535

DYNAMIC BUY QUANTITY:

A WORKABLE ALTERNATIVE

TO

TRADITIONAL ECONOMIC ORDER QUANTITY METHODS

BY

JAMES H. PERRY

ASSOCIATE PROFESSOR OF BUSINESS ADMINISTRATION

THE GEORGE WASHINGTON UNIVERSITY

APRIL 1989
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INTRODUCTION

Many firms, both distributors and manufacturers, utilize a

continuous review, reorder point system to manage material
inventories. The reorder point, composed of leadtime and safety
level, is used to alert the inventory manager when a
replenishment order is required. The order quantity, in turn,
indicates how much should be reordered. Order quantities (often
called operating levels or cycle requirements) provide material
to satisfy normal usage between replenishment actions. This
order quantity has been traditionally based on the economic
tradeoffs which exist between procurement workload (represented
by the cost per order) and inventory investment (represented by
the cost to hold the inventory). Established order-cost and
holding-cost parameters, and an estimate of steady-state demand
for the item in question, are used to compute an Economic Order
Quantity (EOQ) - the quantity of material for which item annual
order costs and annual holding costs are balanced to minimize
total variable costs. This EOQ is then typically passed, via the
procurement process, to the vendor as an order requirement. This
paper examines the process used to determine these so-called
"economic order quantity" requirements and evaluates the
effectiveness of current EOQ techniques in an operating
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environment where some, if not most, of the critical underlying

assumptions do not hold.

CONCEPTUAL FOUNDATIONS

The theoretical purpose of the order quantity is to provide

a level of material to cover normal operating requirements
between replenishment actions. The quantity of material to be
ordered conceptually balances the firm's procurement workload
(and cost) and inventory investment. In customer environments
where demand is random, this EOQ methodology is extremely common.
It should be noted, however, that this general approach involves
several critical assumptions:
o Order cost and holding cost parameters used to
determine the EOQ are accurate and consistent,
o Material ordered is received in one delivery or is
phased at a constant rate over the full procurement
leadtime.
o The administrative processing time (or administrative
leadtime) which derives from the system is reasonable
in terms of processing capabilities and does not unduly
impact other investment costs (such as investment in
safety level).
o The price paid is not a function of the quantity
ordered.
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o Demand is reasonably accurate and is "steady-state"

over the period in question.
The so-called Economic Order Quantity concept was first
introduced by Harris 1 in 1915. This basic lot-sizing approach to
balancing operations and costs was later updated by Wagner and
Whitin2 to reflect the dynamics of the reorder process and has
been further refined by many authors over the years. 3 Based on
order cost and holding cost parameters (which are typically
specific to the item in question) the EOQ approach computes an
economic order quantity to serve as the buy quantity over time.
Fordyce and Webster, 4 Tersine and Toelle5 and LaForge and
Patterson6 have specifically examined the impact of unit cost or
price variation on the traditional Wagner-Whitin formulation
while Ritchie and Tsado, 7' 8 Donaldson, 9 Silver, 10 Ritchie11 ' and
Woolsey and Lienert 12 have addressed the conceptual issue of
demand variation and have proposed alternative approaches to deal
with the existence of known demand variation.
While all the assumptions on which the EOQ concept is founded
may be inappropriate for some items, three assumptions are
particularly suspect in many operating environments and require
further examination. First, based on the typical operating
environment of the firm, order costs reflect a valid
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approximation of the cost to order only at a stated or given

administrative leadtime level. Indeed, to estimate these costs
most firms use historical procurement workload and cost data. No
explicit consideration is generally given to the associated
administrative processing times related to these order costs.
However, these administrative leadtimes are one major factor
which influences the determination of safety level in reorder-
point systems. As a result, it is possible that understated
order costs (by not incorporating administrative leadtime
impacts) may not fully reflect the real cost to order to the
firm.
Second, price and quantity relationships may be quite strong
for certain items and should be recognized in the material
management and purchasing process. Unfortunately, these specific
price-quantity tradeoffs do not typically surface until after
order quantity is determined and the information on price-
quantity options may not be available until the time that the buy
is awarded.
Finally, demand variation over the procurement cycle is
often significant and can substantively impact the real
requirement. Failure to appropriately recognize and incorporate
demand variance in the actual buy decision introduces the
possibility of two alternatives, namely long-supply/excess assets
or material shortages.
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METHODOLOGY

