EconomicOrderQuantityModels

Inacontinuous,orfixedorderquantity,systemwheninventoryreachesaspecificlevel,referredto
asthereorderpoint,afixedamountisordered.Themostwidelyusedandtraditionalmeansfor
determininghowmuchtoorderinacontinuoussystemistheeconomicorderquantity(EOQ)
model,alsoreferredtoastheeconomiclotsizemodel.Theearliestpublishedderivationofthebasic
EOQmodelformulain1915iscreditedtoFordHarris,anemployeeatWestinghouse.
ThefunctionoftheEOQmodelistodeterminetheoptimalordersizethatminimizestotal
inventorycosts.ThereareseveralvariationsoftheEOQmodel,dependingontheassumptions
madeabouttheinventorysystem.Wewilldescribetwomodelversions,includingthebasicEOQ
modelandtheEOQmodelwithnoninstantaneousreceipt.

TheBasicEOQModel
ThebasicEOQmodelisaformulafordeterminingtheoptimalordersizethatminimizesthesumof
carryingcostsandorderingcosts.Themodelformulaisderivedunderasetofsimplifyingand
restrictiveassumptions,asfollows:

Demandisknownwithcertaintyandisconstantovertime.

Noshortagesareallowed.

Leadtimeforthereceiptofordersisconstant.

Theorderquantityisreceivedallatonce.

ThesebasicmodelassumptionsarereflectedinFigure12.1,whichdescribesthecontinuous
inventoryordercyclesysteminherentintheEOQmodel.Anorderquantity,Q,isreceivedandis
usedupovertimeataconstantrate.Whentheinventoryleveldecreasestotherecorderpoint,R,a
neworderisplaced;aperiodoftime,referredtoastheleadtime,isrequiredfordelivery.Theorder
isreceivedallatoncejustatthemomentwhendemanddepletestheentirestockofinventorythe
inventorylevelreaches0sotherewillbenoshortages.Thiscycleisrepeatedcontinuouslyforthe
sameorderquantity,reorderpoint,andleadtime.
Aswementioned,theeconomicorderquantityistheordersizethatminimizesthesumofcarrying
costsandorderingcosts.Thesetwocostsreactinverselytoeachother.Astheordersizeincreases,
fewerordersarerequired,causingtheorderingcosttodecline,whereastheaverageamountof
inventoryonhandwillincrease,resultinginanincreaseincarryingcosts.Thus,ineffect,the
optimalorderquantityrepresentsacompromisebetweenthesetwoinverselyrelatedcosts.
Thetotalannualorderingcostiscomputedbymultiplyingthecostperorder,designatedasCo,
timesthenumberofordersperyear.Sinceannualdemand,D,isassumedtobeknownandtobe
constant,thenumberoforderswillbeD/Q,whereQistheordersizeand

TheonlyvariableinthisequationisQ;bothCoandDareconstantparameters.Thus,therelative
magnitudeoftheorderingcostisdependentupontheordersize.
Totalannualcarryingcostiscomputedbymultiplyingtheannualperunitcarryingcost,designated
asCc,timestheaverageinventorylevel,determinedbydividingtheordersize,Q,by2:Q/2;

Thetotalannualinventorycostisthesumoftheorderingandcarryingcosts:

ThegraphinFigure12.2showstheinverserelationshipbetweenorderingcostandcarryingcost,
resultinginaconvextotalcostcurve.
TheoptimalorderquantityoccursatthepointinFigure12.2wherethetotalcostcurveisata
minimum,whichcoincidesexactlywiththepointwherethecarryingcostcurveintersectsthe
orderingcostcurve.ThisenablesustodeterminetheoptimalvalueofQbyequatingthetwocost
functionsandsolvingforQ:

Alternatively,theoptimalvalueofQcanbedeterminedbydifferentiatingthetotalcostcurvewith
respecttoQ,settingtheresultingfunctionequaltozero(theslopeattheminimumpointonthetotal
costcurve),andsolvingforQ:

Thetotalminimumcostisdeterminedbysubstitutingthevaluefortheoptimalordersize,Qopt,into
thetotalcostequation:

EXAMPLE
12.2

TheEconomicOrderQuantity

TheI75CarpetDiscountStoreinNorthGeorgiastockscarpetinitswarehouseand
sellsitthroughanadjoiningshowroom.Thestorekeepsseveralbrandsandstylesof
carpetinstock;however,itsbiggestsellerisSuperShagcarpet.Thestorewantsto
determinetheoptimalordersizeandtotalinventorycostforthisbrandofcarpetgiven
anestimatedannualdemandof10,000yardsofcarpet,anannualcarryingcostof$0.75
peryard,andanorderingcostof$150.Thestorewouldalsoliketoknowthenumberof
ordersthatwillbemadeannuallyandthetimebetweenorders(i.e.,theordercycle)
giventhatthestoreisopeneverydayexceptSunday,ThanksgivingDay,andChristmas
Day(whichisnotonaSunday).
SOLUTION:
Cc=$0.75peryard
Co=$150
D=10,000yards
Theoptimalordersizeis

ThetotalannualinventorycostisdeterminedbysubstitutingQoptintothetotalcost
formula:

