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Why might a firm keep a safety stock? What effect is it likely to have on carrying cost of inventory?

Short Answer

Expert verified

The safety stock helps an organization against the risk of loss of sales, and the increase in safety stock increases the carrying cost of inventory.

Step by step solution

01

Reason for keeping safety stock

An organization should maintain safety stock to ensure that they have enough stock at a given time which will protect it against the risk of losing prospective sales which will affect the organization’s income. The safety stock will ensure that the organization is able to meet all the deliveries even when there is an unforeseeable delay like equipment breakdown, production delay, etc.

02

Impact of safety stock on carrying cost

The safety stock will result in an increase in the carrying cost of inventory. If an organization keeps a large safety stock, then it will lead to high carrying costs, and even small safety stock will result in a small increase in the inventory carrying cost.

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Most popular questions from this chapter

Nowlin Pipe & Steel has projected sales of 72,000 pipes this year, an ordering cost of \(6 per order, and carrying costs of \)2.40 per pipe.

c. What will the average inventory be?

Esquire Products Inc. expects the following monthly sales:

January

\(28,000

February

\)19,000

March

\(12,000

April

\)14,000

May

\(8,000

June

\)6,000

July

\(22,000

August

\)26,000

September

\(29,000

October

\)34,000

November

\(42,000

December

\)24,000

Total annual sales

\(264,000

Cash sales are 40 percent in a given month, with the remainder going into accounts receivable. All receivables are collected in the month following the sale. Esquire sells all of its goods for \)2 each and produces them for \(1 each. Esquire uses level production, and average monthly production is equal to annual production divided by 12.

c. Determine a cash payments schedule for January through December. The production costs (\)1 per unit produced) are paid for in the month in which they occur. Other cash payments (besides those for production costs) are $7,400 per month.

What are the advantages of commercial paper in comparison with bank borrowing at the prime rate? What is a disadvantage?

Sharpe Knife Company expects sales next year to be \(1,550,000 if the economy is strong, \)825,000 if the economy is steady, and $550,000 if the economy is weak. Mr. Sharpe believes there is a 30 percent probability the economy will be strong, a 40 percent probability of a steady economy, and a 30 percent probability of a weak economy. What is the expected level of sales for the next year?

In the second year, Fisk Corporation finds that it can reduce ordering costs to \(2 per order but that carrying costs stay the same at \)1.60 per unit. Also, volume remains at 49,000 units per year.

d. What is the total cost of ordering and carrying inventory?

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