Economic Order Quantity

The Decisions to be Made

One of the most frequent decisions faced by operations managers is how much or how many of something to make or buy in order to satisfy external or internal requirements for some item. Many times, this decision is made with little or no thought about its cost consequences.

The Definition of EOQ

EOQ, or Economic Order Quantity, is defined as the optimal quantity of orders that minimizes total variable costs required to order and hold inventory.

The basic model makes the following assumptions:

Demand is uniform, constant and continuous over time; The lead time is constant; There is no limit on order size due either to stores capacity; The cost of placing an order is independent of size of order; The cost of holding a unit of stock does not depend on the quantity in stock; Exactly the same quantity is ordered each time that a purchase is made.

How to use EOQ in your organization

How much inventory should we order each month?

The EOQ tool can be used to model the amount of inventory that we should order.

Costs

EOQ accounts for 3 types of costs:

Unit Cost: the cost of the units themselves, assumed to be fixed, regardless of the number of units ordered Inventory-Holding Cost: the cost of holding units in inventory Fixed order cost: represents all the costs associated with placing an order excluding the cost of the units themselves (any administrative costs of placing and/or receiving an order)

Inventory Holding Costs

Reasonably Typical Profile

Category

% of Inventory Value

Housing (building) cost 6% Material handling costs 3% Labor cost 3% Inventory investment costs 11% Pilferage, scrap, & obsolescence 3% Total holding cost 26%

EOQ Model
Annual Cost Holding Cost

Order Quantity

Why Order Cost Decreases

Cost is spread over more units

Example: You need 1000 microwave ovens

1 Order (Postage $ 0.35) 1000 Orders (Postage $350)

Purchase Order Description Qty. Microwave 1000

Purchase Order Purchase Order Purchase Order Description Qty. Purchase Order Description Qty. Description Qty.1 Microwave Description Qty. Microwave Microwave 111 Microwave

Order quantity

EOQ Model

Annual Cost Holding Cost

Order Cost

Order Quantity

EOQ Model

Annual Cost Total Cost Curve

Holding Cost Order Cost Optimal Order Quantity (Q*) Order Quantity

How EOQ Works

The Total Cost Formula

Total Cost = Purchase Cost + Order Cost + Holding Cost

How EOQ Works

The Total Cost Formula

This represents the unchanging fixed costs

P = Purchase cost per unit R = Annual usage in units

How EOQ Works

The Total Cost Formula

This represents the variable order costs

P = Purchase cost per unit R = Annual usage in units C = Cost per order event (not per unit) Q = The number of units ordered

How EOQ Works

The Total Cost Formula

This represents the variable holding costs

P = Purchase cost per unit R = Annual usage in units C = Cost per order event (not per unit) Q = The number of units ordered F = Holding cost factor

How EOQ Works

The EOQ Formula Total Cost Formula

Taking the derivative of both sides of the equation and setting equal to zero to find the minimum value of the function, one obtains:

How EOQ Works

The result of differentiation

The Economic Order Quantity

How EOQ Works

P = Purchase cost per unit R = Annual usage in units C = Cost per order event (not per unit) F = Holding cost factor

How EOQ Works

Expected Number Orders = N = R/Q* Expected time between orders:

T=
Working days / Year N

How EOQ Works

The graphic representation of the EOQ equation

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Real Life Example:

Real Life Example:

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Real Life Example:

First, Recall the EOQ Equation:

P = Purchase cost per unit R = Annual usage in units C = Cost per order event F = Holding cost factor

Real Life Example:

Next lets identify the correct variables

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Real Life Example:

Forecasted Amount

Real Life Example:

Ordering Costs

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Real Life Example:

Cost per Unit

Real Life Example:

Holding Cost Factor

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Real Life Example:

R = Annual demand C = Fixed ordering cost P = Cost per case F = Holding Cost Factor

Real Life Example:

R = 5200 C = $10 per order

P = $2
F = 20% of value of inventory per year

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Real Life Example:

EOQ =

2 (10) (5200) (2 )(.20)

Wrapping It Up
EOQ, or Economic Order Quantity, is defined as the optimal quantity of orders that minimizes total variable costs required to order and hold inventory.

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Conclusion

EOQ is useful for minor stock items of low values with known steady prices, demands and supply lead times; Where there is demand variability, such as seasonality, EOQ can still be calculated but using shorter time period.

EOQ Example
Youre a buyer for SaveMart. SaveMart needs 1000 coffee makers per year. The cost of each coffee maker is $78. Ordering cost is $100 per order. Carrying cost is 40% of per unit cost. Lead time is 5 days. SaveMart is open 365 days/yr. What is the optimal order quantity?

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SaveMart EOQ

R= C= P= F= H= H=

1000 $100 $ 78 40% PxF $31.20

EOQ

2 1000 $100 $31.20

EOQ = 80 coffeemakers

Homework
Calculate the EOQ of A materials if: The annual demand for material "A" is 2,800 pieces The purchase price per unit is $80 The rate of storage cost is of 20% of the purchase price per unit Fixed costs are $500 per order

How many times should we order to meet the annual demand for material "A"?

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