MCL756 : Supply Chain Management

Sensitivity of EOQ

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The EOQ Model

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 MedEquip Example
• Small manufacturer of medical diagnostic equipment.
• Purchases standard steel “racks” into which electronic components
are mounted.
• Metal working shop can produce (and sell) racks more cheaply if they
are produced in batches due to wasted time setting up shop.
• MedEquip doesn’t want to tie up too much precious capital in
inventory.

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 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.
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 Notation
D demand rate (units per year)

c unit production cost, not counting setup or inventory costs (Rs per
unit)

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

h holding cost (Rs per year); if the holding cost consists entirely of
interest on money tied up in inventory, then h = ic where i is an annual
interest rate. decision variable
Q the unknown size of the order or lot size

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 Inventory vs Time in EOQ Model

Inventory Q

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

Time

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 Costs
 Holding Cost: average inventory =
Q
2
hQ
annual holding cost =
2
hQ
unit holding cost =
2D

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

 Production Cost: c per unit

 Cost Function: Y (Q) =

hQ A
+ +c
2D Q

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 MedEquip Example Costs

 D = 1000 racks per year

 c = Rs 250

 A = Rs 500 (estimated from supplier’s pricing)

 h = Rs 35 per unit per year

 i = 10%

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 Costs in EOQ Model
20.00

18.00

16.00

14.00

Cost ($/unit)
12.00

10.00 Y(Q)
Q* =169
8.00

6.00 hQ/2D

4.00

2.00 c A/Q

0.00
0 100 200 300 400 500

Order Quantity (Q)

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 Economic Order Quantity

dY (Q) h A
= − 2 =0
dQ 2D Q

2 AD EOQ Square Root Formula

Q* =
h

2(500)(1000) MedEquip Solution

Q =
*
= 169
35

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 EOQ Modeling Assumptions
1. Production is instantaneous – there is no capacity constraint relax via
and the entire lot is produced simultaneously. EPL model
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.

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 The Key Insight of EOQ
There is a tradeoff between lot size and inventory

 Order Frequency:
D
F=
Q

cQ cD
 Inventory Investment: I = =
2 2F

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 EOQ Tradeoff Curve
50
45

Inventory Investment
40
35
30
25
20
15
10
5
0
0 20 40 60 80 100
Order/Year

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 Sensitivity of EOQ Model to Quantity
 Optimal Unit Cost:
hQ* A We neglect unit cost, c,
Y = Y (Q ) =
* *
+
2 D Q* since it does not affect Q*
h 2 AD h A
= +
2D 2 AD h
2A
=
2 AD h

Annual Cost = 2 ADh

 Optimal Annual Cost: Multiply Y* by D and simplify,

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 Sensitivity of EOQ Model to Quantity (cont.)
 Annual Cost from Using Q':
hQ AD
Y (Q) = +
2 Q

 Ratio: Cost(Q) Y (Q) hQ 2 + AD Q 1  Q Q* 

= = =  *+ 
Cost(Q* ) Y (Q* ) 2 ADh 2 Q Q 

 Example: If Q' = 2Q*, then the ratio of the actual to optimal cost is
 (1/2)[2 + (1/2)] = 1.25

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 Sensitivity of EOQ Model to Order Interval
 Order Interval: Let T represent time (in years) between orders (production runs)

Q
T=
D
 Optimal Order Interval:

2 AD
Q* h = 2A
T =
*
=
D D hD

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 Sensitivity of EOQ Model to Order Interval
(cont.)
 Ratio of Actual to Optimal Costs: If we use T' instead of T*

annual cost under T  1  T  T * 

=  + 
annual cost under T * 2  T * T  

 Powers-of-Two Order Intervals: The optimal order interval, T * must lie

within a multiplicative factor of 2 of a “power-of-two.” Hence, the maximum error from using the
best power-of-two is
1 1 
2 + = 1.06
2  2 

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 The “Root-Two” Interval

2m T1* 2m 2 T2* 2 m +1
divide by multiply by
less than less than
2 to get 2 to get
to 2m to 2m+1

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 Medequip Example
 Optimum: Q*=169, so T*=Q*/D =169/1000 years = 62
days
hQ * AD 35(169 ) 500(1000 )
Y (Q*) = + = + = $5,916
2 Q* 2 169

 Round to Nearest Power-of-Two: 62 is between 32 and 64, but since 322=45.25, it is

“closest” to 64. So, round to T’=64 days or Q’= T’D=(64/365)1000=175.
hQ' AD 35(175) 500(1000 )
Y (Q ' ) = + = + = $5,920
2 Q' 2 175

Only 0.07% error because we were lucky and happened to be close to a power-of-
two. But we can’t do worse than 6%.
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 Powers-of-Two Order Intervals

Order Interval Week

0 1 2 3 4 5 6 7 8
1= 2 0

2 = 21

4 = 22

8 = 23

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 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 =
*

• Total cost is relatively insensitive to lot size (so rounding for

other reasons, like coordinating shipping, may be attractive).

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