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Baumols Model

Most firms try to minimise the sum of the cost of holding cash and the cost of converting marketable
securities to cash.
Baumols cash management model helps in determining a firms optimum cash balance under certainty. As
per the model, cash and inventory management problems are one and the same.

There are certain assumptions that are made in the model. They are as follows:

1. The firm is able to forecast its cash requirements with certainty and receive a specific amount at regular
intervals.
2. The firms cash payments occur uniformly over a period of time i.e. a steady rate of cash outflows.
3. The opportunity cost of holding cash is known and does not change over time. Cash holdings incur an
opportunity cost in the form of opportunity foregone.
4. The firm will incur the same transaction cost whenever it converts securities to cash. Each transaction
incurs a fixed and variable cost.

For example, let us assume that the firm sells securities and starts with a cash balance of C rupees. When
the firm spends cash, its cash balance starts decreasing and reaches zero. The firm again gets back its
money by selling marketable securities. As the cash balance decreases gradually, the average cash balance
will be: C/2. This can be shown in following figure:

The firm incurs a cost known as holding cost for maintaining the cash balance. It is known as opportunity
cost, the return inevitable on the marketable securities. If the opportunity cost is k, then the firms holding
cost for maintaining an average cash balance is as follows:

Holding cost = k (C/2)

Whenever the firm converts its marketable securities to cash, it incurs a cost known as transaction cost.
Total number of transactions in a particular year will be total funds required (T), divided by the cash balance
(C) i.e. T/C. The assumption here is that the cost per transaction is constant. If the cost per transaction is c,
then the total transaction cost will be:

Transaction cost = c (T/C)

The total annual cost of the demand for cash will be:

Total cost = k (C/2) + c (T/C)


Optimum level of cash balance

As the demand for cash, C increases, the holding cost will also increase and the transaction cost will reduce
because of a decline in the number of transactions. Hence, it can be said that there is a relationship between
the holding cost and the transaction cost.

The optimum cash balance, C* is obtained when the total cost is minimum.

Optimum cash balance (C*) = 2cT/k


Where, C* is the optimum cash balance.
T is the total cash needed during the year.
k is the opportunity cost of holding cash balances.

With the increase in the cost per transaction and total funds required, the optimum cash balance will
increase. However, with an increase in the opportunity cost, it will decrease.

Limitations of the Baumol model:

1. It does not allow cash flows to fluctuate.


2. Overdraft is not considered.
3. There are uncertainties in the pattern of future cash flows.

Introduction | Contents |
Baumol Model of Cash Management
Baumol model of cash management helps in determining a firms optimum cash
balance under certainty. It is extensively used and highly useful for the purpose of
cash management. As per the model, cash and inventory management problems are
one and the same.
William J. Baumol developed a model (The transactions Demand for Cash: An
Inventory Theoretic Approach) which is usually used in Inventory management &
cash management.Baumol model of cash management trades off between
opportunity cost or carrying cost or holding cost & the transaction cost. As such firm
attempts to minimize the sum of the holding cash & the cost of converting marketable
securities to cash.

Relevance
At present many companies make an effort to reduce the costs incurred by owning
cash. They also strive to spend less money on changing marketable securities to cash.
The Baumol model of cash management is useful in this regard.

Use of Baumol Model


The Baumol model enables companies to find out their desirable level of cash
balance under certainty. The Baumol model of cash management theory relies on
the trade off between the liquidity provided by holding money (the ability to carry out
transactions) and the interest foregone by holding ones assets in the form of non-
interest bearing money. The key variables of the demand for money are then the
nominal interest rate, the level of real income which corresponds to the amount of
desired transactions and to a fixed cost of transferring ones wealth between liquid
money and interest bearing assets.

Assumptions
There are certain assumptions or ideas that are critical with respect to the Baumol
model of cash management:
The particular company should be able to change the securities that they own into
cash, keeping the cost of transaction the same. Under normal circumstances, all such
deals have variable costs and fixed costs.
The company is capable of predicting its cash necessities. They should be able to do
this with a level of certainty. The company should also get a fixed amount of money.
They should be getting this money at regular intervals.
The company is aware of the opportunity cost required for holding cash. It should stay
the same for a considerable length of time.
The company should be making its cash payments at a consistent rate over a certain
period of time. In other words, the rate of cash outflow should be regular.
Equational Representations in Baumol Model of Cash Management:
Holding Cost = k(C/2)
Transaction Cost = c(T/C)
Total Cost = k(C/2) + c(T/C)

Where T is the total fund requirement, C is the cash balance, k is the opportunity
cost & c is the cost per transaction.