This study addresses the potential impacts of these separate

assumptions in a typical operating environment where the
administrative leadtime, price, and demand assumptions normally
invoked in EOQ-systems may not hold. In order to assess the
potential impact of market dynamics in an EOQ-based replenishment
environment, the material management and procurement processes of
a large, multi-national wholesaler were examined. Using a
statistical data sample of approximately 800 stocked items, the
study analyzed the three primary factors which tend to weaken
EOQ-based models, namely the impact of administrative leadtimes,
the relevance and impact of quantity discounts on the least-cost
buy quantity, and the dynamics of customer demand over the
procurement cycle.
The original data sample was drawn in March 1986. In July
1987, this sample information was updated, thus providing the
status of those same items approximately 15 months later.
The two criteria for selecting sample items were that their EOQ
order quantities would normally compute to a quantity of less
than one (1) year and that overall demand stability was
considered sufficient by the firm to allow the item to be managed
under EOQ methods. Table I below provides a profile of the item
sample at the two points in time.
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TABLE I
Item Sample Profile

198-6 status 1987 status

Months Dollars3 Months Dollars3

Average inventory 9.4 49.3 9.6 48.6

Order quantity 12.1 63.2 12.8 64.8
Safety level 3.4 17.7 3.2 16.2
Administrative leadtime(ALT) 8.3 43.3 10.9 55.1
Production leadtime (PLT) 13.9 72.5 13.5 68.2
Annual demand value 62.8 60.8

a) 1987 dollars in millions.

RESULTS
Based on this item sample, the impact of order quantities on
procurement workload over the period analyzed was unclear.
Today's material management and purchasing environment is highly
volatile and policy and procedural changes in many diverse
functional areas generate additional workload, which affects the
ability of the organization to manage the resulting throughout.
Thus, purchasing workload is often particularly difficult to
forecast.
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As shown in Table II, an overall 20 percent decrease in the

volume of purchase requests processed was experienced by the
organization, however, this decline could not be quantitatively
linked to the size of the order quantities used. This
is because many other factor also changed during the fifteen-
month period including processing requirements, buying methods,
and the mix of total workload flowing through procurement. For
example, some of the procurement workload reduction resulted from
innovative multiple-year procurement methods. However, at the
same time additional processing requirements were added which
increased administrative leadtimes. While procurement workload
declined by about 20% over the period, staffing remained
relatively constant, and administrative leadtimes increased by
30%.

Table II
PROCUREMENT WORKLOAD VOLUME
(Thousands of Purchase Requests)

Purchase
Buying Request Percentage
Office 1985-86 1986-87 Change change

A 61.1 48.7 - 12.4 - 20

B 49.1 31.6 - 17.5 - 35
C 131.8 115.6 - 16.2 - 12
D 815.3 647.3 -168.0 - 20

Total - 1,057.3 843.2 214.1 - 20

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Second, the analysis clearly indicates that, for this

data sample, significantly opportunities exist to exploit vendor
production or distribution economies. Thus, price-quantity
alternatives are available and can be readily identified. By far
the most successful technique being used by the organization was
the solicitation of multiple quantities (ranges) based on the
order quantity requested in the purchase request. In some cases,
these were specified percentages (50 percent, 75 percent, 150
percent, etc.) of the purchase request quantity, while.in other
cases alternative quantity ranges were used. Through this
method, the organization was able to elicit quantity discount
alternatives specific to the line item in question and was able
to exploit these quantity discount alternatives where appropriate
to minimize total cost to the organization. Moreover, we found
that valid PC-based evaluation models had been developed and had
been implemented to mechanize and standardize the process of
evaluating alternative price-quantity combinations.
Finally, the data sample examined strongly suggests that
demand volatility represents a major issue in the application of .
traditional EOQ methods.
Since these items had been identified as stable-demand
items, demand was expected to be reasonably constant over the
period encompassed by the two samples. The results, however,
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indicate a striking variability in demand. As seen in Table III,

