Subunit 5: Inventory Management

Q1. In inventory management, the safety stock will tend to increase if the
A. Carrying cost increases.
B. Cost of running out of stock decreases.
C. Variability of the lead time increases.
D. Variability of the usage rate decreases.

Q2. The optimal level of inventory is affected by all of the following except the
A. Usage rate of inventory per time period.
B. Cost per unit of inventory.
C. Current level of inventory.
D. Cost of placing an order for merchandise.

Q3. A major supplier has offered a corporation a year-end special purchase whereby it could purchase
180,000 cases of sport drink at $10 per case. The corporation normally orders 30,000 cases per month at
$12 per case. The corporation’s cost of capital is 9%. In calculating the overall opportunity cost of this offer,
the cost of carrying the increased inventory would be
A. $32,400
B. $40,500
C. $64,800
D. $81,000

Q4. Which one of the following statements concerning the economic order quantity (EOQ) is correct?
A. The EOQ results in the minimum ordering cost and minimum carrying cost.
B. Increasing the EOQ is the best way to avoid stockouts.
C. The EOQ model assumes constantly increasing usage over the year.
D. The EOQ model assumes that order delivery times are consistent.

Q5. Which one of the following would not be considered a carrying cost associated with inventory?
A. Insurance costs.
B. Cost of capital invested in the inventory.
C. Cost of obsolescence.
D. Shipping costs.

Q6, An example of a carrying cost is

A. Disruption of production schedules.
B. Quantity discounts lost.
C. Handling costs.
D. Spoilage.

Q7. The carrying costs associated with inventory management include

A. Insurance costs, shipping costs, storage costs, and obsolescence.
B. Storage costs, insurance costs, capital invested, and obsolescence.
C. Purchasing costs, shipping costs, set-up costs, and quantity discounts lost.
D. Obsolescence, set-up costs, capital invested, and purchasing costs.

Q8. All of the following are inventory carrying costs except

A. Storage.
B. Insurance.
C. Opportunity cost of inventory investment.
D. Inspections.

Q9. The level of safety stock in inventory management depends on all of the following except the
A. Level of uncertainty of the sales forecast.
B. Level of customer dissatisfaction for back orders.
C. Cost of running out of inventory.
D. Cost to reorder stock.

Q10. The controller at a chain of hardware stores wants to determine the optimum safety stock levels for
an air purifier unit. The inventory manager compiled the following data:
A. $1,750
B. $1,950
C. $550
D. $2,000

Q11. The amount of inventory that a company would tend to hold in safety stock would increase as the
A. Sales level falls to a permanently lower level.
B. Cost of carrying inventory decreases.
C. Variability of sales decreases.
D. Cost of running out of stock decreases.

Q12. The result of the economic order quantity (EOQ) formula indicates the
A. Annual quantity of inventory to be carried.
B. Annual usage of materials during the year.
C. Safety stock plus estimated inventory for the year.
D. Quantity of each individual order during the year.

Q13. Using the economic order quantity (EOQ) model, a decrease in which one of the following variables
would increase the EOQ?
A. Annual sales.
B. Cost per order.
C. Safety stock level.
D. Carrying costs.
Q14. When the economic order quantity (EOQ) model is used for a firm that manufactures its inventory,
ordering costs consist primarily of
A. Insurance and taxes.
B. Obsolescence and deterioration.
C. Storage and handling.
D. Production set-up.

Q15. All of the following are carrying costs of inventory except

A. Storage costs.
B. Insurance.
C. Shipping costs.
D. Opportunity costs.

Q16. An entity uses 400 lbs. of a rare isotope per year. The isotope costs $500 per pound, but the supplier
is offering a quantity discount of 2% for order sizes between 30 and 79 lbs. and a 6% discount for order
sizes of 80 lbs. or more. The ordering costs are $200. Carrying costs are $100 per pound of material and are
not affected by the discounts. If the purchasing manager places eight orders of 50 lbs. each, the total cost
of ordering and carrying inventory, including discounts lost, will be
A. $1,600
B. $4,100
C. $6,600
D. $12,100

Q17. A review of inventories reveals the following cost data for entertainment centers.

