The EOQ Model

To a pessimist, the glass is half empty.

to an optimist, it is half full.

Anonymous

1
EOQ Modeling
Assumptions
1. Production is instantaneous there is no capacity constraint and the
entire lot is produced simultaneously.
2. Delivery is immediate there is no time lag between production and
availability to satisfy demand.
3. Demand is deterministic there is no uncertainty about the quantity or
timing of demand.
4. Demand is constant over time in fact, it can be represented as a
straight line, so that if annual demand is 365 units this translates into a
daily demand of one unit.
5. A production run incurs a fixed setup cost regardless of the size of the
lot or the status of the factory, the setup cost is constant.
6. Products can be analyzed singly either there is only a single product
or conditions exist that ensure separability of products.

2
Notation
D demand rate (units per year)

c unit production cost, not counting setup or inventory costs

(dollars per unit)

A fixed or setup cost to place an order (dollars)

h holding cost (dollars per year); if the holding cost is consists entirely of
interest on money tied up in inventory, then h = ic where i is an annual
interest rate.

Q the unknown size of the order or lot size decision variable

3
Inventory vs Time in EOQ
Model

Q
Inventory

Q/D 2Q/D 3Q/D 4Q/D

Time

4
MedEquip Example
Costs
D = 1000 racks per year

c = $250

A = $500 (estimated from suppliers pricing)

h = (0.1)($250) + $10 = $35 per unit per year

5
Costs
hQ
Holding Cost: unit holding cost
2D

A
Setup Costs: A per lot, so unit setup cost
Q

Production Cost: c per unit

Cost Function:
hQ A
Y (Q) c
2D Q

6
Economic Order
Quantity
dY (Q) h A
2 0
dQ 2D Q

2 AD
Q* EOQ Square Root Formula
h

2(500)(1000) MedEquip Solution

Q* 169
35

7
Example
Example: The annual demand for chocolate flavored beer is 2,500 units.
The setup cost is $15 per order. The holding cost per unit per year is
$0.25.
What is the optimum number of units per order? Q*
What is the expected number of orders per year? - N
Assuming a 250 day working year, what is the expected time between
orders? - T
What are the total annual inventory costs?- TC
If delivery of the beer takes 2 days, at what level of stock should a new order
be placed? -ROP
Solution
A=
D=
H=
Q* =
N = D / Q* =
T = Days per year / N =
TC = (D / Q) A + (Q / 2) h =
ROP = dL =
PRODUCTION
EOQ
Notation EPL Model
D demand rate (units per year)

c unit production cost, not counting setup or inventory costs

(dollars per unit)

A fixed or setup cost to place an order (dollars)

h holding cost (dollars per year); if the holding cost is consists entirely of
interest on money tied up in inventory, then h = ic where i is an annual
interest rate.

Q the unknown size of the production lot size decision variable

11
 Inventory vs Time in EPL
Model
Production run of Q takes Q/P time units

(P-D)(Q/P)
Inventory

-D P-D
(P-D)(Q/P)/2

Time

12
 Solution to EPL Model
Annual Cost Function: AD h(1 D / P )Q
Y (Q ) Dc
Q 2
setup holding production

Solution (by taking derivative and setting equal to zero):

tends to EOQ as P
2 AD
Q*
h(1 D / P ) otherwise larger than EOQ
because replenishment takes
longer

13
Example
Your sister sells coquito. The forecast for demand is 4,000 units per year,
with an average daily demand of 20 units. The production process is
most efficient when 60 units per day are produced. The setup cost is
$15, and the holding cost is $0.25 per unit per year. What is the
optimum number of units per order?
Solution
A=
D=
P=
h=
EOQ Takeaways

Batching causes inventory (i.e., larger lot sizes translate into more stock).

Under specific modeling assumptions the lot size that optimally balances
holding and setup costs is given by the square root formula:

2 AD
Q
*

h
Total cost is relatively insensitive to lot size (so rounding for other reasons,
like coordinating shipping, may be attractive).

16