Thenumberofordersperyeariscomputedasfollows:

Giventhatthestoreisopen311daysannually(365daysminus52Sundays,
Thanksgiving,andChristmas),theordercycleis

Theoptimalorderquantity,determinedinthisexample,andingeneral,isanapproximatevalue,
sinceitisbasedonestimatesofcarryingandorderingcostsaswellasuncertaindemand(although
alloftheseparametersaretreatedasknown,certainvaluesintheEOQmodel).Inpracticeitis
acceptabletoroundtheQvaluesofftothenearestwholenumber.Theprecisionofadecimalplace
isgenerallynotnecessary.Inaddition,becausetheoptimalorderquantityiscomputedfroma
squareroot,errorsorvariationsinthecostparametersanddemandtendtobedampened.For
instance,inExample12.2,iftheordercosthadactuallybeen30percenthigher,or$200,the
resultingoptimalordersizewouldhavevariedonlybyalittleunder10percent(i.e.,2,190yards
insteadof2,000yards).Variationsinbothinventorycostswilltendtooffseteachother,sincethey
haveaninverserelationship.Asaresult,theEOQmodelisrelativelyresilienttoerrorsinthecost
estimatesanddemand,orisrobust,whichhastendedtoenhanceitspopularity.

TheEOQModelwithNoninstantaneousReceipt
AvariationofthebasicEOQmodelisthenoninstantaneousreceiptmodel,alsoreferredtoasthe
gradualusageandproductionlotsizemodel.InthisEOQmodeltheassumptionthatordersare
receivedallatonceisrelaxed.Theorderquantityisreceivedgraduallyovertime,andtheinventory
levelisdepletedatthesametimeitisbeingreplenished.Thissituationismostcommonlyfound
whentheinventoryuserisalsotheproducer,asinamanufacturingoperationwhereapartis
producedtouseinalargerassembly.Thissituationalsocanoccurwhenordersaredelivered
graduallyovertimeorwhentheretailerisalsotheproducer.
ThenoninstantaneousreceiptmodelisshowngraphicallyinFigure12.3.Theinventorylevelis
graduallyreplenishedasanorderisreceived.InthebasicEOQmodel,averageinventorywashalf
themaximuminventorylevel,orQ/2,butinthismodelvariation,themaximuminventorylevelis
notsimplyQ;itisanamountsomewhatlowerthanQ,adjustedforthefacttheorderquantityis
depletedduringtheorderreceiptperiod.

Inordertodeterminetheaverageinventorylevel,wedefinethefollowingparametersuniquetothis
model:
p=dailyrateatwhichtheorderisreceivedovertime,alsoknownastheproductionrate
d=thedailyrateatwhichinventoryisdemanded
Thedemandratecannotexceedtheproductionrate,sincewearestillassumingthatnoshortages
arepossible,and,ifd=p,thereisnoordersize,sinceitemsareusedasfastastheyareproduced.
Forthismodeltheproductionratemustexceedthedemandrate,orp>d.
ObservingFigure12.3,thetimerequiredtoreceiveanorderistheorderquantitydividedbytherate
atwhichtheorderisreceived,orQ/p.Forexample,iftheordersizeis100unitsandtheproduction
rate,p,is20unitsperday,theorderwillbereceivedin5days.Theamountofinventorythatwill
bedepletedorusedupduringthistimeperiodisdeterminedbymultiplyingbythedemandrate:
(Q/p)d.Forexample,ifittakes5daystoreceivetheorderandduringthistimeinventoryis
depletedattherateof2unitsperday,then10unitsareused.Asaresult,themaximumamountof
inventoryonhandistheordersizeminustheamountdepletedduringthereceiptperiod,computed
as

Sincethisisthemaximuminventorylevel,theaverageinventorylevelisdeterminedbydividing
thisamountby2:

Thetotalcarryingcostusingthisfunctionforaverageinventoryis

Thusthetotalannualinventorycostisdeterminedaccordingtothefollowingformula:

SolvingthisfunctionfortheoptimalvalueQ,

EXAMPLE
12.3

TheEOQModelwithNoninstantaneousReceipt

AssumethattheI75OutletStorehasitsownmanufacturingfacilityinwhichit
producesSuperShagcarpet.Theorderingcost,Co,isthecostofsettingupthe
productionprocesstomakeSuperShagcarpet.RecallCc=$0.75peryardandD=
10,000yardsperyear.Themanufacturingfacilityoperatesthesamedaysthestoreis
open(i.e.,311days)andproduces150yardsofthecarpetperday.Determinethe
optimalordersize,totalinventorycost,thelengthoftimetoreceiveanorder,the
numberofordersperyear,andthemaximuminventorylevel.
SOLUTION:

Theoptimalordersizeisdeterminedasfollows:

Thisvalueissubstitutedintothefollowingformulatodeterminetotalminimumannual
inventorycost:

Thelengthoftimetoreceiveanorderforthistypeofmanufacturingoperationis

commonlycalledthelengthoftheproductionrun.

Thenumberofordersperyearisactuallythenumberofproductionrunsthatwillbe
made:

Finally,themaximuminventorylevelis