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Production Information System

Economic Optimal Order Quantity

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Table of Contents
1 WHAT IS INVENTORY ?....................................................................................................3
1.1 INVENTORY MANAGEMENT ......................................................................................3
1.2 TYPES OF INVENTORY .................................................................................................4
2 COST COMPONENTS ........................................................................................................4
2.4 LEAD TIME:.......................................................................................................................7
3 ASSUMPTIONS OF THE MODEL.....................................................................................8
4 REORDER POINT ...............................................................................................................8
THE STATISTICAL “ REORDER POINT “ WITH PROBABILISTIC DEMAND AND
CONSTANT ORDER LEAD TIME ......................................................................................8
...................................................................................................................................................10
EXAMPLE 1 ...........................................................................................................................11
EXAMPLE 2 ...........................................................................................................................11
5.1 HISTORY OF ECONOMIC ORDER QUANTITY .....................................................12
5.2 ECONOMIC ORDER QUANTITY FORMULAS .......................................................13
6 EXAMPLES.........................................................................................................................15
6.1 EXAMPLE 1 .....................................................................................................................15
SOLUTION .............................................................................................................................15
6.2 EXAMPLE 2 .....................................................................................................................17
6.3 EXAMPLE 3 .....................................................................................................................17

Production Information System

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1 What is inventory ?

Inventory is the total amount of goods and/or materials contained in a

store or factory at any given time. Store owners need to know the precise
number of items on their shelves and storage areas in order to place
orders or control losses. Factory managers need to know how many units
of their products are available for customer orders. All of these business
rely on an inventory count to provide answers.

1.1 Inventory Management

In general, inventory management refers to the method by which

businesses handle tangible resources and materials in order to make sure
resources are readily available for use. Inventories are generally managed
using a paper list system or a computer software-enabled system. By
using an inventory management system, a household can expect to keep
necessary supplies on hand while a business can use resources more
efficiently in order to generate revenues.

The simplest form of inventory management is the hard-copy method

whereby a list is kept of materials that are used on a regular basis. When
items are brought in, they are added to the list. When supplies run low, a
purchase is made to replenish materials. In this manner, a
running inventory of the most important materials can be provided at any
time. This simple form of inventory management is helpful so that
materials can be purchased at opportune times when prices are low and
nothing critical ever runs out.

Another popular form of inventory administration is the computer-

software-based inventory managementsystem. As supplies accumulate, a
computer inventory management system can be used to keep track of
large amounts of products and materials. Whenever an individual material
is brought in or leaves the inventory, the inventory-management software
makes adjustments to correspond with these activities.

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1.2 Types Of Inventory

1.2.1 Raw materials: The purchased items or extracted materials that are
transformed into components or products.

1.2.2 Components: Parts or subassemblies used in building the final product.

1.2.3 Work-in-process (WIP): Any item that is in some stage of completion in

the manufacturing process.

1.2.4 Finished goods: Completed products that will be delivered to

customers.

1.2.5 Distribution inventory: Finished goods and spare parts that are at various
points in the distribution system.

1.2.6 Maintenance, repair, and operational (MRO) inventory (often called supplies):
Items that are used in manufacturing but do not become part of the
finished product.

2 Cost Components

2.1 Annual Usage/Demand:

Expressed in units this is generally the easiest part of the equation. You
simply input your forecasted annual usage.

2.2 Order Cost:

Also known as purchase cost or set up cost, this is the sum of the fixed
costs that are incurred each time an item is ordered. These costs are not
associated with the quantity ordered but primarily with physical activities
required to process the order.

