Chapter 3

EOQ

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Inventory Mangement
Two Questions
1. How much inventory should be ordered at one time?
2. When should an order be placed?

Management needs some decision rules

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Stock Keeping Units (SKU’s)
Control of individual items
In the field of inventory management, a stock keeping
unit is a distinct type of item for sale, such as a
product or service, and all attributes associated with
the item type that distinguish it from other item types

EXAMPLE - Four different size bolts in two different

thread configurations (fine and coarse) would
represent eight different SKU’s

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lot
a lot, or batch, as “a quantity produced together and
sharing the same production costs and specifications.
Following are some common decision rules for
determining what lot size to order at one time.

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Lot Size Decision rules
Lot-for-lot (L4L)
Fixed order quantity
Periods of supply
Dynamic order quantities

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Lot for Lot (L4L)
Order exactly what is needed
Changes as requirements change
Requires time-phased information
MRP or Master Schedule
No unused inventory
Most often used with ‘A’ items

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Fixed Order Quantity
Order the same amount each time
Easy to understand
Does not minimize costs
Min-max system
Order when you go below the minimum
Order up to the max

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Periods of Supply
Order enough to cover a demand over a certain
period of time
Days of supply
Period Order Quantity
discussed later

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Economic Order Quantity
Minimizes the total costs of Carrying and Ordering
Assumptions
1. Demand is relatively constant and known
2. The item is purchased in lots or batches
3. Preparation costs and ordering costs are constant and
known
4. Replacement occurs all at once

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When not to use EOQ
Make-to-order when customer sets the quantity
needed
Shelf life is short
There are other limitations
Tool life is limited
Raw material batch size has limitations

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Development of the EOQ Formula
Under the assumptions given, the quantity of an item in
inventory decreases at a uniform rate
Suppose for a particular item that the order quantity is
200 units and the usage rate is 100 units a week.
The vertical lines represent stock arriving all at once as the
stock on hand reaches zero
The quantity of units in inventory then increases
instantaneously by Q, the quantity ordered.
This is an accurate representation of the arrival of
purchased parts or manufactured parts where all parts are
received at once

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Development of the EOQ Formula -
Example

Figure 10.1 Inventory on hand over time

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Development of the EOQ Formula
Average inventory = order quantity
2

Number of orders / yr = annual demand

order quantity

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Development of the EOQ Formula -
Example
Order Quantity (Q) = 200 units
Usage = 100 units per week

Average inventory = Q = 200 = 100 units

2 2
Number of orders per year = annual demand
order quantity
= 100 x 52
200
= 26 times per year

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Example Problem
The annual demand for an SKU is 10,075 units, and it is
ordered in quantities of 650 units. Calculate the average
inventory and the number of orders placed per year

Annual demand = 10,075 units per year

Order quantity = 650 units

Average inventory = Q/2 = 650/2 = 325 units

Number of orders per year

= A/Q = 10,075/650 =15.5 orders per year

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Relevant Costs
Annual cost of placing orders
Annual cost of carrying inventory

As the order quantity increases

the average inventory and the cost of carrying
inventory increases
the number of orders per year and the annual cost of
placing orders decreases

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Relevant Costs
Need to find the order quantity where:

“the cost of carrying inventory

and the costs of ordering
will be a
minimum”

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Inventory Costs
A = annual demand/ annual usage in units
S = ordering cost in dollars/order (setup)
i = annual carrying cost as a decimal or
percentage (interest rate)
c = unit cost in dollars
Q = order quantity in units

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Annual Ordering Cost
= (number of orders/year) x (cost/order)

=
A xS
Q

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Annual Carrying Cost
= average inventory x cost of carrying one unit for
one year

= average inventory x unit cost x carrying cost

= Q x c x i
2

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Total annual Costs
The total of ordering and carrying costs

= A xS + Q x c x i
Q 2

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Example Problem
The annual demand is 10,000 units, the ordering cost
$30 per order, the carrying cost 20%, and the unit cost
$15. The order quantity is 600 units. Calculate:
a. Annual ordering cost
b. Annual carrying cost
c. Total annual cost

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Example Problem - Solution
A = 10,000 units
It’s a good
S = $30 idea to write
c = $15 these down
every time
i = 20% (.20)

a. Annual ordering cost = A xS

Q
= (10,000/600) x $30
= $500

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Example Problem - Solution Continued
b. Annual carrying cost = Q x c x i
= (600/2) x $15 x .20 2
= $900

c. Total annual cost

= cost of ordering + cost of carrying
= $500 + $900
= $1,400

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Trial-and-Error Method
A hardware supply distributor carries boxes of 3-inch
bolts in stock. The annual usage is 1000 boxes, and
demand is relatively constant throughout the year.
Ordering costs are $20 per order, and the cost of
carrying inventory is estimated to be 20%. The cost
per unit is $5.

