A contractor has $180,000 invested in material inventory with an annual carrying cost of 25%. If they can reduce inventory to $120,000 through better management, what is the annual savings?
Correct Answer
C) $15,000
Inventory reduction: $180,000 - $120,000 = $60,000. Annual savings: $60,000 × 25% = $15,000 in reduced carrying costs.
Why This Is the Correct Answer
The correct answer is A because the annual savings equals the inventory reduction multiplied by the carrying cost percentage. The contractor reduces inventory by $60,000 ($180,000 - $120,000), and with a 25% annual carrying cost, the savings is $60,000 × 0.25 = $15,000. This represents the actual reduction in carrying costs achieved through better inventory management.
Why the Other Options Are Wrong
Option B: $30,000
$45,000 is incorrect and would result from applying the 25% rate to the final inventory level ($180,000 × 25%), which doesn't represent savings but rather the carrying cost of the original inventory.
Option D: $45,000
$60,000 is incorrect as this represents the total inventory reduction amount without applying the carrying cost percentage - it's the raw dollar reduction, not the annual savings.
Memory Technique
Remember 'RCR' - Reduction × Carrying Rate = Real savings. Only the reduced amount generates savings, not the total inventory.
Reference Hint
Business and Finance for Contractors - Chapter on Inventory Management and Working Capital
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