For purchased items these would include the cost to enter the Purchase
Order and/or Requisition, any approval steps, the cost to process the
receipt, incoming inspection, invoice processing and vendor payment, and
in some cases a portion of the inbound freight may also be included in
order cost. It is important to understand that these are costs associated
with the frequency of the orders and not the quantities ordered. For
example in your receiving department the time spent checking in the
receipt, entering the receipt and doing any other related paperwork would

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be included while the time spent repacking materials, unloading trucks,
and delivery to other departments would likely not be included. If you
have inbound quality inspection where you inspect a percentage of the
quantity received you would include the time to get the specs and process
the paperwork and not include time spent actually inspecting, however if
you inspect a fixed quantity per receipt you would then include the entire
time including inspecting, repacking, etc. In the purchasing department
you would include all time associated with creating the purchase order,
approval steps, contacting the vendor, expediting, and reviewing order
reports, you would not include time spent reviewing forecasts, sourcing,
getting quotes (unless you get quotes each time you order), and setting
up new items. All time spent dealing with vendor invoices would be
included in order cost.

Associating actual costs to the activities associated with order cost is

where many an EOQ formula runs afoul. Do not make a list of all of the
activities and then ask the people performing the activities "how long does
it take you to do this?" The results of this type of measurement are rarely
even close to accurate. I have found it to be more accurate to determine
what percentage of time within the department is consumed performing
the specific activities and multiplying this by the total labor costs for a
certain time period (usually a month) and then dividing by the line items
processed during that same period.

It is extremely difficult to associate inbound freight costs with order costs

in an automated EOQ program and I suggest it only if the inbound freight
cost has a significant effect on unit cost and its effect on unit cost varies
significantly based upon the order quantity.

In manufacturing the Order cost would include the time to initiate the work
order, time associated with picking and issuing components excluding
time associated with counting and handling specific quantities, all
production scheduling time, machine set up time, and inspection time.
Production scrap directly associated with the machine setup should also
be included in order cost as would be any tooling that is discarded after
each production run. There may be times when you want to artificially
inflate or deflate set up costs. If you lack the capacity to meet the
production schedule using the EOQ you may want to artificially increase
set up costs to increase lot sizes and reduce overall set up time. If you
have excess capacity you may want to artificially decrease set up costs,
this will increase overall set up time and reduce inventory investment. The
idea being that if you are paying for the labor and machine overhead
anyway it would make sense to take advantage of the savings in reduced
inventories.

For the most part Order cost is primarily the labor associated with

5
processing the order however you can include the other costs such as the
costs of phone calls, faxes, postage, envelopes, etc.

2.3 Carrying Cost (Inventory Holding Costs):

Also called Holding cost, carrying cost is the cost associated with having
inventory on hand. It is primarily made up of the costs associated with the
inventory investment and storage cost. For the purpose of the EOQ
calculation, if the cost does not change based upon the quantity of
inventory on hand it should not be included in carrying cost. In the EOQ
formula, carrying cost is represented as the annual cost per average on
hand inventory unit. Below are the primary components of carrying cost.

Interest;

If you had to borrow money to pay for your inventory, the interest rate
would be part of the carrying cost. If you did not borrow on the inventory
however have loans on other capital items, you can use the interest rate
on those loans since a reduction in inventory would free up money that
could be used to pay these loans. If by some miracle you are debt free you
would need to determine how much you could make if the money was
invested.

Insurance;

Since insurance costs are directly related to the total value of the
inventory, you would include this as part of carrying cost.

Taxes;

If you are required to pay any taxes on the value of your inventory they
would also be included.

Storage Costs;

Mistakes in calculating storage costs are common in EOQ

implementations. Generally companies take all costs associated with the
warehouse and divide it by the average inventory to determine a storage
cost percentage for the EOQ calculation. This tends to include costs that

6
are not directly affected by the inventory levels and does not compensate
for storage characteristics. Carrying costs for the purpose of the EOQ
calculation should only include costs that are variable based upon
inventory levels.

