Carrying Costs of Inventory

To see another example of an opportunity cost, consider the following data for Soho’s DVD player purchasing decision:

A table shows data for Soho’s DVD player purchasing decision.
a The example assumes that DVD-player purchases for its 2-in-1 system will be used uniformly throughout the year. The average investment in inventory during the year is the cost of the inventory when a purchase is received plus the cost of inventory just before the next purchase is delivered (in our example, zero) divided by 2.

The table depicts data for Soho’s DVD player purchasing decision. The details of the table are as follows:

1. Estimated DVD player requirements for its 2-in-1 system for next year: 250,000 units

2. Cost per unit when each purchase is equal to 2,500 units: 64.00 dollars

3. Cost per unit when each purchase is equal to or greater than 30,000 units, 64 dollars minus 0.5 percent discount: 63.68 dollars

4. Cost of a purchase order: 150.00 dollars

5. Soho’s managers are evaluating the following alternatives:

6. Average investment in inventory. The example assumes that DVD-player purchases for its 2-in-1 system will be used uniformly throughout the year. The average investment in inventory during the year is the cost of the inventory when a purchase is received plus the cost of inventory just before the next purchase is delivered (in our example, zero) divided by 2.

7. Annual rate of return if cash is invested elsewhere (for example, bonds or stocks) at the same level of risk as investment in inventory: 12 percent

Soho will pay cash for the DVD players it buys for its 2-in-1 system. Which purchasing alternative is more economical for Soho?

The management accountant presents the following analysis to the company’s managers using the total alternatives approach, recognizing that Soho has, on average, $995,000 of cash available to invest. If Soho invests only $80,000 in inventory as in alternative A, it will have $915,000 ($995,000−$80,000) of cash available to invest elsewhere, which at a 12% rate of return will yield a total return of $109,800. This income is subtracted from the ordering and purchasing costs incurred under alternative A. If Soho invests all $995,000 in inventory as in alternative B, it will have $0 ($995,000−$995,000) available to invest elsewhere and will earn no return on the cash.

A table shows investment alternatives A and B plus the difference between the two using the total alternatives approach.

The table depicts investment alternative A, make 100 purchases of 2,500 units each during the year and invest any excess cash, investment alternative B, make 8 purchases of 31,250 units each during the year and invest any excess cash, and the difference between the two alternatives (alternative A minus alternative B). It uses the total alternatives approach. The details of the table are as follows:

1. Annual purchase order costs

2. Annual purchase costs

3. Deduct annual rate of return earned by investing cash not tied up in inventory elsewhere at the same level of risk

4. Relevant costs

Consistent with the trends toward holding smaller inventories, it is more economical (by $16,000) for Soho’s managers to purchase smaller quantities of 2,500 units 100 times a year than to purchase 31,250 units 8 times a year even though the purchase and purchase-order costs are higher when purchasing smaller quantities.

The following table presents the management accountant’s analysis of the two alternatives using the opportunity-cost approach. Each alternative is defined only in terms of the two purchasing choices with no explicit reference to investing the excess cash.

A table shows investment alternatives A and B plus the difference between the two using the opportunity-cost approach.

The table depicts investment alternative A, make 100 purchases of 2,500 units each during the year, investment alternative B, make 8 purchases of 31,250 units each during the year, and the difference between the two alternatives (alternative A minus alternative B). It uses the total opportunity-cost approach. The details of the table are as follows:

1. Annual purchase-order costs

2. Annual purchase costs

3. Opportunity cost: annual rate of return that could be earned if investment in inventory were invested elsewhere at the same level of risk

4. Relevant costs

Recall that under the opportunity-cost approach, the relevant cost of any alternative is (1) the incremental cost of the alternative plus (2) the opportunity cost of the profit forgone from choosing that alternative. The opportunity cost of holding inventory is the income forgone by tying up money in inventory and not investing it elsewhere. The opportunity cost would not be recorded in the accounting system because, once the money is invested in inventory, there is no money available to invest elsewhere and so no return related to this investment to record. On the basis of the costs recorded in the accounting system (purchase-order costs and purchase costs), Soho’s managers would erroneously conclude that making eight purchases of 31,250 units each is the less costly alternative. Column 3, however, indicates that, as in the total-alternatives approach, purchasing smaller quantities of 2,500 units 100 times a year is more economical than purchasing 31,250 units eight times during the year by $16,000. Why? Because the lower opportunity cost of holding smaller inventory exceeds the higher purchase and ordering costs. If the opportunity cost of money tied up in inventory were greater than 12% per year, or if other incremental benefits of holding lower inventory were considered, such as lower insurance, materials-handling, storage, obsolescence, and breakage cost, making 100 purchases would be even more economical.