Limitations of the Baumol model:


1.It does not allow cash flows to fluctuate.
2. Overdraft is not considered.
3. There are uncertainties in the pattern of future cash flows.
EOQ is the backorder quantity for replenishment that minimizes total inventory costs. The backorder is
triggered when the inventory level hits the reorder point. The EOQ is calculated in order to minimize a
combination of costs such as the purchase cost (which may include volume discounts), the inventory
holding cost, the ordering cost, etc. The order quantity optimization is complementary to the safety
stock optimization that focuses on finding the optimal threshold to trigger the reorder.

Model and formula


The classical EOQ formula (see the Wilson Formula section below) is essentially a trade-off between the
ordering cost, assumed to be a flat fee per order, and inventory holding cost. Although this formula dating
for 1913 is extremely well-known, we advise against using such a formula in any modern supply
chain environment. The underlying mathematical assumptions behind this formula are simply incorrect
nowadays.

The historical formula assumes that the cost of the act of ordering is the one key business driver. It
certainly was an important factor back in 1913 when an army of clerks was required to manually keep
track of the books, but with inventory management software and possibly EDI, this factor is usually
insignificant. As a result, the "optimization" performed by the formula makes little sense, and completely
ignores any price break that can be available when larger quantities are ordered.

Download Excel sheet: eoq-calculator.xlsm (illustrated calculation)

Thus, we propose here an EOQ formula variant that optimizes the trade-off of carrying costs vs
volume discounts. Let's introduce the variables:

[Math Processing Error]Z be the lead demand.


[Math Processing Error]H be the carrying cost per unit for the duration of the lead time (1).
[Math Processing Error] be the delta inventory quantity needed to reach the reorder point (2).
[Math Processing Error]P be the per unit purchase price, a function that depends on the order quantity [Math
Processing Error]q.

(1) The time scope considered here is the lead-time. Hence, instead of considering the more
usual annual carrying cost [Math Processing Error]Hy, we are considering [Math Processing
Error]H=d365Hy assuming that [Math Processing Error]dis the lead time expressed in days.

(2) The delta quantity needs to take into account both the stock on hand [Math Processing
Error]qhand and the stock on order [Math Processing Error]qorder, which gives the relationship [Math
Processing Error]=Rqhandqorder where [Math Processing Error]Ris the reorder point.
Intuitively, [Math Processing Error]+1 is the minimal quantity to be ordered in order to maintain the
desired service level.

Then, the optimal order quantity is given by (the reasoning is detailed below): [Math Processing
Error]Q=argminq=+1..(12(q1)H+ZP(q)) Despite it's seemingly complicated look, this function can
be easily computed with Microsoft Excel, as illustrated by the sheet provided here above.
What about the order cost?
At first glance, it might look as if we are assuming a zero ordering cost, but not quite so. Indeed, the
framework we introduce here is relatively flexible and the order cost (if any) can be embedded into the
price function [Math Processing Error]P.

Cost function
In order to model the cost function for the order quantity which takes into account volume discounts, let's
introduce [Math Processing Error]R the reorder point. The inventory cost is the sum of the
inventory carrying costplus the purchase cost, that is: [Math Processing
Error]C(q)=(R+q12)H+ZP(q) Indeed, taking an amortized viewpoint over the lead time period, the total
quantity to be ordered will be [Math Processing Error]Z the lead demand.

Then, the inventory level is varying all the time, but if we consider strict minimal reorders (i.e. [Math
Processing Error]q=+1) then, the average stock level over time is equal to [Math Processing Error]R the
reorder point. Then, since we are precisely considering order quantity greater than [Math Processing
Error]+1, those extra ordered quantities are shifting upward the average inventory level (and also
postponing the time when the next reorder point will be hit).

The [Math Processing Error](q1)/2 represents the inventory shift caused by the reorder assuming that
the lead demand is evenly distributed for the duration of the lead time. The factor 1/2 is justified because
an increased order quantity of N is only increasing the average inventory level of N/2.

Minimization of the cost function


In order to minimize [Math Processing Error]C(q), we can start by isolating the part that does not depends
of [Math Processing Error]q with: [Math Processing Error]C(q)=RH+12(q1)H+ZP(q) Since [Math
Processing Error]RH does not depend on [Math Processing Error]q, optimizing [Math Processing
Error]C(q) is the same as optimizing [Math Processing Error]C(q) where:[Math Processing
Error]C(q)=12(q1)H+ZP(q) Then, in this context, since the volume discount function [Math
Processing Error]P is an arbitrary function, there is no direct algebraic solution to minimize this formula.
Yet, it does not imply that this minimization is hard to solve either.

