Your staff members have different jobs with different levels and kinds of responsibility. Required rate of return computes a cost for the money used by the purchasing manager.
The more you spend on inventory, the less cash you have for other purposes. The EOQ calculates the ideal quantity of inventory to order for a given product. That activity increases total ordering costs. Inventory Goal Congruence.
You pass up other business opportunities. Cost Accounting: As you set up goals for everyone, the company-wide goals can get lost. Bottom line: Your purchasing manager may buy more inventory than you think is necessary. Finally, larger purchases use up more cash.
That process gets tough when you start to set up evaluation criteria for employees. The solution is to evaluate the purchasing manager using multiple criteria. The extra dollars that the manager is using to buy inventory has a cost.
The manager avoids stockouts by — you guessed it — buying more inventory than the company really needs. The whole point of calculating EOQ is to minimize carrying costs and ordering costs.
The carrying cost is higher. When you raise money to run your business, investors who provide the funds to you have an expectation about what they will earn on those funds.
If you buy more inventory than needed, you need to store it, insure it, and protect it against theft.
If the purchasing manager is evaluated on stockouts and required rate of return, he or she has to strike a balance. If you explain things to the manager, he or she will probably see the benefit of EOQ and use it. The manager wants to avoid stockouts.
The purchasing manager gets a good job evaluation an important goal for him or her because stockouts never happen. Also, if the purchasing manager panics every time inventory levels decline, he or she may place frequent orders.