ASSIGNMENT COVER PAGE

Course Code POM 507

Course Title Production and Operations Management

Explain the assumptions of Economic Order Quantity
Assignment Topic (EOQ) model and their impact on effective inventory
management.

Exam’s Name Final Examination

Student’s ID 2102140435

Student’s Name Istiaqur rahman chowdhury

Semester’s Name and Fall 2021

Year
Course Teacher’s S. M. Naser Iqbal
Name and Designation
Department’s Name Business Administration

Date of Submission December 16, 2021

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֍ INTRODUCTION :
What Is Economic Order Quantity (EOQ) - Economic order quantity (EOQ) is the ideal
order quantity a company should purchase to minimize inventory costs such as holding costs,
shortage costs, and order costs. This production-scheduling model was developed in 1913 by
Ford W. Harris and has been refined over time. The formula assumes that demand, ordering,
and holding costs all remain constant.

Formula for Calculating Economic Order Quantity (EOQ)

Economic order quantity will be higher if the company’s setup costs or product demand
increases. On the other hand, it will be lower if the company’s holding costs increase.

Importance of Economic Order Quantity - Economic order quantity is important because it

helps companies manage their inventory efficiently. Without inventory management
techniques such as this, companies will tend to hold too much inventory during periods of
low demand, while also holding too little inventory in periods of high demand. Either
problem creates missed opportunities for companies: Too much inventory generally means
too little cash on hand, while not holding enough inventory will lead to missed sales. For
investors, calculating the economic order quantity for a company can help to assess how
efficiently that company is managing its inventory.

₪ Assumptions of Economic Order Quantity (EOQ) model:

The formula is based on the following assumptions. Without these assumptions, the
EOQ model cannot work to its optimal potential.

1. The demand rate for the year is known and evenly spread throughout the year.
2. There is no time gap between placing an order and receiving its supply.

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3. Ordering cost very directly with the number of orders.
4. Carrying cost very directly with the average inventory.
5. There is no quantity discount.

The goal of the EOQ formula is to identify the optimal number of product units to order. If
achieved, a company can minimize its costs for buying, delivering, and storing units. The
EOQ formula can be modified to determine different production levels or order intervals, and
corporations with large supply chains and high variable costs use an algorithm in their
computer software to determine EOQ. EOQ is an important cash flow tool. The formula can
help a company control the amount of cash tied up in the inventory balance. For many
companies, inventory is its largest asset other than its human resources, and these businesses
must carry sufficient inventory to meet the needs of customers. If EOQ can help minimize the
level of inventory, the cash savings can be used for some other business purpose or
investment. The EOQ formula determines a company's inventory reorder point. When
inventory falls to a certain level, the EOQ formula, if applied to business processes, triggers
the need to place an order for more units. By determining a reorder point, the business avoids
running out of inventory and can continue to fill customer orders. If the company runs out of
inventory, there is a shortage cost, which is the revenue lost because the company has
insufficient inventory to fill an order. An inventory shortage may also mean the company
loses the customer or the client will order less in the future.

EOQ takes into account the timing of reordering, the cost incurred to place an order, and the
cost to store merchandise. If a company is constantly placing small orders to maintain a
specific inventory level, the ordering costs are higher, and there is a need for additional
storage space.

For example, a retail clothing shop carries a line of men’s jeans, and the shop sells 1,000
pairs of jeans each year. It costs the company $5 per year to hold a pair of jeans in inventory,
and the fixed cost to place an order is $2.

The EOQ formula is the square root of (2 x 1,000 pairs x $2 order cost) / ($5 holding cost) or
28.3 with rounding. The ideal order size to minimize costs and meet customer demand is
slightly more than 28 pairs of jeans. A more complex portion of the EOQ formula provides
the reorder point.

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₪ Impact of EOQ on effective inventory management:
The economic order quantity (EOQ) refers to the ideal order quantity a company should
purchase in order to minimize its inventory costs, such as holding costs, shortage costs, and
order costs. EOQ is necessarily used in inventory management, which is the oversight of the
ordering, storing, and use of a company's inventory. Inventory management is tasked with
calculating the number of units a company should add to its inventory with each batch order
to reduce the total costs of its inventory.

The EOQ model seeks to ensure that the right amount of inventory is ordered per batch so a
company does not have to make orders too frequently and there is not an excess of inventory
sitting on hand. It assumes that there is a trade-off between inventory holding costs and
inventory setup costs, and total inventory costs are minimized when both setup costs and
holding costs are minimized.

The Formula for Economic Order Quantity (EOQ)

To calculate the EOQ for inventory must to know the setup costs, demand rate, and holding
costs. Setup costs refer to all of the costs associated with actually ordering the inventory, such
as the costs of packaging, delivery, shipping, and handling. Demand rate is the amount of
inventory a company sells each year.
Holding costs refer to all the costs associated with holding additional inventory on hand.
Those costs include warehousing and logistical costs, insurance costs, material handling
costs, inventory write-offs, and depreciation.

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Ordering a large amount of inventory increases a company's holding costs while ordering
smaller amounts of inventory more frequently increases a company's setup costs. The EOQ
model finds the quantity that minimizes both types of costs.
EOQ considers the timing of reordering, the cost incurred to place an order, and the costs to
store merchandise. If a company is constantly placing small orders to maintain a specific
inventory level, the ordering costs are higher, along with the need for additional storage
space.
For example, consider a retail clothing shop that carries a line of men’s shirts. The shop sells
1,000 shirts each year. It costs the company $5 per year to hold a single shirt in inventory,
and the fixed cost to place an order is $2.

The EOQ formula is the square root of (2 x 1,000 shirts x $2 order cost) / ($5 holding cost),
or 28.3 with rounding. The ideal order size to minimize costs and meet customer demand is
slightly more than 28 shirts.

Limitations of the EOQ Model:

The assumptions made in the EOQ formula restrict the use of the formula. In practice
cost per unit of purchase of an item change time to time and lead time are also
uncertain. It is necessary for the application of EOQ order that the demands remain
constant throughout the year which is not possible. Ordering cost per order can’t be
constant because it’s including transport cost.

֍ CONCLUSION : The EOQ is very useful tool for inventory control it may be applied to
finished goods inventories, work-in-progress inventories and raw material inventories. It
regulate of purchase and storage of inventory in such a way so as to maintain an even flow of
production at the same time avoiding excessive investment in inventories.

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