Question

Why are safety stocks required?

Conceptually, how would you evaluate a quantity discount offer from a supplier?

What effect does inflation typically have on the EOQ?

Can the EOQ model be used when a company faces seasonal demand fluctuations? Explain.

What effect do minor deviations from the EOQ have on total inventory cost?

Answer 1

(a) Safety stock level is required to be maintained by every manufacturer because if the production has to be paused because of lack of raw material to the production department involves a very high cost and also hurts the reputation of the company in the market if company fails to fulfill its commitments in the market. Moreover, it is quiet difficult to predict with 100.% certainty the amount of stock that will be needed. The manufacturers have also to protect themselves against unforeseen events such as spikes in demand or supply shortages.Therefore, in order to avoid such situations, every manufacturer maintains a minimum stock safety level.

(b) Quantity discounts offered by a supplier will reduce per unit cost of material resulting in reduced carrying cost per unit of material. This will in turn increase the EOQ to be ordered from the supplier and can also impact the Ordering Cost if the discount is offered on quantities increased from the current level of EOQ. On the other side, it will also be reducing the total purchase cost of the material. Hence, to evaluate the overall effect of the discount offered, impact on total inventory cost before offering discount and after discount should be computed to analyse the overall impact of the discount. Therefore a net benefit analysis is to be done to evaluate the discount offer.

(c) Typically, EOQ is inversely proportional with the inventory carrying cost per unit. Therefore, as the unit price of material increases due to inflation, The EOQ level will go down. However practically, a minor level of inflation will not impact the current EOQ level. Only substantial rate of inflation will affect the EOQ levels.

(d) When a company faces seasonal demand fluctuations in demand, the EOQ model should be applied separately in every phase of fluctuation, i.e. EOQ should be determined separately for the period of high demand and low demand of the product.

(e) Minor deviations from EOQ will increase the cost of purchases(insignificant increase) either by increasing the ordering cost or by increasing the inventory carrying cost.