Session 9

EOQ Model
Krannert School of Management

Professor Pengyi SHI
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MGMT660 Introduction to Operations

Management
Where are we

Process Analysis

MGMT660 Introduction to Operations

Management
Process Variability

Inventory Management

Supply Chain Coordination

Order Inventory: Retail stores
 Inventory models
 Deterministic Models (Known demand)

No Model Objective Used for Session

1 EOQ Min. Annual Purchase Session 9
2 EPQ Inventory Cost Production Textbook

MGMT660
Introduction to Operations Management
 Probabilistic Models (Unknown demand)
No Model Objective Used for Session
3 Newsvendor Min. expected cost Sessions 10-12
Continuous Purchase
4 Achieve desired Session 13
review
service level
5 Periodic review Session 13
Outline
• EOQ:  Economic Order Quantity
• Order from an outside supplier or another plant

MGMT660 Introduction to Operations

Management
 Order Inventory: Retail stores

MGMT660 Introduction to Operations

Management
Order Inventory
orders

On-hand
inventory
Supply

• Key questions: • What cost to

• How often to review? consider?
• When to place an order?
• How much to order?
• How much stock to keep?
 Example: Ordering Coke
• Drink one can of coke per day
• Buy 12 cans whenever it runs out

Order quantity

MGMT660 Introduction to Operations

Management
12 cans

Order Order Order Time

Time between two ordering
12 cans / (1 can/day) = 12 days
Ordering Coke
• Drink one can of coke per day. Buy 12 cans whenever it runs 
out.

• Annual demand (assuming 360 days per year)

MGMT660 Introduction to Operations

Management
• D = 360 cans/year
• Order quantity
• Q = 12 cans
• Number of orders per year
• D/Q = (360 cans/year)/(12 cans) = 30 per year

• Time between two orders

• T = 1/num of orders per year = Q/D = 1/30 years = 12 days
Buying more cans or less cans?
• Buying more cans each time
• Pros
• Cons

MGMT660 Introduction to Operations

Management
• Buying less cans each time
• Pros
• Cons
Tradeoff between ordering cost
and inventory cost
• Ordering cost: a fixed cost incurred for every order
• Holding cost: cost charged on average inventory

MGMT660 Introduction to Operations

Management
• Larger ordering quantity
• Ordering cost increases or decreases?
• Inventory cost increases or decreases?

• Smaller ordering quantity
• Ordering cost increases or decreases?
• Inventory cost increases or decreases?
Ordering Coke
• Annual demand (assuming 360 days per year)
• D = 360 cans/year
• Order quantity
• Q = 12 cans

MGMT660 Introduction to Operations

Management
• Order cost S = $10 per order
• Unit holding cost H = $30 per unit per year

• Annual ordering cost = S*Number of orders per year
•
• Annual holding cost = H*average inventory
•
• Annual total cost = 
 Maximum and Average
Inventory Level

Maximum inventory level = Q = 12 cans

MGMT660 Introduction to Operations

Management
Order quantity
Q = 12 cans
Average inventory level = Q/2 = 6 cans

Order Order Order Time

T = 1/30 years
Ordering Coke
• Annual demand (assuming 360 days per year)
• D = 360 cans/year
• Order quantity
• Q = 12 cans

MGMT660 Introduction to Operations

Management
• Order cost S = $10 per order
• Unit holding cost H = $30 per unit per year

• Annual ordering cost = S*Number of orders per year
• S*(D/Q) = 10*30 = $300 per year
• Annual holding cost = H*average inventory
• H*(Q/2) = $30*6 = $180 per year
• Annual total cost = S*(D/Q) + H*(Q/2) = $480
Annual Inventory Cost
• Annual ordering cost
• = Ordering cost per order * Number of orders per year
= S * (D/Q)

MGMT660 Introduction to Operations

Management
• Annual holding cost
• = Holding cost per unit per year * Average inventory
= H * (Q/2)

• Total annual inventory cost with order quantity Q
𝐷 𝑄
𝑇𝐶 𝑆 𝐻
𝑄 2
 EOQ =
H
2DS
Cost Curves

MGMT660 Introduction to Operations

Management
EOQ: Economic Order Quantity
• Objective: optimal order quantity to minimize total cost
2 DS 2(Annual Demand)(Ordering cost)
EOQ  
H Annual Unit Holding Cost

MGMT660 Introduction to Operations

Management
1 Annual demand is known precisely, occurs at D [unit/year]
uniform rate
2 Ordering cost is fixed for every order S [$]
3 Holding cost is charged on average inventory H [$/(unit*year)]
can also be expressed as a percentage (h per year) of product value ($C per unit). H = hC

4 Order quantity is fixed each time Q [unit]

EOQ model
• EOQ model is widely used in inventory management 
• Captures the tradeoff between ordering cost and 
inventory cost

MGMT660
Introduction to Operations Management
• Objective: finding the optimal ordering size

Developed in 1915 by Harris. Very simple, robust.

