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M&DCPurchasing&SupplyChain:MaterialManagement

Order Quantities

IntroductiontoMaterialManagement

MasterScheduling

Contents

MaterialRequirementsPlanning
CapacityManagement

1.

Introduction

ProductionActivityControl

2.

EconomicOrderQuantity(Eoq)

Purchasing

3.

VariationsOfTheEoqModel

4.

QuantityDiscounts

5.

UseOfEoqWhenCostsAreNotKnown

6.

PeriodOrderQuantity(P00)

Forecasting
OrderQuantities

IndependentDemandOrderingSystems
PhysicalInventoryandWarehouseManagement
PhysicalDistribution

1.Introduction
Theobjectivesofinventorymanagementaretoprovidetherequiredlevelofcustomerserviceandto
reducethesumofallcostsinvolved.Toachievetheseobjectives,twobasicquestionsmustbe
answered:

a.
b.

Howmuchshouldbeorderedatonetime?
Whenshouldanorderbeplaced?
Managementmustestablishdecisionrulestoanswerthesequestionssoinventorymanagement
personnelknowwhentoorderandhowmuch.Lackinganybetterknowledge,decisionrulesareoften
madebasedonwhatseemsreasonable.Unfortunately,suchrulesdonotalwaysproducethebest
results.
Thischapterwillexaminemethodsofansweringthefirstquestion,andthenextchapterwilldealwith
thesecondquestion.First,wemustdecidewhatweareorderingandcontrolling.

a.StockKeepingUnit(SKU)
Controlisexercisedthroughindividualitemsinaparticularinventory.Thesearecalled
astockkeepingunit(SKU).Twowhiteshirtsinthesameinventorybutofdifferent
sizesorstyleswouldbetwodifferentSKUs.Thesameshirtintwodifferentinventories
wouldbetwodifferentSKUs.

b.LotSizeDecisionRules
TheeightheditionoftheAPICSDictionarydefinesalot,orbatch,asaquantity
producedtogetherandsharingthesameproductioncostsandspecifications.Following
aresomecommondecisionrulesfordeterminingwhatlotsizetoorderatonetime.

Lotforlot.Thelotforlot
rulesaystoorderexactlywhatisneedednomorenoless.The
orderquantitychangeswheneverrequirementschange.This
techniquerequirestimephasedinformationsuchasprovidedbya
materialrequirementsplanoramasterproductionschedule.Since
itemsareorderedonlywhenneeded,thissystemcreatesnounused
lotsizeinventory.Becauseofthis,itisthebestmethodforplanning
Aitemsandisalsousedinajustintimeenvironment.

Fixedorderquantity
Fixedorderquantityrulesspecifythenumberofunitstobeordered
eachtimeanorderisplacedforanindividualitemorSKU.The
quantityisusuallyarbitrary,suchas200unitsatatime.The
advantagetothistypeofruleisthatitiseasilyunderstood.The
disadvantageisthatitdoesnotminimizethecostsinvolved.
Avariationonthefixedorderquantitysystemisthemmmaxsystem.
Inthissystem,anorderisplacedwhenthequantityavailablefalls
belowtheorderpoint(discussedinthenextchapter).Thequantity
orderedisthedifferencebetweentheactualquantityavailableatthe
timeoforderandthemaximum.Forexample,iftheorderpointis100
units,themaximumis300units,andthequantityactuallyavailable

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whentheorderisplacedis75,theorderquantityis225units.Ifthe
quantityactuallyavailableis80units,anorderfor220unitsisplaced.
Onecommonlyusedmethodofcalculatingthequantitytoorderisthe
economicorderquantity,whichisdiscussedinthenextsection.

Ordernperiodssupply.
Ratherthanorderingafixedquantity,inventorymanagementcan
orderenoughtosatisfyfuturedemandforagivenperiodoftime.The
questionishowmanyperiodsshouldbecovered?Theansweris
givenlaterinthischapterinthediscussionontheperiodorder
quantitysystem.

c.Costs
Asshowninthelastchapter,thecostoforderingandthecostofcarryinginventory
bothdependonthequantityordered.Ideally,theorderingdecisionrulesusedwill
minimizethesumofthesetwocosts.Thebestknownsystemistheeconomicorder
quantity.

2.EconomicOrderQuantity(Eoq)
a.Assumptions
TheassumptionsonwhichtheEOQisbasedareasfollows:

a.

Demandisrelativelyconstantandisknown.

b.

