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The Economic Order Quantity (EOQ)
Introduction
The Economic Order Quantity is that quantity that results in minimal costs in terms of holding costs for a particular period. The EOQ provides a good measure for calculating the optimal stock quantity required.
1a).EOQ = √2 (Annual Usage in Units) (Order Costs)/ (Annual Carrying Cost per Unit)
EOQ = √2 (CoD/Ch
Where Co = Cost of Placing Order = £2
D = Annual demand = 20,000
Ch = Cost of holding one item for a year = £1.5
EOQ = √2 (2×20, 000/1.5
EOQ =230.94
1b). The implications of holding stock occur when stock outs are registered before the delivery of new orders. The shortage experienced causes delay for customer’s orders who eventually search for reliable suppliers. Alternatively excessive stocks lead to dead stock and holding of capital in stock instead of being utilized in other operations that can be more productive for the company. The above implications above compel the company to identify the right Economical Order Quantity to maintain (Doupnik and Perera 2012)
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2. a)
| Cash flow Forecast for UniFood 2016 | ||||||||||||
| Date | Jan | Feb | Mar | Apr | May | Jun | Jul | Aug | Sep | Oct | Nov | Dec |
| Receipts | ||||||||||||
| Sales | 18000 | 18000 | 22000 | 22000 | 26000 | 20000 | 10000 | 10000 | 27000 | 28000 | 28000 | 25000 |
| Credit Sales | 2000 | 3000 | 3000 | 4000 | 4000 | 3000 | 2000 | 1000 | 1000 | 5000 | 6000 | 4000 |
| Capital Amounting | 10000 | |||||||||||
| Total Receipts (A) | 30000 | 21000 | 25000 | 26000 | 30000 | 23000 | 12000 | 11000 | 28000 | 33000 | 34000 | 29000 |
| Payments | ||||||||||||
| Cash Pymts to supplier | 2000 | 2500 | 3000 | 3000 | 3000 | 1500 | 1500 | 2000 | 3000 | 3000 | 3000 | 2500 |
| Cr pymts to supplier | 6000 | 6500 | 7000 | 4000 | 6000 | 2000 | 1000 | 2000 | 6000 | 7000 | 7000 | 6000 |
| Delivery Cost | 1000 | 1200 | 1500 | 100 | 1200 | 900 | 800 | 1000 | 1000 | 1500 | 1500 | 1200 |
| Rent and rates | 40000 | |||||||||||
| Insurance | 960 | |||||||||||
| General expenses | 30 | 30 | 30 | 30 | 30 | 30 | 30 | 30 | 30 | 30 | 30 | 30 |
| Stationary | 20 | 20 | 20 | 20 | 20 | 10 | 10 | 10 | 20 | 20 | 20 | 10 |
| Bank Loan | 1000 | 1000 | 1000 | 1000 | 1000 | 1000 | 1000 | 1000 | 1000 | 1000 | 1000 | 1000 |
| Wages | 8000 | 8000 | 8000 | 8000 | 8000 | 8000 | 8000 | 8000 | 8000 | 8000 | 8000 | 8000 |
| Advertising | 40 | 50 | 50 | 40 | 40 | 0 | 30 | 50 | 50 | 50 | 50 | 40 |
| Vehicle Running | 200 | 200 | 200 | 200 | 200 | 150 | 100 | 150 | 200 | 200 | 200 | 100 |
| Vehicle Tax | 250 | |||||||||||
| Total Payments (B) | 58540 | 19500 | 20800 | 16390 | 19490 | 13590 | 12470 | 14240 | 19300 | 21760 | 20800 | 18880 |
| Net In/Out Flow (A-B) | -28540 | 1500 | 4200 | 9610 | 10510 | 9410 | -470 | -3240 | 8700 | 11240 | 13200 | 10120 |
| Opening Balance | 5000 | -23540 | -22040 | -17840 | -8230 | 2280 | 11690 | 11220 | 7980 | 16680 | 27920 | 41120 |
| Closing Balance | -23540 | -22040 | -17840 | -8230 | 2280 | 11690 | 11220 | 7980 | 16680 | 27920 | 41120 | 51240 |
2b) The months that will experience cash shortage are January, February, March and April.
2c) The cause of the cash shortage is that the business capital is insufficient to pay all the initial costs of operating the business. The credit sales are also contributing to the shortage of cash. The rental charges are also very high (Doupnik, Hoyle and Schaefer 2012).
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2d) To improve the Cash Flow Unifoods should apply for some low cost financing from a convenient bank that can advance a soft loan of £23540 or source for funding from an alternative source to facilitate the business operations during the first four months of the year. Unifoods may also opt to shop for cheaper premises that are within the same locality but which have the same goodwill or advantages as their present premises (Vance 2003).
4a) i.
| Unifood | ||||
| Project A | Project B | |||
| Years | Income | balance | Income | balance |
| 0 | 100,000 | -100,000 | 100,000 | -100,000 |
| 1 | 60,000 | -40,000 | 60,000 | -40,000 |
| 2 | 80,000 | 40,000 | 70,000 | 30,000 |
| 3 | 90,000 | 130,000 | 80,000 | 110,000 |
| 4 | 100,000 | 230,000 | 90,000 | 200,000 |
| 5 | 100,000 | 330,000 | 95,000 | 295,000 |
| Payback period | 1 year and 6 months. | 1 year and 7 months | ||
The Payback Period for project A is one year six months while the payback period for Project B one year seven months (Hermanson, Edwards & Invacevich, 2011)
4b) ii.
| Unifood Accounting Rate of Return | ||||
| Project A | Project B | |||
| Years | Income | ARR | Income | ARR |
| 0 | 100,000 | 100,000 | ||
| 1 | 60,000 | 60,000 | ||
| 2 | 80,000 | 70,000 | ||
| 3 | 90,000 | 80,000 | ||
| 4 | 100,000 | 90,000 | ||
| 5 | 100,000 | 95,000 | ||
| Total | 530,000 | 495,000 | ||
| Less 100,000 | 430% | Less 100,000 | 395% | |
| ARR | Average annual returns/Initial inv | |||
The ARR for project A is 430% while the ARR for Project 395% (Bodie, Kane & Marcus 2008).