If you are running a pick/pack operation where you have fixed picking
locations assigned to each item where the locations are sized for picking
efficiency and are not designed to hold the entire inventory, this portion of
the warehouse should not be included in carrying cost since changes to
inventory levels do not effect costs here. Your overflow storage areas
would be included in carrying cost. Operations that use purely random
storage for their product would include the entire storage area in the
calculation. Areas such as shipping/receiving and staging areas are usually
not included in the storage calculations, however if you have to add an
additional warehouse just for overflow inventory then you would include all
areas of the second warehouse as well as freight and labor costs
associated with moving the material between the warehouses.

There are situations where you may not want to include any storage costs
in your EOQ calculation. If your operation has excess storage space of
which it has no other uses you may decide not to include storage costs
since reducing your inventory does not provide any actual savings in
storage costs. As your operation grows near a point at which you would
need to expand your physical operations you may then start including
storage in the calculation.

A portion of the time spent on cycle counting should also be included in

carrying cost, remember to apply costs which change based upon changes
to the average inventory level. So in cycle counting you would include the
time spent physically counting and not the time spent filling out
paperwork, data entry, and travel time between locations.

Other costs that can be included in carrying cost are risk factors
associated with obsolescence, damage, and theft. Do not factor in these
costs unless they are a direct result of the inventory levels and are
significant enough to change the results of the EOQ equation.

2.4 Lead Time:

The lead time, which is the amount of time between the placement of an
order to replenish inventory and the receipt of the goods into inventory.
If the lead time always is the same (a fixed lead time), then the
replenishment can be scheduled just when desired.

7
3 ASSUMPTIONS OF THE MODEL

• Demand is known and deterministic ( constant )

• The Lead Time , ie. The time between the placement of the order
and receipt of the order is known and constant .
• The receipt of inventory is instantaneous . In oher words the
inventory from an order arrives in one batch at one point in time .
• Quantity discounts are not possible , in other words it does not make
any difference how much we order , the price of the product will stil
be the same . That the only costs pertinent to the inventory model
are the cost of placing an order and the cost of holding or storing
inventory over time .
• There is no stockouts .
• There isn ‘t safety stock.

4 Reorder Point

The Statistical “ Reorder Point “ with Probabilistic Demand and constant Order Lead
Time

If the average demand during the order lead time is represented by μ and
the reorder point is represented by x , then the safety stock is ( x-μ ) ,
which can be derived from the standart deviation Formula , Z = ( x-μ ) / σ .
Then if the probability of stockout is represented by a , the probability
that inventory is sufficient to cover demand . ( the in – stock probability )
is 1-a . The in stock probability is commonly referred to as a service level .

8
Service level = Average demand during lead time ( μ )
Safety stock = ( x-μ )
Reorder point = x
Probability of stockout = a

The Z value can be determined from standardized normal curve and the
desire for a spesific in stock probability . For ex. , a 97.5 percent in stock
probability or 2.5 percent stockouts ( a = 2,5 percent ) corresponds to a Z
value of 1,96 . At the middle of the normal curve where the reorder point
equals the average lead time demand , the safety stock is zero and the
probability of stockout is 50 percent . Thus if no safety stock was
incorporated into the ROP and the firm ordered when existing inventory
level was equal to the average lead time demand , then the firm would
expect to stockout 50 percent of the time prior to receiving the order .

The statistical reorder point ( x ) can be calculated as the average demand

during the order lead time plus safety stock or ;

ROP = dLT + Z σdLt

The reorder point for replenishment of stock occurs when the level
of inventory drops down to zero. In view of instantaneous replenishment of

Servic
stock the level of inventory jumps to the original level from zero level. The
reorder point is the quantity of units in inventory that will trigger an order
to purchase additional units. Let’s assume that a company’s reorder point
for its Product X is 80 units. When the inventory of Product X drops to 80
units, the company places an order for additional units of Product X.

9
That is ;

We have two cases ,

1. There is a stockout

d
ROP = LT + Z σ
dLt
2. There is not stockout

d = max daily or weekly or monthly usage

L = Lead time

Reorder point = ROP = d x L

In
ven
to
ry
O
pt
ima
l
O
rd
er
10
Example 1

There is not any stockouts . The average daily usage rate of a material is 50 units and the lead-
time is seven days . Reorder point = ?

