For products with elastic demand, it is wiser to estimate demand based on an established, acceptable market price. Typically, total revenues and total costs are modeled as linear values, implying that each unit of output incurs the same per-unit revenue and per-unit variable costs.
Volume sales or bulk purchasing may incorporate quantity discounts, but the linear model appears to ignore these options. A primary key to detecting the applicability of linearity is determining the relevant range of output. If the forecast of demand suggests that units will be demanded, but quantity discounts on materials are applicable for purchases over units from a single supplier, then linearity is appropriate in the anticipated range of demand units plus or minus some fore-cast error.
If, instead, quantity discounts begin at 50 units of materials, then the average cost of materials may be used in the model. A more difficult issue is that of volume sales, when such sales are frequently dependent on the ordering patterns of numerous customers. In this case, historical records of the proportionate quantity-discount sales may be useful in determining average revenues.
For example, if demand surpasses the capacity of a one-shift production line, then a second shift may be added. The second-shift supervisor's salary is a fixed-cost addition, but only at a sufficient level of output. Modeling the added complexity of nonlinear or step-function costs requires more sophistication, but may be avoided if the manager is willing to accept average costs to use the simpler linear model. One obviously important measure in the break-even model is that of fixed costs.
In the traditional cost-accounting world, fixed costs may be determined by full costing or by variable costing. Full costing assigns a portion of fixed production overhead charges to each unit of production, treating these as a variable cost. Variable costing, by contrast, treats these fixed production overhead charges as period charges; a portion of these costs may be included in the fixed costs allocated to the product.
Thus, full costing reduces the denominator in the break-even model, whereas the variable costing alternative increases the denominator. While both of these methods increase the break-even point, they may not lend themselves to the same conclusion. Recognizing the appropriate time horizon may also affect the usefulness of break-even analysis, as prices and costs tend to change over time. For a prospective outlook incorporating generalized inflation, the linear model may perform adequately.
However, weakened market demand for the product may occur, even as materials costs are rising. Managers should project break-even quantities based on reasonably predictable prices and costs. It may defy traditional thinking to determine which costs are variable and which are fixed. Typically, variable costs have been defined primarily as "labor and materials. In this case, labor should be included in the fixed costs in the model. Complicating the analysis further is the concept that all costs are variable in the long run, so that fixed costs and the time horizon are interdependent.
Using a make-or-buy analysis, managers may decide to change from in-house production of a product to subcontracting its production; in this case, fixed costs are minimal and almost percent of the costs are variable. Alternatively, they may choose to purchase cutting-edge technology, in which case much of the variable labor cost is eliminated; the bulk of the costs then involve the fixed depreciation of the new equipment. Managers should project break-even quantities based on the choice of capital-labor mix to be used in the relevant time horizon.
Traditionally, fixed costs have been allocated to products based on estimates of production for the fiscal year and on direct labor hours required for production.
Technological advances have significantly reduced the proportion of direct labor costs and have increased the indirect costs through computerization and the requisite skilled, salaried staff to support company-wide computer systems. Activity-based costing ABC is an allocation system in which managers attempt to identify "cost drivers" which accurately reflect the appropriate usage of fixed costs attributable to production of specific products in a multi-product firm.
Break-even analysis typically compares revenues to costs. However, other models employ similar analysis. Figure 2 Crossover Chart of Three Options. The optimal plan is calculated for only one product. There is no delay in the replenishment of the stock, and the order is delivered in the quantity that was demanded, i.
These underlying assumptions are the key to the economic order quantity model, and these assumptions help the companies to understand the shortcomings they are incurring in the application of this model.
No registration required! But if you signed up extra ReadyRatios features will be available. Have you forgotten your password? Are you a new user? ReadyRatios - financial reporting and statements analysis on-line IFRS financial reporting and analysis software. FAQ Manuals Contacts. Sign up or. Definition The economic order quantity EOQ is a model that is used to calculate the optimal quantity that can be purchased or produced to minimize the cost of both the carrying inventory and the processing of purchase orders or production set-ups.
See also Inventories Financial Modeling. Pages: 1 2 3 Next. It calculates the ideal number of units you should order, such that the cost involved is minimal and number of units is optimal. The Annual demand is the number of units that you sell annually. If actual units are not available, then you can use expected sales figure based on your sales trend.
This refers to the costs that are involved with an order but cannot be directly associated with the purchase cost. This refers to all the costs that are involved in storing or handling the items in your store or warehouse. Usually, holding costs are fixed in nature. Once these three are calculated, the following formula is used to calculate the EOQ:. The following table will give you a better idea about what the other factors are that can have an impact on demand and your business operations:.
The EOQ assumes that the demand for your products will remain constant throughout the year. It does not consider seasonal changes or fluctuations in demand. The EOQ assumes that holding and ordering cost remain constant, which may not always be the case. An increase or decrease in your transport charges, a change in the salary of your employees, or rising rent for your warehouse can all impact your costs and affect the calculations that go into the EOQ.
The EOQ also fails to factor in vendor discounts. Sometimes it makes sense for a retailer to buy a product in bulk from the vendor to get a discount.
In such cases, buying items in fewer installments can actually optimize the retailer's costs despite what the EOQ predicts. To read the full version of this content please select one of the options below:. Other access options You may be able to access this content by logging in via your Emerald profile.
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