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Trial-and-Error Method
A = 1,000
S = $20 per order
c = $5 per unit
i = 20% (.20)
Cost of ordering = 1,000 x $20
Q
Cost of carrying = Q x $5 x .20
2
What happens to total cost when we change Q?
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Trial-and-Error Method

Figure 10.2 Costs for different lot sizes

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Total Costs and Order Quantity
There is an order quantity which minimizes total
costs
The lowest cost occurs where the cost of ordering
equals the cost of carrying
The total cost varies little for a wide range of lot sizes
about the minimum

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Total Costs and Order Quantity

Figure 10.3 Cost versus lot size

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Economic Order Quantity Formula
The EOQ is found by solving for the
order quantity (Q) where the costs
of carrying are equal to the costs of
ordering

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Economic Order Quantity Formula
Qic = AS
2 Q
eoQ
Q2 = 2AS the Quantity
ic you order
Q = 2AS
ic

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EOQ
example from trial and error method
EOQ = 2 A S A = 1,000 units
ic S = $20
i = .20
= 2x1,000x20 c = $5
.2 x 5

= 200 units

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Costs
example from trial and error method
Carrying Cost Ordering Cost (annual)

= Qic =AS
2 Q
= 200 x .2 x $5 = 1,000 x $20
2 200
= $100 = $100

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EOQ
Minimizes Total Cost of Carrying and Ordering

Cost to Order = Cost to Carry

Used on ‘C’ items

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Variations of the EOQ Model
Monetary Unit Lot Size
There are several modifications that can be made to
the basic EOQ model to fit particular circumstances.

Two that are often used are the monetary unit lot-
size model and the no instantaneous receipt model.

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Variations of the EOQ Model
Monetary Unit Lot Size
Does not require unit cost (of each item)

AD = annual usage in dollars

S = ordering cost in dollars (no change)
i = carrying cost as a decimal (no change)

EOQ = 2AS (in dollars)

i

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Example problem
An item has an annual demand of $5000, preparation
costs of $20 per order, and a carrying cost of 20%.
What is the EOQ in dollars?

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Solution
AD = $5000
S = $20
i = 20% = 0.20

EOQ = (2 * 5000 * 20 /0.2)^1/2 = $1000

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Noninstantaneous Receipt
Model
 In some cases when a replenishment order is made, the order is not all
received at one time
 The most common reason for this is that the ordered material is being
produced over an extended period of time, yet material is received for
the order as it is being produced
 In this case the EOQ is modified to reflect the rate of production as
related to rate of demand:

 p the rate of production (in units per day) and

 d the rate of demand (in units per day)

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EXAMPLE PROBLEM
An item has a setup cost for production of $500 per
order, and the inventory carrying costs for the item is
$12 per year. The demand for the item is constant at 11
units per day. The production rate is 50 units per day
while the item is being produced. What is the non
instantaneous economic order quantity?

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41
Quantity Discounts
A discount is given for orders over a certain
volume
Must consider:
Purchase cost
Ordering cost (usually annual)
Carrying cost (also annual)
If no order quantity is given, compare the discount
quantity with the EOQ

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Quantity Discounts
Encourages buying more than normal
Will increase the amount of inventory
Increases inventory carrying cost
Decreases ordering costs

Savings from lower unit cost must be enough to offset

higher carrying cost

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Quantity Discount - Example
An item has an annual demand of 25,000 units, a
unit cost of $10, an order preparation cost of $10,
and a carrying cost of 20%. It is ordered on the basis
of an EOQ, but the supplier has offered a discount
of 2% on orders of $10,000 or more. Should the offer
be accepted?

*Note the discount is in dollars. It would be easier

to calculate the EOQ in dollars.