Solution :

Reorder level = Average daily usage rate x Lead time in days = 50 units x 7 days = 350 units

Example 2

London Inc Stocks a crucial part that has a normal distribution demand pattern during the
order lead time period . Past demand shows that the average demand during lead time ( μ )
for the part is 550 units and the standart deviation of demand during order

σ
lead time period ( dLt) is 40 units . The manager wants determine the
safety stock required and the statistical reorder point that would result in
5 percent stockouts , or an in stock probability of 95 percent . What would
the ROP and required safety stock be if the manager decided to attain a
99 percent in – stock probablity ?

Solution :

1. The normal table or Z table shows that a 95 percent in stock probability

corresponds to a Z value of 1.65 standart deviations above the mean
Z = 1.65

2. The required safety stock is then

safety stock = Z σdLt = 1.65 x 40 = 66 units

3. The ROP = dLT + Z σdLt = 550 + 66 = 616 units

4. The required safety stock at a 99 percent in stock probability = Z σdLt = 2.33 x 40

= 93 units and ;
The ROP = 550 + 93 = 643 units

11
5 WHAT İS EOQ ( Economic Order Quantity )

Inventory is held to avoid the nuisance, the time and the cost etc. of
constant replenishment. However, to replenish inventory only infrequently
would necessitate the holding of very large inventories. It is therefore
apparent that some balance or trade-off or compromise is needed in
deciding how much inventory to hold, and therefore how much inventory
to order. There are costs of holding inventory and there are costs of re-
ordering inventory and these two costs need to be balanced. The purpose
of the EOQ model is to minimise the total costs of inventory.

The important costs are the ordering cost, the cost of placing an order,
and the cost of carrying or holding a unit of inventory in stock. All other
costs such as, for example, the purchase cost of the inventory itself, are
constant and therefore not relevant to the model.
Our purpose is to minimize the total cost which is the sum of the
inventory holding cost and the ordering cost .

5.1 History Of Economic Order Quantity

Donald Erlenkotter published two articles on the history of the Economic

Order Quantity ( EOQ ) model ( Erlenkotter , 1989 , 1990 ) . The
articles gave a comprehensive review of the literature up to that time and
moved the origin of the EOQ model from a 1934 Harvard Business Review
article by R.H.Wilson back to a 1913 article by Ford Whitman Harris in
Factory : The Magazine of Management . F.W.Harris seems like character
out of an Horatio Alger hero . Harris was an engineer with Westinghouse ,
but he was not a ‘ graduate engineer ‘ . His formal schooling extended
only through high school . Self – thought , Harris was phenomenally
succesful . He was published over 70 articles , he held some 50 patents .
He retired from engineering and ‘ read the law ‘ with a Californa law firm .
He went on to be admitted to the California bar and become a succesful
patent attorney . F.W.Harris lived the American dream .

Total Cost = Holding Cost + Ordering Cost

12
Holding cost curve with ordering cost curve is opposite each other . If
order the total ordering cost decreases and if the average order quantity
increases , average inventory holding cost increases . The purpose of
model is to minimize the sum of inventory holding cost and the ordering
cost .

5.2 Economic Order Quantity Formulas

D = Annual demand (units)

C = Cost per unit ($)
Q = Order quantity (units)
S = Cost per order ($)
I= Holding cost (%)
H = Holding cost ($) = I x C (also known as carrying cost or storage
holding cost ( warehouse space , refrigeration , insurance,...usually not
related to the unit cost )

ROP= Reorder Point

Number of Orders = D / Q
Ordering costs = S x (D / Q)