Theitemisproducedorpurchasedinlotsorbatchesandnotcontinuously.

c.
d.

Orderpreparationcostsandinventorycarryingcostsareconstantandknown.
Replacementoccursallatonce.
Theseassumptionsareusuallyvalidforfinishedgoodswhosedemandisindependent
andfairlyuniform.However,therearemanysituationswheretheassumptionsarenot
validandtheEOQconceptisofnouse.Forinstance,thereisnoreasontocalculate
theEOQformadetoorderitemsinwhichthecustomerspecifiestheorderquantity,
theshelflifeoftheproductisshort,orthelengthoftherunislimitedbytoollifeorraw
materialbatchsize.Inmaterialrequirementsplanning,thelotforlotdecisionruleis
oftenused,buttherearealsoseveralrulesusedthatarevariationsoftheeconomic
orderquantity.

b.DevelopmentoftheEOQFormula
Undertheassumptionsgiven,thequantityofanitemininventorydecreasesata
uniformrate.Supposeforaparticularitem,theorderquantityis200units,andthe
usagerateis100unitsaweek.Figure10.1showshowinventorywouldbehave.
Theverticallinesrepresentstockarrivingallatonceasthestockonhandreaches
zero.ThequantityofunitsininventorythenincreasesinstantaneouslybyQ,the
quantityordered.Thisisanaccuraterepresentationofthearrivalofpurchasedpartsor
manufacturedpartswhereallpartsarereceivedatonce.
Fromthepreceding,

order
quantity200
Averagelotsizeinventory==
=100units

22

annual
demand100X52
Numberofordersperyear==
.
order
quantity200
=26timesperyear

c.ExampleProblem
TheannualdemandforanSKUis10,075units,anditisorderedinquantitiesof650

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units.Calculatetheaverageinventoryandthenumberofordersplacedperyear.

Answer

order
quantity200
Averagecycleinventory==
=100units

22

annual
demand10.075
Numberofordersperyear==
.=15.5
order
quantity650

Noticeintheexampleproblemthenumberofordersperyearisroundedneitherupnordown.Itisan
averagefigure,andtheactualnumberofordersperyearwillvaryfromyeartoyearbutwillaverageto
thecalculatedfigure.Intheexample,16orderswillbeplacedinoneyearand15inthesecond.

d.Relevantcosts
Therelevantcostsareasfollows:
Annualcostofplacingorders.
Annualcostofcarryinginventory.
Astheorderquantityincreases,theaverageinventoryandtheannualcostofcarrying
inventoryincrease,butthenumberofordersperyearandtheorderingcostdecrease.
Itisabitlikeaseesawwhereonecostcanbereducedonlyattheexpenseof
increasingtheother.Thetrickistofindtheparticularorderquantityinwhichthetotal
costofcarryinginventoryandthecostoforderingwillbeaminimum.
Let:
A=annualusageinunits
S=orderingcostindollarsperorder
i=annualcarryingcostrateasadecimalofapercentage
c=unitcostindollars
Q=orderquantityinunits
Then:
Annualorderingcost=numberofordersxcostsperorder

A
=
xS
Q
Annualcarryingcost=averageinventoryxcostofcarryingone
unitforoneyear
=averageinventoryxunitcostxcarrying
cost

Q
=
xcxi
2
Totalannualcosts=annualorderingcosts+annualcarrying
costs

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AQ
=
xs+xcxi

Q2
everalrulesusedthatarevariationsoftheeconomicorderquantity.

e.ExampleProblem
Theannualdemandis10,000units,theorderingcost$30perorder,thecarryingcost
20%,andtheunitcost$15.Theorderquantityis600units.Calculate:

a.

Annualorderingcost

b.

Annualcarryingcost

c.

Totalannualcost

Answer
A=10,000units
S=$30
i=0.20
C=$15
Q=600units
A
10,000
a. annualorderingcost=xS=
x$30=$500

Q600

b. Q600
annualcarryingcost=xcxi=
x$15x0.2=$900

22
c. totalannual
cost
=$1400
Ideally,thetotalcostwillbeaminimum.Foranysituationinwhichtheannual
demand(A),thecostofordering(S),andthecostofcarryinginventory(i)aregiven,
thetotalcostwilldependupontheorderquantity(Q).

f.TrialandErrorSolution
Considerthefollowingexample:

a.