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Quantity Discount - Example continued
AD = 25,000 x $10 = $250,000
S = $10
i = 20% = 0.2

EOQ = 2 x 250,000 x 10 = $5,000

0.2

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Quantity Discount - Example continued
Discounted Order Quantity = $10,000 x 0.98 = $9,800
No Discount With Discount
Unit price $10 $9.80
Lot Size $5,000 $9,800
Avg Inventory Qc/2 $2,500 $4,900
# of Orders/yr A/Q 50 25

Purchase Cost $250,000 $245,000

Carrying Cost (20%) 500 980
Ordering Cost ($10) 500 250
Total Cost $251,000 $246,230

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Quantity Discount - Example continued
There is a savings in purchase cost
$250,000 - 245,000 = $5,000
Carrying cost increases
$980 - 500 = $480
Ordering cost decreases
$500 - 250 = $250
Total cost decreases Good Idea?
$251,000 - 246,230 = $4,770

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Use of EOQ When Costs Are Not Known
Ordering costs and carrying costs are generally the
same for a family of items
Costs may not be easy to determine

Q = 2 AD S
i
S and i are the same for all items

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Use of EOQ When Costs Are Not Known
Let K = 2S K is used as a constant
i
Then Q = K AD

Also Q = annual demand

orders per year

Therefore K AD = AD
N

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Use of EOQ When Costs Are Not Known
Example Problem
A family of products is each ordered 4 times per year which is not the
EOQ. The cost of ordering and carrying are not known. Can a better
decision rule be calculated?
Annual Orders Present K = AD
Item Usage per yr Lot Size AD AD N

A $10,000 4 $2,500 $100 25

B 400 4 100 20 5
C 144 4 36 12 3
12 $2,636 $132 33

Average Inventory = Σ Q/2 =$2,636 / 2 = $1,318

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Use of EOQ When Costs Are Not Known
Example Problem
All items should have the same ordering and carrying costs and should
have the same value for K. This doesn’t seem to be true for these items. It
would be better to use an average value for K.

K = Σ AD
N
= 132
12
= 11

Use this value of K to calculate the individual order

quantities
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Use of EOQ When Costs Are Not Known
Example Problem
Annual Orders Present New Lot New Orders
Size = per year =
Item Usage per yr Lot Size AD K AD N = AD/Q

A $10,000 4 $2,500 $100 $1100 9.09

B 400 4 100 20 220 1.82
C 144 4 36 12 132 1.09
12 $2,636 $132 $1452 12.00
Average Inventory = $1,318 $726
The inventory has been reduced (45%) while the number of orders stays
the same

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Period Order Quantity (POQ)
EOQ assumes demand is uniform
this is usually not true
EOQ orders a quantity that attempts to balance
the cost of ordering with the cost of carrying
POQ sets a time interval that orders the same
number of times per year as the EOQ
POQ can reduce carrying costs especially with
non-uniform demand

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Period Order Quantity
POQweeks = EOQ
average weekly usage
Example
The EOQ for an item is 2800 units and the annual usage is
52,000 units. What is the POQ?
Average usage = 52,000 / 52 = 1,000 per week
POQ = 2800 / 1000 = 2.8 weeks 3 weeks
When an order is placed the order quantity is set to cover
requirements for the next 3 weeks

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MRP Record EOQ = 250 units

Week 1 2 3 4 5 6 7 8 9 10 Total

Net
100 50 150 75 200 55 80 150 30 890
Requirements
Planned Order
250 250 250 250
Receipts

Ending Inventory 150 100 200 200 125 175 120 40 140 110 1360

POQ Method
Weekly demand = 890 / 10 = 89 units
POQ = 250 / 89 = 2.81 3 weeks

Week 1 2 3 4 5 6 7 8 9 10 Total

Net
100 50 150 75 200 55 80 150 30
Requirements
Planned Order
300 330 260
Receipts

Ending Inventory 200 150 0 0 255 55 0 180 30 0 870

Note, the total ending inventory is reduced from 1360 to 870 units over the 10 week period.

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Order Quantities - Summary
EOQ assumes uniform demand
Gives reasonable results
The total cost curve is flat around the EOQ
 good guesses are close to the optimum

Costs of ordering and carrying can be difficult to

determine
 the EOQ concept can be used for groups of items

Order quantity influences the costs of carrying and

ordering
Period Order Quantity is best for lumpy demand

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