A. $105
B. $115
C. $120
D. $420
Q18. A company expects to use 48,000 gallons of paint per year costing $12 per gallon. Inventory carrying
cost is equal to 20% of the purchase price. The company uses its inventory at a constant rate. The lead time
for placing the order is 3 days, and the company holds 2,400 gallons of paint as safety stock. If the
company orders 2,000 gallons of paint per order, what is the cost of carrying inventory?
A. $2,400
B. $5,280
C. $5,760
D. $8,160

Q19. The new manager of inventory at a major retailer is developing an inventory control system and
knows he should consider establishing a safety stock level. The safety stock can protect against all of the
following risks except for the possibility that
A. Customers cannot find the merchandise they want, and they will go to the competition.
B. Shipments of merchandise from the manufacturers is delayed by as much as 1 week.
C. The distribution of daily sales will have a large variance due to holidays, weather, advertising, and
weekly shopping habits.
D. New competition may open in the company’s market area.

Q20. A distributor is reviewing its inventory policy with respect to safety stocks of its most popular
product. Four safety stock levels were analyzed and annual stockout costs estimated for each level.

A. 1,000 units.
B. 1,250 units.
C. 1,500 units.
D. 2,000 units.

Q21. Using the economic order quantity (EOQ) model as part of its inventory control program, an increase
in which one of the following variables would increase the EOQ?
A. Carrying cost rate.
B. Purchase price per unit.
C. Ordering costs.
D. Safety stock level.
Q22. Which one of the following is not explicitly considered in the standard calculation of economic order
quantity (EOQ)?
A. Level of sales.
B. Fixed ordering costs.
C. Carrying costs.
D. Quantity discounts.

Q23. The basic Economic Order Quantity (EOQ) model includes which of the following assumptions?

A. I and IV only.
B. II and III only.
C. I, II, and IV only.
D. I, II, III, and IV.

Q24, A firm calculates that its annual cost to hold excess goods in order to avoid any chance of running out
of inventory is $50,000. This $50,000 is an example of a
A. Prime cost.
B. Quality cost.
C. Carrying cost.
D. Stockout cost.
 ANSWERS

Answer 1 (C) is correct.

A company maintains safety stocks to protect itself against losses caused by stockouts. These can take the
form of lost sales or lost production time. Safety stock is needed because of the variability in lead time and
usage rates. As the variability in lead time increases, a company tends to carry larger safety stocks.

Answer 2 (C) is correct.

The optimal level of inventory is affected by the factors in the economic order quantity (EOQ) model and
delivery or production lead times. These factors are (1) the periodic demand for inventory; (2) the carrying
cost, which includes the interest on funds invested in inventory; (3) the usage rate; and (4) the cost of
placing an order or making a production run. The current level of inventory is irrelevant to the optimal
inventory level.

Answer 3 (A) is correct.

If the corporation makes the special purchase of 6 months of inventory (180,000 cases ÷ 30,000 cases per
month), the average inventory for the 6-month period will be $900,000 [(180,000 × $10) ÷ 2]. If the special
purchase is not made, the average inventory for the same period will be the average monthly inventory of
$180,000 [(30,000 × $12) ÷ 2]. Accordingly, the incremental average inventory is $720,000
($900,000 – $180,000), and the interest cost of the incremental 6-month investment is $32,400
[($720,000 × 9%) × (6 ÷ 12)].

Answer 4 (D) is correct.

One of the underlying assumptions of the EOQ model is that delivery times are predictably consistent.
Other assumptions are that sales are perfectly predictable and that usage is constant.

Answer 5 (D) is correct.

Carrying costs are incurred to hold inventory. Examples include such costs as warehousing, insurance, the
cost of capital invested in inventories, inventory taxes, and the cost of obsolescence and spoilage. Shipping
costs and the initial cost of the inventory are the purchase costs.

Answer 6 (D) is correct.

Inventory costs consist of four categories: purchase costs, order or set-up costs, carrying (holding) costs,
and stockout costs. Carrying costs include storage costs for inventory items plus opportunity cost (i.e., the
cost incurred by investing in inventory rather than making an income-earning investment). Examples are
insurance, spoilage, interest on invested capital, obsolescence, and warehousing costs.

Answer 7 (B) is correct.

Carrying costs include storage costs, insurance costs, interest on capital invested, and obsolescence.

Answer 8 (D) is correct.