Average inventory
units = Q / 2
$ = (Q / 2) x C

Cost to carry

13
average inventory = (Q / 2) x I x C
= (Q /2) x H

Total cost = (Q/2) x I x C + S x (D/Q)

inv carry cost order cost

If We take the 1st derivative ;

d(TC)/d(Q) = (I x C) / 2 - (D x S) / Q²

To optimize: set d(TC)/d(Q) = 0

DS/ Q² = IC / 2

Q²/DS = 2 / IC

Q²= (DS x 2 )/ IC

Q = sqrt (2DS / IC)

2 ×D ×S
EOQ =
H

D= Annual demand (units)

S= Cost per order ($)
C= Cost per unit ($)
I = Holding cost (%)
H= Holding cost ($) = I x C

2 × D ×S
Q ==
Optimal Order Quantity =EOQ H

Expected Number Orders = N = D / Q

Expected Time Between Orders = T = Working Days – Year / N

14
d = D / Working Days – Year

ROP (REORDERING POINT ) = d x L

6 EXAMPLES

6.1 EXAMPLE 1

Jaydep Company buys 6000 units of an item every year with a unit cost of
30 euro . It costs 125 euro to process an order and arrange delivery , while
interest and storage costs amount to 6 euro a year for each unit held .
What is the best ordering policy for the item ?

Solution

Listing the values we know in consistent values ;

Demand = D = 6000 units

Unit Cost = C = 30 euro
Holding Cost = H = 6 euro
Ordering Cost = 125 euro

Substituting these figures into the economic order quantity equation

gives ;

2 ×D ×S
EOQ =
H = sqrt {( 2 x 6000 x 125 ) / 6 }

EOQ = Q = 500 units

The inventory holding cost = Q / 2 x H = 250 x 6 = 1500 euro for a year

Ordering Cost = S x ( D / Q ) = 125 x ( 6000 / 500 ) = 1500 euro

Total Cost = Inventory Holding Cost + Ordering Cost

15
Total Cost = 1500 + 1500 = 3000 euro for a year

ECONOMİC ORDER QUANTITY MODEL

Problem Jaydeep Company

Parameter Values :
$
125,0
Fixed Cost per Order S = 00
Annual Number of Items Demanded D = 6000
Unit Cost of Procuring an Item C = $ 30
Annual Holding Cost per Dollar value H = $6

Decision Variables :
Optimal Order
Quantity Q = 500

Results :
Holding Cost H $
= 1500
Order Cost $
= 1500
Total Cost $
= 3000

16
6.2 EXAMPLE 2

Demand for the Deskpro computer at Best Buy is $ 1000 units per month .
Best Buy incur a fixed order placement, transportation , and receiving cost
of $ 4000 each time an order is placed . Each computer costs Best Buy $
500 and the retailer has a holding costs of 20 percent .

Annual demand D = 1000 X 12 = 12000

Order cost per lot S = $ 4000
Price per unit C = $ 500
Annual Holding cost I = 0.2

Optimal Order Quantity Q = SQRT ( ( 2DS)/IC )

SQRT ( ( 2*12000*4000 ) / 0.2*500 ) = 980
Annual Holding Cost = ( Q/2 ) * I * C
= (980/2)*0.2*500 = $ 49000
Order Cost = ( D/Q ) * S
= ( 12000 / 980 ) * 4000 = $ 48979.59
Total Cost = Annual Holding Cost + Order Cost
Total Cost = $ 49000 + 48979.59 = $ 97980

6.3 EXAMPLE 3

The store manager at Best Buy would like to reduce optimal order quantity
from 980 to 200 . For this lot quantity to be optimal , the store manager
wants to evaluate how much the order cost per lot should be reduced .

Annual demand D = 1,000 X 12 = 12,000

Price per unit C = $ 500
Annual Holding cost I = 0.2
Desired optimal order quantity Q* = 200
Desired order cost per lot S = ((IC(Q*)(Q*))/(2D)
S = (0.2*500*200*200)/(2*12000)
S = $ 166.67

17
Problem
18