Theoretical Literature Review: Economic Order Quantity Model

For this week’s reflection, please write three complete and well composed paragraphs and, in your own words (do not quote from a book or website) explain what working capital is and why it is important for a business. As an example, describe a business that operates where you live and describe how knowing what the working capital of that company would be useful to the business leaders of that company and to outside investors.

In the Fixed-Order Quantity Model (Q-Model), every time that the stocks reach a specific level an order is placed. Q-Model requests a constant monitoring in inventory levels. The risk of stock out only occurs during the lead time, thus the safety stock is less than in P-Model for the same service level. Reorders are placed when stocks reach (R), and the safety stock that must be reordered is:

Cost of inventory is determined using the average method; inventory is stated at the lower of cost or market. +pB13

As a result, holding cash would be essential component of the firm strategy. To develop new products, buy new equipment or expand geographically, firm has to spend money on marketing research, product design, prototype development and so on. Moreover, if a recession hits and the economy start to slow down,

The economic order quantity is used for this situation because it shows the number of pairs of laces that can be added to the inventory each time an order is placed to minimize the holding and ordering costs. It provides the information that can be used to control the inventory levels and costs.

We prefer the EOQ/ ROP system as gains from reducing the order/ production size (gains in terms of less value of inventory being produced) which though lead to increase in setup cost far outweigh the gains from Blanchard’s current system (gains in terms of reduction of setup cost) while, costs are that of the value of inventory being produced.

Working capital is of major importance to a business because it controls the current day-to-day operations including payment of salaries, wages, inventory, raw materials, other business expenses, purchase of stocks, buildings, land, fixed assets, etc.

There are three types of inventory models primarily used by organizations, these include the economic order quantity model (EOC), production

EOQ as described everywhere is “the order quantity that minimizes total inventory holding costs and ordering costs. It is one of the oldest classical production scheduling models”. This model uses the following assumptions:

On the other hand, the company has been growing constantly. In deed, according to the net income estimation for 2007 (see Table 7) the company increases its profits $25 thousand dollars more than the previous year. This is an evidence of how the company is been management and of its willing to grow year after year. Nevertheless, the first quarter of 2007 the working capital only has increased by $7 thousand dollars, which is the difference between the current assets and current liabilities but the importance of this is that according to the rotation on receivables and payable accounts, shown in Table 5 and 10, leads us to the conclusion that the company will have to pay its suppliers

Economic Order Quantity (EOQ): Our warehouse utilization has increased from 65% to 90%, it is apparent a significant quantity of our money is being tied up in inventory. The EOQ calculation shows the lot size that will minimize total annual inventory holding and inventory costs.

1) EOQ/ROP system is essentially a reactive approach; this approach gives only an order quantity, it does not suggest ways to reduce the inventory.

Working capital is the excess of a company’s current assets over its current liabilities. Financially healthy firms have positive working capitals.

The management of cash is essential to the survival of any organization. Managing an organization’s financial operation requires knowledge of the economy and ways to maximize revenue. For any organization to operate on a daily basis adequate cash flow is required. Without cash management the organization will be unable to function because there is no cash readily available in case of inconsistencies in the market. Cash is also needed to keep the cycle of the company’s operations going.

We can use this approach in case of steady demand i.e. for non seasonal products. The real cost of inventory can be understood. As, in this case, TEP is proposing to construct a very expensive warehouse extension which would cost about 1 million Euros. If it was required just to hold the total EBQ, then we can argue the opportunity cost and working capital of the inventory should be included in holding cost. Seasonal products like Garden range, barbecue range should not be considered.