Inventory control features in the syllabuses of several ACCA examination papers. The areas usually tested in these papers are:
- determining an economic order quantity (EOQ) – calculations to assess how many units of a particular inventory item to order at a time
- finding an optimal re-order level (optimal ROL) – providing some idea of the level to which inventories can be allowed to fall before placing an order for more
- discussions of various practical aspects of inventory management – often referred to by students with no practical experience as ‘theory’.
Advantages and disadvantages of holding inventory
The basis of the theoretical calculations of an EOQ and an optimal ROL is that there are advantages and disadvantages of holding inventory (of buying inventory in large or small quantities). The advantages include:
- the need to meet customer demand
- taking advantage of bulk discounts
- reducing total annual re-ordering cost
The disadvantages include:
- storage costs
- cost of capital tied up in inventory
- deterioration, obsolescence, and theft
The aim behind the calculations of EOQ and ROL is to weigh up these, and other advantages and disadvantages and to find a suitable compromise level.
When determining how much to order at a time, an organisation will recognise that:
- as order quantity rises, average inventory rises and the total annual cost of holding inventory rises
- as order quantity rises, the number of orders decreases and the total annual re-order costs decrease.
The total of annual holding and re-order costs first decreases, then increases. The point at which cost is minimised is the EOQ. This cost behaviour is illustrated by the graph in Figure 1.