of the 789 items in the sample, demand increased for 255 item
(32.3 percent), declined for 512 items (64.9 percent), and
remained the same for 22 items (2.8 percent). Almost two-thirds
of the sample experienced demand changes greater than 20 percent,
either up or down. Of the 512 items with demand decline, two-
fifths had demand drop off greater than 40 percent. The demand
data used were forecast demand, which is smoothed; actual demand
variation was even greater.
TABLE III

DEMAND CHANGE IN ITEM SAMPLE

Percent decrease ____Percent increase

Number 29 58 110 151 164 22 95 45 33 20 7 55

of items

Total -512(64.9%)22(2.8%)255 (32.3%)

A DYNAMIC BUY QUANTITY CONCEPT

Based on our analysis, we believe that strict application of

EOQ principles in determining the order quantity fails to
properly compensate for existing purchasing workload constraints,
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does not adequately recognize the possibility of quantity

discounts on selected items, and ignores the potential for
substantial demand variance. Balancing order costs and holding
costs through the use of traditional EOQ methods may be a valid
approach for determining general inventory requirements, for
basic budget development, and for generating an initial target
stock replenishment order quantity. This so-called EOQ should
not be accepted as the ultimate buy quantity, however, without
adjustment as necessary for changes in demand, asset position,
and available price-quantity discounts at the time the purchase
is actually made. Thus, traditional EOQ should be viewed as an
economic order quantity, not necessarily an economic buy
quantity, and indeed, the information necessary to determine an
economic buy quantity is generally available only at the time of
award.
In recognition of the potential deficiencies of the EOQ
approach, a basic strategic change in purchasing and materials
management policy is necessary, a change that will exploit
existing market opportunities on a selective basis while
integrating the efforts and objectives of the inventory
management and procurement functions. This Dynamic Buy Quantity
concept has the following characteristics or elements:
o Use of EOQ methods only for generating a target order
quantity for solicitation purposes. This EOQ approach
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should be designed to recognize the economic tradeoffs
between order cost and holding cost.
Routine solicitation of quantity ranges (as multiples
of the EOQ quantity). Given the proven success of
this approach in creating opportunities to make cost-
effective buy decisions, this technique should be a
standard part of most purchasing actions to provide the
flexibility to adjust to demand and asset changes
during the administrative leadtime and at the same time
effectively generate price-quantity options where they
exist. These options can in turn, typically be
employed directly in purchase decision without further
interaction with vendors. Moreover, the method also
gives the supplier incentives to provide price breaks
where production and distribution cost economies will
allow.
Determination of the Dynamic Buy Quantity at the time
purchase is actually made using the quantity discount
information (and other relevant data such as current
demand/asset position by adjusting the initial EOQ
target quantity. This approach will allow the buyer to
be selective in that the recommended EOQ-based quantity
would be adjusted in the buying process only in those
specific instances in which the price-quantity data
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indicate a lower total cost to the firm that can be

defended based on known line item data. The actual buy
quantity, determined by the buyer in consultation with
the inventory manager when necessary would be dynamic
and could be determined by the input of price-quantity
options into a structured evaluation process which
would determine total cost to the firm for each option
and recommend the optimal buy quantity to the buyer for
the final purchase decision. Total cost to the firm
would include not only the actual material costs
associated with each option, but would also consider
transportation, inventory investment, and relevant
administrative costs in making a recommendation. Such
evaluation techniques and models exist, are
computationally sound, and provide creditable and
defensible logic to support dynamic buy quantity
decisions.
POLICY IMPLICATIONS
The management policy implications of this shift are
dramatic. The approach essentially recognizes that for inventory
management purposes, the basic traditional cost tradeoffs between
order cost and holding cost remain valid and appropriate in
development general inventory requirements and in providing a
target range for solicitation. At the same time, the strategy
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provides an effective vehicle for dealing with real price

