of 125 boxes which is a three month’s supply. The cost per box is
₹125 and the ordering cost is ₹250 per order. The inventory carrying cost is estimated at 20%
of unit value per annum. You are required to ascertain:
(i) The total annual cost of existing inventory policy?
(ii) How much money would be saved by employing the economic order quantity?
Solution:
(i) Total annual cost under existing inventory policy
Total cost = (no. of boxes in a year × cost per box) + ordering cost + carrying cost
Total cost = (125×4×₹125) + (250×4) + [(125/2)×₹125×20/100]
Total cost = 62500 + 1000 + 1562.5
Total cost = ₹65,062.50
(ii) Total cost by adopting EOQ
( )
EOQ = √ = 100 units
Total cost = (125×4×₹125) + (250×5) + [(100/2)×₹125×20/100]
Total cost = 62500 + 1250 + 1250
Total cost = ₹65,000
6|Page