Inventory carrying costs are incurred to hold inventory. Examples include the costs of storage, insurance,
security, inventory taxes, depreciation or rent of warehouse facilities, obsolescence and spoilage, and the
opportunity cost of inventory investment. Inspection costs are not related to the length of time inventory
is held. They are costs of taking delivery and are best classified as ordering costs.

Answer 9 (D) is correct.

Inventory carrying costs are incurred to hold inventory. Examples include the costs of storage, insurance,
security, inventory taxes, depreciation or rent of warehouse facilities, obsolescence and spoilage, and the
opportunity cost of inventory investment. Inspection costs are not related to the length of time inventory
is held. They are costs of taking delivery and are best classified as ordering costs.

Answer 10 (A) is correct.

The cost of safety stock is given as carrying cost plus expected stockout cost. At 20% of the $50 unit
inventory cost, carrying cost is $10 per unit per year. Thus, carrying cost for 100 units of safety stock is
$1,000. A stockout has a 15% probability at this level of safety stock, and stockout costs are $500 (100 ×
$5) for each occurrence. If the firm orders 10 times per year, the expected number of stockouts is 1.5
(15% × 10). Hence, total expected stockout cost for the year is $750 ($500 × 1.5). Total cost is $1,750 per
year ($1,000 + $750).

Answer 11 (B) is correct.

A firm’s economic order quantity is a function of demand, carrying costs, and ordering costs. A decrease in
carrying costs permits a company to carry more inventory at the same cost and thereby reduce stockout
costs.

Answer 12 (D) is correct.

The EOQ model is a deterministic model that calculates the ideal order (or production lot) quantity given
specified demand, ordering or setup costs, and carrying costs. The model minimizes the sum of inventory
carrying costs and either ordering or production setup costs.

Answer 13 (D) is correct.

The EOQ model minimizes the total of ordering and carrying costs. The EOQ is calculated as follows:

Answer 14 (D) is correct.

A manufacturer can use the EOQ model by substituting production set-up costs for ordering costs. Set-up
costs are the manufacturer’s equivalent of ordering costs. The result is sometimes referred to as the
economic batch quantity.

Answer 15 (C) is correct.

The cost of shipping inventory is a cost of acquiring, not carrying, it.
Answer 16 (D) is correct.
Average inventory can be calculated based on the average order size (total order quantity divided by 2).
For this entity, that is 50 lbs. ÷ 2, which is 25 lbs. for average inventory. The entity’s annual ordering costs
are $1,600 ($200 per order × 8 orders per year), and the annual carrying costs are $2,500 ($100 per pound
× 25 lbs. average inventory). Gross annual product purchase cost is $200,000 ($500 per pound × 400 lbs.
annual usage). Because the differential discount lost is 4% (6% – 2%), annual discounts lost equal $8,000
($200,000 × 4%). If the purchasing manager places 8 orders of 50 lbs. each, the entity’s total cost can be
calculated as follows:

Answer 17 (C) is correct.

The cost of carrying a unit of inventory can be calculated as follows:

Answer 18 (D) is correct.

The company’s per-gallon carrying cost is $2.40 ($12 purchase price per gallon × 20% carrying cost).
Average inventory can be calculated based on the average order size as the total order quantity divided by
the number of orders. Average inventory is 1,000 gallons (2,000 gallons ordered divided by 2 orders). The
cost of carrying safety stock is $5,760 (2,400 gallons × $2.40), and the cost of carrying average inventory is
$2,400 (1,000 gallons × $2.40). Thus, total inventory carrying cost is $8,160 ($5,760 + $2,400).

Answer 19 (D) is correct.

Safety stock cannot protect against the entry of new competitors.

Answer 20 (C) is correct.

Answer 21 (C) is correct.
Fixed cost per order is in the numerator of the EOQ fraction. An increase results in an increase in the EOQ.

Answer 22 (D) is correct.

Quantity discounts are not a factor in the EOQ formula.

Answer 23 (D) is correct.

The basic EOQ model assumes that the same fixed quantity is ordered at each reorder point, purchasing
costs are unaffected by the quantity ordered, purchase order lead-time is known with certainty, and
adequate inventory is always maintained to avoid stockouts.

Answer 24 (C) is correct.

The costs of holding or storing inventory are carrying costs. Examples include the costs of capital,
insurance, warehousing, breakage, and obsolescence.