4c) iii.
| Unifood | ||
| NPV | ||
| Project A | Project B | |
| Year | Cash flow | Cash flow |
| 0 | -100,000 | -100,000 |
| 1 | 60,000 | 60,000 |
| 2 | 80,000 | 70,000 |
| 3 | 90,000 | 80,000 |
| 4 | 100,000 | 90,000 |
| 5 | 100,000 | 95,000 |
| Discount Rate | 10.00% | 10.00% |
| PV for future cash flows | $318,672.97 | $292,960.61 |
| NPV | $218,672.97 | $192,960.61 |
The NPV for project A is $218672.97 while the NPV for Project B 192960.61 (Brealey, Myers & Allen 2005).
4b)
The best project to invest in is project A. The payback period for the first project is shorter. The Accounting rate of return is 430% which is also higher than that of project B. The NPV for Project A is also higher than that of project B. The NPV for project A is £218,672.97 while that of project b is £192,960.61 (McLaney 2003). The other factors which should also be considered are the other extra expenses like the preliminary expenses. It may be costly to commence trading on some projects hence all the total costs should be considered (Harrington 2003).
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5).
The Gross Profit Margin for Unifood is 65.76% while the Net Profit Margin is 15.31%. The total costs for the project would amount to 84.69%. The profitability ratios for Unifood are good and above average. The total costs are a little high but they can be brought down by strategically moving to cheaper premises. The efficiency ratios for Unifood are: Average collection Period Days in a Year/Inventory Turnover. To obtain the turnover the average stocks have to be obtained and which are not available (Helfert 2007).
| Date | Totals | Analysis | |||||
| Receipts | |||||||
| Sales | 254000 | ||||||
| Credit Sales | 38000 | 12.58% | |||||
| Capital Amounting | 10000 | ||||||
| Total Receipts (A) | 302000 | 302,000 | |||||
| Payments | |||||||
| Cash Pymts to supplier | 30000 | ||||||
| Cr pymts to supplier | 60500 | ||||||
| Delivery Cost | 12900 | 103400 | |||||
| Gross Profit | 198,600 | 65.7616 | (Gross Profit Margin) | ||||
| Rent and rates | 40000 | ||||||
| Insurance | 960 | ||||||
| General expenses | 360 | ||||||
| Stationary | 200 | ||||||
| Bank Loan | 12000 | ||||||
| Wages | 96000 | ||||||
| Advertising | 490 | ||||||
| Vehicle Running | 2100 | ||||||
| Vehicle Tax | 250 | ||||||
| Total Costs | 255760 | 255760 | 84.6887 | ||||
| Net In/Out Flow (A-B) | 46240 | 15.3113 | (Net Profit Margin) | ||||
| Opening Balance | 52240 | ||||||
| Closing Balance | 98480 |
The credit sales are only 12.6% of the total sales which represent a low rate of credit sales. Unifood needs to provide flexible credit terms to encourage more sales to improve its profitability.
To increase the working capital, Unifood should cut down on its revenue costs. For example, Unifood should look for a way to reduce its rental income which is very high (Fridson 2002).The wages are also very high the company should find a way of reducing the high wages (Samuels et al 1998). Unifood has also to negotiate with the suppliers to provide more favorable credit terms to facilitate increased purchases and trade.\
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To conclude the Economical Order Quantity has provided an accurate way of determining the optimal stock level that a company should maintain having in mind the annual demand of the company and the holding costs that the company incurs in cases of overstocking and the costs of placing an order. The analysis of the company indicates that the financial performance of unifood is good as it is making profits and the suppliers are paid on time while the debtors are also maintained are reasonably low levels.
Bibliography
Bodie, Z., Kane, A., & Marcus, A. J., 2008, Investments (7th International ed) Boston: McGraw-Hill. 303.
Brealey, R.A, Myers, S. C., Allen, F., 2005, .Principles of Corporate Finance Boston: McGraw-Hill/Irwin.
Fridson, M., 2002, Financial Statement Analysis: A Practitioner’s Guide. New York: John Wiley.
Harrington, D, R., 2003, Corporate Financial Analysis: Decisions in a Global Environment. 4th ed. Chicago: Richard D. Irwin, Inc.
Helfert, E, A., 2007, Techniques of Financial Analysis: A Modern Approach. 9th ed. Chicago: Richard D. Irwin, Inc.
Hermanson, R.H., Edwards, J.D., & Invacevich, S.D., 2011, Accounting Principles: A Business Perspective. First Global Text Edition, Volume 2 Managerial Accounting, 37-73.
Vance, D. (2003). Financial analysis and decision making: tools and techniques to solve financial problems and make effective business decisions. New York: McGraw-Hill.
Doupnik, T.S., Hoyle, J.B. and Schaefer, T.F., 2012, Advanced Accounting. Boston: Irwin/McGraw-Hill, Print.
Doupnik, T.S, and Perera, H.B., 2012, International Accounting. New York: McGraw-Hill Irwin, 2012. Print.
McLaney, E. J., 2003, Business Finance: Theory and Practice (5th Ed). London: Pearson Education Ltd.
Samuels, J. M., Wilkes, F. M. and Brayshaw, R. E., 1998, Management of Company Finance (7th Ed). International Thomson Business Press.
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