Economic Order Quantity (EOQ)

with Quantity Discounts

Prepared by:

Robbie Harmon
Brigham Young University
November 28, 2005

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 Outline
• What is EOQ?
• When do I use it?
• Definition of EOQ components
• How does it work?
• Introducing Quantity Discounts
• Are there any limitations?
• Real World Example
• Practice
• Summary

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 What is EOQ?
• EOQ = mathematical device for arriving at
the purchase quantity of an item that will
minimize the cost equation below

total cost = holding costs + ordering

costs

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 So…What does that mean?

Basically, EOQ helps you identify the most

economical way to replenish your inventory
by showing you the best order quantity.

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 When do I use it?
• Suppose you are responsible for ordering
inventory. You have the following information.

• It costs $5 to hold one widget in inventory for a year

• It costs $100 to place an order for widgets, regardless of size

• Customers demand 2,500 widgets every year

(Sales are distributed evenly throughout the year)

How large should your orders be to minimize total cost?

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 How large should your orders
be?
• If your orders are too large, you’ll have excess inventory and high holding
costs

• If your orders are too small, you will have to place more orders to meet
demand, leading to high ordering costs

Order Size Holding Costs Ordering Costs

Too LARGE High Low

Too SMALL Low High

• EOQ helps you find the balance!!!

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 EOQ

Holding Cost
Cost

Ordering Cost
Total Cost

Order Quantity

EOQ is the quantity where Holding cost = Ordering cost 7

 Definition of EOQ Components
H = annual holding cost for one unit of inventory

S = cost of placing an order, regardless of size

P = price per unit

d = demand per period

D = annual demand

L = lead time

Q = Order quantity (this is what we are solving for)

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 How does it work?
• Total annual holding cost = (Q/2)H

• Total annual ordering cost = (D/Q)S

• EOQ:
– Set (Q/2)H = (D/Q)S and solve for Q

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 Solve for Q algebraically
• (Q/2)H = (D/Q)S

• Q2 = 2DS/H

• Q = square root of (2DS/H) = EOQ

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 When should we place an order for
Q units?
• SS = safety stock

• Reorder point = ROP = d L + SS

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 Introducing Quantity Discounts
What are quantity discounts?
Example:

Order Size 1 - 100 101 - 200 201 - 300

Price per unit $20 $18 $16

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 EOQ with Quantity Discounts
• Minimize the following equation:
– Total cost = holding costs + ordering costs + item costs
(Total cost = (Q/2)H + (D/Q)S + DP)

• This is done in 2 steps

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 2 Steps
1. Calculate EOQ. If this amount can be purchased at the
lowest price, you have found the quantity that minimizes
the equation. If not, proceed to step 2.

2. Compare total cost at the EOQ quantity with total costs

at each price break above the EOQ.

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 Limitations of this basic model

1. H and S are often estimated imprecisely

2. Ordering costs and demand rates vary

throughout the year

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 Real World example
• 1974 Report to Congress by the
Comptroller General of the U.S.

– “Proper Use of the Economic Order Quantity

Principle Can Lead to More Savings”

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 Practice
• Suppose you are responsible for ordering inventory. You
have the following information.

• It costs $5 to hold one widget in inventory for a year

• It costs $100 to place an order for widgets, regardless of size

• Customers demand 2,500 widgets every year

(Sales are distributed evenly throughout the year)

• What is EOQ?
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 EOQ

$3,000

$2,500

$2,000

Holding Cost
Cost

$1,500 Ordering Cost

Total Cost

$1,000

$500

$0
100 150 200 250 300 350 400 450 500
Order Quantity

EOQ = 316 18
 Practice continued…
• Now suppose the following quantity discounts are
available.

Order Size 1 - 200 201 - 350 351 - 500

Price per unit $20 $18 $16

• What amount should be purchased?

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 Summary
• Understanding EOQ and quantity discounts
can result in substantial savings!

• Review

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 Review
• What is EOQ?

• What 2 steps should be taken when

considering quantity discounts?

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 Reading List
Bogner, Michael. “Quantity Discounts / Economic Order Quantity.”
http://www.dau.mil/pubs/pm/pmpdf02/Sept_Oct/BOGSE-0C2.pdf

Bozarth, Cecil C., & Handfield, Robert B. Introduction to Operations and Supply
Chain Management. Upper Saddle River, NJ: Pearson Prentice Hall, 2005

Bragg, Steven M. Inventory Best Practices. Hoboken, NJ: John Wiley & Sons,
Inc., 2004

Ozcan, Yasar A. Quantitative Methods in Health Care Management. San

Francisco, CA: Jossey-Bass, 2005 (pp. 259 -267)

Report to the Congress by the Comptroller General of the United States. “Proper
Use of the Economic Order Quantity Principle Can Lead to More Savings”:
United States General Accounting Office, 1974 (pp. 1-10)

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 Reading List
Schreibfeder, Jon. “Effective Replenishment Parameters.” Microsoft. Microsoft
Business Solutions.
http://download.microsoft.com/download/d/6/9/d69de816-aecb-4869-a920-2b
5afccd7589/eimwp4_replenish.pdf

Toomey, John W. Inventory Management: Principles, Concepts, and Techniques.

Norwell, MA: Kluwer Academic Publishers, 2000 (pp. 61-72)

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