CPIM Practice Exam

Which formula is used to calculate total inventory costs effectively?

1. Annual carrying cost plus projected sales

2. Annual ordering cost plus annual carrying cost

3. Lot size quantity plus order frequency

4. Annual demand multiplied by order point

The correct answer is: Annual ordering cost plus annual carrying cost

The formula for calculating total inventory costs effectively focuses on understanding the two main components that drive inventory expenses: ordering costs and carrying costs. The choice that combines these two essential elements is the sum of annual ordering cost and annual carrying cost. Annual ordering costs refer to the expenses incurred each time an order is placed, which may include shipping fees, handling expenses, and costs associated with processing purchase orders. As the frequency of orders increases, so too do the total ordering costs since more orders are placed throughout the year. On the other hand, annual carrying costs relate to the costs of holding inventory, which includes warehousing costs, insurance, depreciation, and opportunity costs. The longer inventory remains unsold and stored, the higher the carrying costs become. By adding the annual ordering costs to the annual carrying costs, one gains a comprehensive view of the total inventory costs associated with managing stock levels. This approach helps organizations optimize inventory management strategies, balance order quantities and timing, and ultimately minimize total costs while meeting service demands. The other options do not adequately represent the complete model for understanding total inventory costs. For instance, simply adding projected sales or lot size to other factors would not cover all relevant costs, thus failing to provide an accurate calculation of total inventory expenses.