Used by thousands of companies around the
world.
Examples of costs
• Holding costs
• Cost of capital
• Interest rate
• Cost of obsolescence

MGMT660
Introduction to Operations Management
• Cost of storage

• Ordering costs (setup costs)
• Order processing cost
• Transportation costs
• Administrative overhead
• Changeover costs
• Setup costs
Ordering costs vs Purchase costs
• Ordering cost S is the setup costs
• Usually a fixed amount regardless of how much you purchase

• Purchase cost P is the cost per unit to purchase the inventory

MGMT660 Introduction to Operations

Management
• Why purchase cost does not enter the EOQ calculation?
• The purchase cost is always P*D no matter your choice of Q

• However, we need to account for purchase cost if there is a 
quantity discount

• We also need to account for purchase cost if there is variability 
(you may have shortage or leftover, e.g., in Flanders case)
ATM Example
• How much cash should you take from an ATM?
• How do you decide? Add notation:
• Usage rate or demand (D)
• Cost of withdrawing money (S)

MGMT660
Introduction to Operations Management
• Cost of having money in your pocket instead of the bank (H)
• Amount to withdraw ‐ Q

T=Q/D
Practice 1: ATM Example
Let D = $520 per year ($10 per week)
Cost of withdrawing money S = $1 
Cost of having money in your pocket instead of the bank? H = $0.1 
per year

MGMT660
Introduction to Operations Management
• Find out the EOQ quantity

• Under the EOQ quantity, find the annual holding cost and 
annual order cost
ATM Example
Let D = $520 per year ($10 per week)
Cost of withdrawing money S = $1 
Cost of having money in your pocket instead of the bank? H = $0.1 
per year

MGMT660
Introduction to Operations Management
∗ ∗
• EOQ =  $102
.

• Using the EOQ $102
• annual holding cost: 102/2 * 0.1 = $5.1
• annual order cost: 520/102 * 1 = $5.1
Practice 2: South Face Example
• Some facts about The South Face retail shop:
D = 1200 jackets / year
S = $2,000
C = $200 per jacket (purchasing cost)

MGMT660
Introduction to Operations Management
i = 25% (annual rate of “obsolescence” out of purchasing cost)
H  = C * i = 200 * 25%
• What order size (Q) would you recommend for The South 
Face ?
Practice: South Face Example
• Some facts about The South Face retail shop:
D = 1200 jackets / year
S = $2,000
C = $200 per jacket (purchasing cost)

MGMT660
Introduction to Operations Management
i = 25% (annual rate of “obsolescence” out of purchasing cost)
H  = C * i = 200 * 25%
• What order size (Q) would you recommend for The South 
Face ?

2 *1200 * 2000
Q  309
200 * 25%
Economic Order Quantity Summary

Model
• Notation:
• D = Demand rate (units / yr)
• S = Setup cost or per order or per production run ($)
• C = Cost of purchasing or producing a unit ($ / unit)

MGMT660
Introduction to Operations Management
• i = Interest rate, holding cost rate (%/yr)
• H = Annual holding cost per unit of inventory ($ / (unit•yr))
• Sometimes estimated as H = C * i
• Decision:
• Q = Quantity of an order (units)

• Objective: To minimize the annual total cost
2 DS 2(Annual Demand)(Ordering cost)
EOQ  
H Annual Unit Holding Cost
 Summary
Timing and quantity
Inventory
Slope = D (units/year)

MGMT660 Introduction to Operations

Management
Time

• Number of orders per year = D/Q ( / yr)

 Annual ordering cost =
(D / Q)  S ($ / yr)

• Average inventory = Q/2 (units)

 Annual holding cost =
(Q / 2)  H ($ / yr)
Extension
• EOQ:  Economic Order Quantity
• Order from an outside supplier or another plant

MGMT660 Introduction to Operations

Management
• EPQ: Economic Production Quantity
• Optional reading
Produce Inventory
Start production (“order”)

Step using
Finished
Production in-process
goods
inventory

• Key questions: • What cost to

• When to start production? consider?
• How much to produce?
EPQ model
• Optimal production quantity

2 RS P
EPQ 
H PR

MGMT660 Introduction to Operations

Management
• Same tradeoff between setup cost (S) and holding cost (H)
• P = rate of production (capacity of first step)
• R = rate of inventory usage (capacity of 2nd step)
4th case: Flanders of Springfield
Catalog Retailer 
Women’s clothing (Sweaters)

MGMT660
Introduction to Operations Management
Important decisions:
• What products? 
• Quantity to order? (inventory decision)
• Catalog design?  Distribution?
• Selling price?
• Demand forecast
Expected contribution
• Purchasing cost = $35/sweater
• Salvage value = $15/sweater (liquidated at $15)
• Selling price = $100 & Order size = 1200

MGMT660
Introduction to Operations Management
Demand Prob Contribution
600 (sale) x 100$    +  600 (leftover) x 15$ ‐ 1200 x 35$ = 
600 0.3
$27,000

1200 0.4 “$”

2400 0.3 “$$”

• Expected contribution = 0.3 x 27000 + 0.4 x $ + 0.3 x $$ = ?