CPIM Practice Exam

In inventory management, how is the annual carrying cost calculated?

1. (Annual demand x lot size quantity) x cost per unit

2. (Lot size quantity / 2) x cost per unit x carrying cost rate

3. (Lot size quantity x carrying cost rate) / annual demand

4. (Cost per unit x annual order cost) / lot size quantity

The correct answer is: (Lot size quantity / 2) x cost per unit x carrying cost rate

The annual carrying cost is calculated using the formula that considers how much inventory is held on average during a year. The carrying cost takes into account the cost associated with holding inventory, which typically includes storage costs, insurance, depreciation, and opportunity costs of the capital tied up in inventory. The correct approach is to consider the average inventory level, which is half of the lot size quantity, because inventory levels fluctuate between zero and the full lot size quantity during the replenishment cycle. Therefore, taking the lot size quantity, dividing it by two gives the average inventory. This average is then multiplied by the carrying cost rate and the unit cost to derive the total carrying cost for the year. Thus, the formula captures the financial implications of maintaining inventory and provides an accurate representation of the annual carrying cost, forming a crucial aspect of inventory management and cost control strategies. The other calculation options do not convey the relationship between average inventory and carrying costs as effectively, leading to incorrect representations of how to assess annual carrying costs accurately.