differentials associated with the buy quantity by acquiring and
using the specific vendor data necessary to effectively evaluate
and exploit purchases opportunities and allows the buyer to
adjust to market dynamics and demand changes. It represents a
reconciliation of two diverse, but equally valid, views of the
stock replenishment process. Finally, while today's distributed
information processing systems have many of the capabilities
necessary to implement the strategic policy thrust noted above,
these capabilities are often not fully-integrated into main, on-
line processing systems, do not currently provide mechanized
feedback to inventory management files, and may not have not been
utilized with the purchasing volumes anticipated under this
concept.
Accordingly, the move to Dynamic Buy Quantity policy, where
the actual buy quantity is routinely determined at point of
purchase, may also require associated changes in information
processing resources. Several specific systems capabilities are
necessary. First, many off-line evaluation models now in use
must be integrated to the extent feasible into the firm's normal
on-line processing flow. Second, when the buyer purchases a
quantity larger than the EOQ quantity the firm's inventory
management structure and processes must recognize that decision
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as a valid inventory requirement. Third, an appropriate

financial management process must be developed to effectively
accommodate purchase quantities larger than the initial EOQ-based
order quantity.
In summary, the continued application of strict EOQ-based
quantities in the purchasing process does not adequately address
the dynamics of the interaction of customer demand, time, and
market conditions which must be incorporated at the line item
level to make a reasoned buy quantity decision at the time
purchase. These shortcomings argue for a major strategic change
to current EOQ based material management. This strategic shift,
which may require information systems changes and revised
processing rule in many companies is essential to effective
materials management in the future.
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Endnotes

1. Harris, F.W. , "Operations and Cost, Factory Management

Series, A.W. Show Company, Chicago, (1915), pps.
48-52.
2. Wagner, H.M. and Whitin, T.M. "Dynamic Version of the
Economic Lot Size Model," Management Science. Volume 5,
No. 1 (October 1958), pp. 89-96.

3. See Aucamp, D.C., "A Variable Demand Lot-Sizing Procedure

and a Comparison with Various Well Known Strategies,"
Production and Inventory Management, Vol, 26, #2, pps.
I-20.
4. Fordyce, J.M. and Webster, F.M., "Nonconstant Unit
Cost/Price with the Wagner-Whitin Algorithm,"
Production and Inventory Management. Vol. 26. #3. DPS.
II-80. Inventory Management,
5. Tersine, R.J. and Toelle, R.A., "Lot Size Determination with
Quantity Discounts," Production and Inventory
Management. Vol. 26, #3, pps.1-23.
6. La Forge, R.L. and Patterson, J.W., "Adjusting the Part-
period Algorithm for purchase Quantity Discounts,"
Production and Inventory Management, Vol. 26, #1, pps.
138-150.
7. Ritchie, E. and Tsado, A., "The Penalties of Using the EOQ:
A Comparison of Lot Sizing Rules for Linear Increasing
Demand," Production and Inventory Management. Vol. 27,
#1, pps. 12-17.
8. Ritchie, E. and Tsado, A., "A Review of Lot Sizing
Techniques for Deterministic Time-Varying Demand,"
Production and Inventory Management, Vol 27, #3, pps.
65-79.
9. Donaldson, W.A., "Inventory Replenishment Policy for a
Linear Trend in Demand - An Optimal Solution," Journal
of the Operational Research Society. Vol. 28 (1977),
pps. 663-670.
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10. Silver, E.A., "A Simple Inventory Replenishment Decision

Rule for a Linear Trend in Demand" Journal of the
Operational. Research Society, Volume 30 (1979), pps.
71-75.
11. Ritchie, E. "Practical Inventory Replenishment Policy for a
Linear Trend in Demand followed by Steady Demand,"
Journal of the Operational Research Society. Volume 31
(1980), pps. 606-613.
12. Woolsey, R.E.D. and Lienert, C.E., "Ordering Inventory When
The Forecast Is Ridiculous," Production and Inventory
Management. Vol. 27, #1 (1986), p. 144.