Other Topics in Working Capital Management
ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS
The Economic Ordering Quantity (EOQ) model combines the annual costs
associated with ordering different quantities with the annual costs of
carrying different average inventory balances.
Ordering costs decline
with larger orders, but larger orders mean larger average inventory
balances, which mean larger carrying costs.
The EOQ model finds the
optimal order size, defined as the order size that minimizes the total
annual costs of ordering and carrying inventories.
The BOC Excel model
illustrates the EOQ model.
The EOQ model operates on the premise that it is costly to place and
receive orders, that delays occur between ordering and receiving
inventories, and that it is necessary to have stocks of inventories to
avoid business stoppages.
Those conditions hold for some firms, and
for them the EOQ model makes sense as a way to think about inventory
For other firms, however, an alternative concept, the just-in-time
(JIT) procedure, is more appropriate for many firms.
JIT operates on
the theory that firms can work with their suppliers in a “supply chain”
sense so as to minimize inventory holdings at all levels of the supply
Manufacturing procedures must generally be modified to go from
an EOQ to a just-in-time framework, and manufacturers throughout the
chain must share plans and cooperate fully to derive the benefits of
Everything must function smoothly, including
the quality of parts received from suppliers, for just-in-time to work.
There are, of course, overlaps between the two approaches to
inventory management, but they really involve different mind-sets, so
they are more different than they are similar.
William Baumol modified the EOQ inventory model and applied it to cash
He treated the transactions cost of either selling
marketable securities or borrowing to replenish the cash balance as
ordering costs in an EOQ sense, and in his model the income lost by
holding non-earning or low-earning cash balances is equivalent to EOQ
Baumol’s approach had much to recommend it in the pre-computer days,
but today sophisticated treasurers use electronic methods to move money
around, to borrow with extremely low transactions costs on an almost
real-time basis, and to sell securities with low costs and on short
Cash management has moved beyond EOQ and the Baumol model.
Inventories used must be charged to cost of goods sold, which is
subtracted from sales to produce gross operating profit.
primary methods used to value inventory are these:
identification, where each item’s cost is recorded and used as the cost
Answers and Solutions:
22 - 1