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Economic Order Quantity - EOQ
What is an 'Economic Order Quantity - EOQ'
Economic order quantity (EOQ) is an equation for inventory that determines the ideal order quantity a company should purchase for its inventory given a set cost of production, demand rate and other variables. This is done to minimize variable inventory costs, and the formula takes into account storage, or holding, costs, ordering costs and shortage costs. The full equation is as follows:
where :
S = Setup costs
D = Demand rate
P = Production cost
I = Interest rate (considered an opportunity cost, so the risk-free rate can be used)
BREAKING DOWN 'Economic Order Quantity - EOQ'
The EOQ formula can be modified to determine different production levels or order interval lengths, and corporations with large supply chains and high variable costs use an algorithm in computer software to determine EOQ.
How Inventory Impacts Cash-Flow Planning
EOQ is an important tool for management to minimize the cost of inventory and the amount of cash tied up in the inventory balance. For many companies, inventory is the largest asset balance owned by the company, and these businesses must carry sufficient inventory to meet the needs of customers. If EOQ can help minimize the level of inventory, the cash savings can be used for some other business purpose.
Factoring in a Reorder Point
One component of the EOQ formula calculates a reorder point, which is a level of inventory that triggers the need to place an order for more inventory. By determining a reorder point, the business avoids running out of inventory and is able to fill all customer orders. If the company runs out of inventory, there is a shortage cost, which is the revenue lost because the company does not fill an order. Having an inventory shortage may also mean the company loses the customer or the client orders less in the future.
Example of Using EOQ
EOQ takes into account the timing of reordering, the cost incurred to place an order and costs to store merchandise. If the company is constantly placing small orders to maintain a specific inventory level, the ordering costs are higher, along with the need for additional storage space. Assume, for example, a retail clothing shop carries a line of men’s jeans and the shop sells 1,000 pairs of jeans each year. It costs the company $5 per year to hold a pair of jeans in inventory, and the fixed cost to place an order is $2. The EOQ formula is the square root of: (2 X 1,000 pairs X $2 order cost) / ($5 holding cost), or 28.284 with rounding. The ideal order size to minimize costs and meet customer demand is slightly over 28 pairs of jeans. A more complex portion of the EOQ formula provides the reorder point.
Read more: Economic Order Quantity (EOQ) http://www.investopedia.com/terms/e/economicorderquantity.asp#ixzz4wUlQm4mg
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Inventory Valuation Methods Introduction
Inventory valuation methods are used to calculate the cost of goods sold and cost of ending inventory. Following are the most widely used inventory valuation methods:
First-in-First-Out Method (FIFO)
According to FIFO, it is assumed that items from the inventory are sold in the order in which they are purchased or produced. This means that cost of older inventory is charged to cost of goods sold first and the ending inventory consists of those goods which are purchased or produced later. This is the most widely used method for inventory valuation. FIFO method is closer to actual physical flow of goods because companies normally sell goods in order in which they are purchased or produced.
Last-in-First-Out Method (LIFO)
This method of inventory valuation is exactly opposite to first-in-first-out method. Here it is assumed that newer inventory is sold first and older remains in inventory. When prices of goods increase, cost of goods sold in LIFO method is relatively higher and ending inventory balance is relatively lower. This is because the cost goods sold mostly consists of newer higher priced goods and ending inventory cost consists of older low priced items.
Average Cost Method (AVCO)
Under average cost method, weighted average cost per unit is calculated for the entire inventory on hand which is used to record cost of goods sold. Weighted average cost per unit is calculated as follows:
| Weighted Average Cost Per Unit= | Total Cost of Goods in Inventory |
| Total Units in Inventory |
The weighted average cost as calculated above is multiplied by number of units sold to get cost of goods sold and with number of units in ending inventory to obtain cost of ending inventory.
Written by Irfanullah Jan
Contract costing
Contract costing is the tracking of costs associated with a specific contract with a customer. For example, a company bids for a large construction project with a prospective customer, and the two parties agree in a contract for a certain type of reimbursement to the company. This reimbursement is based, at least in part, on the costs incurred by the company in order to fulfill the terms of the contract. The company must then track the costs associated with that contract so that it can justify its billings to the customer.
The most typical types of cost reimbursement are:
- Fixed fee. The company is paid a fixed total amount for completing the project, possibly including progress payments. Under this arrangement, the company will want to engage in contract costing to compile all of the costs relevant to the construction project, just to see if the company earned a profit on the deal.
- Cost plus. The company is reimbursed for the costs it incurred, plus a percentage profit or fixed profit. Under this arrangement, the company will be forced under the terms of the contract to track the costs related to the project, so that it can apply to the customer for reimbursement. Depending on the size of the project, the customer may send an auditor to examine the company's contract costs, and may disallow some of them.
- Time and materials. This approach is similar to the cost plus arrangement, except that the company builds a profit into its billings, rather than being awarded a specific profit. Again, the company must track all contract costs carefully, since the customer may review them in some detail.
Contract costing can involve a considerable amount of overhead allocation work. Customer contracts typically specify exactly which overhead costs can be allocated to their projects, and this calculation may vary by contract.
In some industries, such as government contracting and commercial construction, contract costing is the primary task of the accounting department, or may even be organized as an entirely separate department. Proper contract costing can contribute a considerable amount of profits, and so is typically staffed with more experienced contract managers and accountants.
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