Economic Order Quantity

Economic order quantity

Economic Order Quantity (also known as the Wilson EOQ Model or simply the
EOQ Model) is a model that defines the optimal quantity to order that minimizes
total variable costs required to order and hold inventory.

The model was originally developed by F. W. Harris in 1915, though R. H. Wilson is

credited for his early in-depth analysis of the model.

Underlying assumptions
1. the monthly demand for the item is known, deterministic and constant
2. the lead time is zero, i.e., delivery is immediate
3. the receipt of the order occurs in a single instant and immediately after
ordering it
4. quantity discounts are not calculated as part of the model
5. the setup cost is constant

Note that deterministic does not imply the constancy of the demand. For instance, the
sine function is deterministic, but not constant.

Some consequences
1. Shortages or stockouts do not occur, as delivery of the order is immediate.
What is EOQ
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.

Cost Components
Annual Usage/Demand:

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

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

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 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.

Since storage costs are generally applied as a percentage of the inventory value you
may need to classify your inventory based upon a ratio of storage space requirements
to value in order to assess storage costs accurately. For example let's say you have just
opened a new E-business called "BobsWeSellEverything.com". You calculated that
overall your annual storage costs were 5% of your average inventory value, and
applied this to your entire inventory in the EOQ calculation. Your average inventory
on a particular piece of software and on 80 lb. bags of concrete mix both came to
$10,000. The EOQ formula applied a $500 storage cost to the average quantity of
each of these items even though the software actually took up only 1 pallet position
while the concrete mix consumed 75 pallet positions. Categorizing these items would
place the software in a category with minimal storage costs (1% or less) and the
concrete in a category with extreme storage costs (50%) that would then allow the
EOQ formula to work correctly.

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.

Assumptions of the Model

1. Demand is known and is deterministic, ie. constant.
2. The lead time, ie. the time between the placement of the order and the receipt
of the order is known and constant.

3. The receipt of inventory is instantaneous. In other words the inventory from an

order arrives in one batch at one point in time.

4. Quantity discounts are not possible, in other words it does not make any
difference how much we order, the price of the product will still be the same.
(for the Basic EOQ-Model)

5. 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

Important Note: When calculating the Economic Order Quantity, be aware of the
assumptions mentioned above!

Variations
There are many variations on the basic EOQ model. I have listed the most useful ones below.
• Quantity discount logic can be programmed to work in conjunction with the EOQ
formula to determine optimum order quantities. Most systems will require this
additional programming.
• Additional logic can be programmed to determine max quantities for items subject to
spoilage or to prevent obsolescence on items reaching the end of their product life
cycle.
• When used in manufacturing to determine lot sizes where production runs are very
long (weeks or months) and finished product is being released to stock and
consumed/sold throughout the production run you may need to take into account the
ratio of production to consumption to more accurately represent the average
inventory level.
 • Your safety stock calculation may take into account the order cycle time that is driven
by the EOQ. If so, you may need to tie the cost of the change in safety stock levels
into the formula.

Graphical Solution
If we minimize the sum of the ordering and carrying costs, we are also minimizing the
total costs. To help visualize this we can graph the ordering cost and the holding cost
as shown in the chart below:

This chart shows costs on the vertical axis or Y axis and the order quantity on the
horizontal or X axis. The straight line which commences at the origin is the carrying
cost curve, the total cost of carrying units of inventory. As expected, as we order more
on the X axis, the carrying cost line increases in a proportionate manner. The
downward sloping curve which commences high on the Y axis and decreases as it
approaches the X axis and moves to the right is the ordering cost curve. This curve
represents the total ordering cost depending on the size of the order quantity.
Obviously the ordering cost will decrease as the order quantity is increased thereby
causing there to be fewer orders which need to be made in any particular period of
time.

The point at which these two curves intersect is the same point which is the minimum
of the curve which represents the total cost for the inventory system. Thus the sum of
the carrying cost curve and the ordering cost curve is represented by the total cost
curve and the minimum point of the total cost curve corresponds to the same point
where the carrying cost curve and the ordering cost curve intersect.
How to calculate
Basic EOQ:

The objective is to determine the quantity to order which minimizes the total
annual inventory management cost.

Thus: Minimize! Total cost per period = inventory holding costs per period +
order costs per period

where Order Cost = The Number of Orders Placed in the period x Order Costs

and Carrying Cost = Average Inventory Level x the Carrying Costs of 1 unit of
Stock for one period

with:

• Q = order quantity
• A = demand per time period (e.g. Annual Demand)

• S = Carrying / Holding Cost of 1 unit of Stock for one period

• P = Order Cost

and the derivation set to zero we get the following formula:

So we can see that the two cost elements at the economic order quantity are equal,
one to the other; (compare with the graphical solution!)
If we now isolate the Q, we get the following Basic EOQ-Formula:

Production EOQ:
 Instead of instantaneous replenishment, we include the finite Production Rate R
which leads to the following formula: (You can see, that production rate must be
greater than demand rate, in order to fulfill the demand!)

EOQ = sqrt ( 2 * A * P / (S*(1-A/R))

Backlogging EOQ:

By including the Backlogging Cost B, which is the cost of back-logging one unit
per period, we get the following formula:

EOQ = sqrt (2 * A * P * (S+B) / S * B)

Extensions
Economic production quantity
Economic Production Quantity model (also known as the EPQ model) is an
extension of the Economic Order Quantity model. The difference being that the
EPQ model assumes orders are received incrementally during the production
process. The function of this model is to balance the inventory holding cost and the
average fixed ordering cost.

Variables
• K = ordering cost
• D = demand rate
• F = holding cost
• T = cycle length
• P = production rate

Formula
Case
Stop n Slurp Convenience Store

Annual Demand: 5200 Cases of Coca Cola

Fixed Ordering Cost: 500 per order
Cost Per Case: 100
Holding Cost: 20% of value of inventory per year

Suppose EOQ assumptions hold (Constant demand, no lag/lead time, no shortages)

How Much Coca Cola should Stop n Slurp Order?

Solution

EOQ Parameters:

Annual Usage = 5200

Order Cost = 500
Annual Carrying Cost = 20% of 100 = 20

Optimum Ordering Policy:

Q = sqrt(2 x 5200 x 500)/(20) = 509.9 ~ 510 Cases

Bibliography
Materials Management an integrated approach – P. Gopalakrishnan

Cost Accounting

http://www.pafis.shh.fi/~stecon02/afis/ws2/
http://www.inventoryops.com/economic_order_quantity.htm
http://www.caam.rice.edu/~timredl/caam376/
http://en.wikipedia.org/wiki/Economic_order_quantity