A simple minimization for [Math Processing Error]C(q) consists of a (naive) extensive numerical
exploration, that is computing the function for a large range of [Math Processing Error]q values. Indeed,
virtually no business is needing order quantities greater than 1,000,000 units, and letting a computer
explore all costs values for [Math Processing Error]q=1..1,000,000 takes less 1 second even if the
calculation is done within Excel on a regular desktop computer.

However, in practice, this computation can be vastly accelerated if we assume that [Math Processing
Error]P(q) is astrictly decreasing function, that is to say that the price per unit strictly decreases when
the order quantity increases. Indeed, if [Math Processing Error]P(q) decreases, then we can start the
value exploration at [Math Processing Error]q=+1, iterates, and finally stop whenever the situation [Math
Processing Error]C(q+1)>C(q) gets encountered.
In practice, unit price rarely increases with quantities, yet, some local bumps in the curve may be
observed if shipments are optimized for pallets, or any other container that favors certain package sizes.

In the Excel sheet attached here above, we are assuming the unit price to be strictly decreasing with the
quantity. If it is not the case, then edit the macro EoqVD() to revert back to a naive range exploration.

Wilson Formula
The most well-known EOQ formula is the Wilson Formula developed in 1913. This formula relies on the
following assumptions:

The ordering cost is flat.


The rate of demand is known, and spread evenly throughout the year.
The lead time is fixed.
The purchase unit price is constant i.e. no discount is available.

Let's introduce the follow variables:

[Math Processing Error]Dy be the annual demand quantity


[Math Processing Error]S be the fixed flat cost per order (not a per unit cost, but the cost associated to the operation
of ordering and shipping).
[Math Processing Error]Hy the annual holding cost.

Under those assumptions, the Wilson optimal EOQ is: [Math Processing Error]Q=2DySHy In practice, we
suggest to use a more locally adjusted variant (time-wise) of this formula where [Math Processing
Error]Dy is replaced by [Math Processing Error]D the forecast demand rate for the duration of the lead
time (aka the lead demand [Math Processing Error]Z divided by the lead time), and where [Math
Processing Error]Hy is replaced by [Math Processing Error]H, the carrying cost for the duration of the lead
time.

Comparison of the two EOQ formula


For retail or wholesale, we believe that our ad-hoc EOQ formula presented at the top of this page, that
emphasizes volume discounts is better suited, hence more profitable, than the Wilson formula. For
manufacturers, it depends. In particular, if the order triggers a new production, then indeed, there might
be a significant ordering cost (production setup) and little or no benefits in marginal unit cost afterward. In
such a situation, the Wilson Formula is more appropriate.
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Home > Managerial Accounting > Inventory Management > Economic Order Quantity (EOQ)

Economic Order Quantity (EOQ)

Economic order quantity (EOQ) is the order quantity of inventory that minimizes the total cost of
inventory management.

Two most important categories of inventory costs are ordering costs and carrying costs. Ordering
costs are costs that are incurred on obtaining additional inventories. They include costs incurred on
communicating the order, transportation cost, etc. Carrying costs represent the costs incurred on
holding inventory in hand. They include the opportunity cost of money held up in inventories, storage
costs, spoilage costs, etc.

Ordering costs and carrying costs are quite opposite to each other. If we need to minimize carrying
costs we have to place small order which increases the ordering costs. If we want minimize our
ordering costs we have to place few orders in a year and this requires placing large orders which in
turn increases the total carrying costs for the period.

We need to minimize the total inventory costs and EOQ model helps us just do that.

Total inventory costs = Ordering costs + Holding costs

By taking the first derivative of the function we find the following equation for minimum cost

EOQ = SQRT(2 Quantity Cost Per Order / Carrying Cost Per Order)

Example

ABC Ltd. is engaged in sale of footballs. Its cost per order is $400 and its carrying cost unit is $10 per
unit per annum. The company has a demand for 20,000 units per year. Calculate the order size, total
orders required during a year, total carrying cost and total ordering cost for the year.

Solution

EOQ = SQRT(2 20,000 400/10) = 1,265 units

Annual demand is 20,000 units so the company will have to place 16 orders (= annual demand of
20,000 divided by order size of 1,265). Total ordering cost is hence $64,000 ($400 multiplied by 16).
Average inventory held is 632.5 ((0+1,265)/2) which means total carrying costs of $6,325 (i.e. 632.5
$10).

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