Assignment No.

2
Supply Chain Management
Aalia Affandi
SAP 11030
MSPM 2ndSemester Group (A)
Discuss how fixed cost is treated in various elements EOQ formula?
Demand
Ordering cost
Carrying cost
Unit cost
Economic order quantity (EOQ) refers to the optimum amount of an item that should be ordered
at any given point in time, such that the total annual cost of carrying and ordering that item is
minimized. EOQ is also sometimes known as the optimum lot size. It helps minimize holding
costs and order costs for your business.  The formula assumes that demand, ordering, and
holding costs all remain constant. The economic order quantity is computed by both
manufacturing companies and merchandising companies. Manufacturing companies compute it
to find the optimal order size of raw materials inventory and merchandising companies compute
it to find the optimal order size of ready to use merchandise inventory.

Demand:

The EOQ model assumes that demand is constant, and that inventory is depleted at a fixed rate
until it reaches zero. At that point, a specific number of items arrive to return the inventory to its
beginning level. Since the model assumes instantaneous replenishment, there are no inventory
shortages or associated costs. Therefore, the cost of inventory under the EOQ model involves a
tradeoff between inventory holding costs (the cost of storage, as well as the cost of tying up
capital in inventory rather than investing it or using it for other purposes) and order costs (any
fees associated with placing orders, such as delivery charges). Ordering a large amount at one
time will increase a small business's holding costs, while making more frequent orders of fewer
items will reduce holding costs but increase order costs.

Ordering cost:

Ordering cost is the cost of placing an order to the supplier for inventory. The number of orders
is calculated by the annual quantity demanded divided by volume per order.

The ordering costs are the costs that are incurred every time an order for inventory is placed with
the supplier. Examples of these costs include telephone charges, delivery charges, invoice
verification expenses and payment processing expenses etc. The total ordering cost usually
varies according to the frequency of placing orders. Mostly, it is directly proportional to the
number of orders placed during the year which means If the number of orders placed during the
year increases, the annual ordering cost will also increase and if, on the other hand, the number
of orders placed during the year decreases, the annual ordering cost will also decrease.

Number of orders = D / Q

Where,

 D = Annual quantity demanded

 Q = Volume per order

 Annual Ordering Cost

An annual ordering cost is the number of orders multiply by ordering cost.

Annual ordering cost = (D * S) / Q

Where,

 S = Ordering cost
Holding Cost/ Carrying Cost:

Holding cost is the cost of a holding of inventory in storage. It is the direct cost that needs to be
calculated to find the best opportunity whether to store inventory or instead of it invest it
somewhere else. Assuming demand to be constant. The holding costs (also known as carrying
costs) are the costs that are incurred to hold the inventory in a store or warehouse. Examples of
costs associated with holding of inventory include occupancy of storage space, rent, shrinkage,
deterioration, obsolescence, insurance and property tax etc. The total holding cost usually
depends upon the size of the order placed for inventory. Mostly, the larger the order size, the
higher the annual holding cost and vice versa. The total holding cost is some time expressed as a
percentage of total investment in inventory.

 H = i*C

Where,

 H= Holding cost , i= Carrying cost , C= Unit cost

Here as demand is constant inventory will decrease with usage when it reduces to zero-order
placed again.

Unit cost:

Unit cost is the manufacturing cost of a single unit of demand .in unit cost when company
produce any type of product in bulk per unit cost automatically decreases due to Mass
production.
Discussion
EOQ applies only when demand for a product is constant over the year and each new order is
delivered in full, when inventory reach zero there is a fixed cost for each order place .
Unit cost remains constant regardless of the changes of volume . but total changes
proportionality , unit fixed cost is inversely changes with change in volume , total fixed cost
stays constant within the relevant range.