AhardwaresupplydistributorcSarriesboxesof3inchboltsinstock.The
annualusageis1000boxes,anddemandisrelativelyconstantthroughoutthe
year.Orderingcostsare$20perorder,andthecostofcarryinginventoryis
estimatedtobe20%.Thecostperunitis$5.

Let:
A=1000units
S=$20perorder
c=$5perunit
i=20%=0.20
Then:

A1000
Annualorderingcost=xS=x20
QQ

QQ
Annualcarryingcost=xcxi=
x5x0.20
22
Totalannualcost=annualorderingcost+annual
carryingcost
Figure10.2isatabulationofthecostsfordifferentorderquantities.Theresultsfrom

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thetableinFigure10.2arerepresentedonthegraphofFigure10.3.
Figures10.2and10.3showthefollowingimportantfacts:

a.

Thereisanorderquantityinwhichthesumoftheorderingcostsandcarrying
costsisaminimum.

b.

ThisEOQoccurswhenthecostoforderingequalsthecostofcarrying.

c.

ThetotalcostvarieslittleforawiderangeoflotsizesaboutEOQ.
Thelastpointisimportantfortworeasons.First,itisusuallydifficulttodetermine
accuratelythecostofcarryinginventoryandthecostofordering.Sincethetotalcost
isrelativelyflataroundtheEOQ,itisnotcriticaltohaveexactvalues.Good
approximationsaresufficient.Second,partsareoftenorderedinconvenientpackages
suchaspalletloads,cases,ordozens,anditisadequatetopicktheclosestpackage
quantitytotheEOQ.
OrderQuantity
(Q)

Ordering
Costs

CarryingCosts

TotalCosts

(Qci/2)

(AS/Q)
50

$400

$25

$425

100

200

50

250

150

133

75

208

200

100

100

200

250

80

125

205

300

67

150

217

350

57

175

232

400

50

200

250

g.EconomicOrderQuantityFormula
TheprevioussectionshowedthattheEOQoccurredatanorderquantityinwhichthe
orderingcostsequalthecarryingcosts.Ifthesetwocostsareequal,thefollowing
formulacanbederived:

Thisvaluefortheorderquantityistheeconomicorderquantity.Usingtheformulato
calculatetheEOQintheprecedingexampleyields:

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h.HowtoReduceLotSize
LookingattheEOQformula,therearefourvariables.TheEOQwillincreaseasthe
annualdemand(A)andthecostofordering(S)increase,anditwilldecreaseasthe
costofcarryinginventory(i)andtheunitcost(c)increase.
Theannualdemand(A)isaconditionofthemarketplaceandisbeyondthecontrolof
manufacturing.Thecostofcarryinginventory(i)isdeterminedbytheproductitself
andthecostofmoneytothecompany.Assuch,itisbeyondthecontrolof
manufacturing.
Theunitcost(c)iseitherthepurchasecostoftheSKUorthecostofmanufacturing
theitem.Ideally,bothcostsshouldbeaslowaspossible.Inanyevent,astheunit
costdecreases,theEOQincreases.
Thecostofordering(S)iseitherthecostofplacingapurchaseorderorthecostof
placingamanufacturingorder.Thecostofplacingamanufacturingorderismadeup
fromproductioncontrolcostsandsetupcosts.Anythingthatcanbedonetoreduce
thesecostsreducestheEOQ.
Justintimemanufacturingemphasizesreductionofsetuptime.Thereareseveral
reasonswhythisisdesirable,andthereductionoforderquantitiesisone.Chapter15
discussesjustintimemanufacturingfurther.

3.VariationsOfTheEoqModel
ThereareseveralmodificationsthatcanbemadetothebasicEOQmodeltofitparticular
circumstances.Twothatareoftenusedarethemonetaryunitlotsizemodelandthe
noninstantaneousreceiptmodel.

a.MonetaryUnitLotSize
TheEOQcanbecalculatedinmonetaryunitsratherthanphysicalunits.Thesame
EOQformulagivenintheprecedingcanbeused,buttheannualusagechangesfrom
unitstodollars.
AD=annualusageindollars
S=orderingcostsindollars
i=carryingcostrateasadecimalofapercent
Becausetheannualusageisexpressedindollars,theunitcostisnotneededinthe
modifiedEOQequation.
TheEOQindollarsis:

b.ExampleProblem
Anitemhasanannualdemandof$5000,preparationcostsof$20perorder,anda
carryingcostof20%.WhatistheEOQindollars?
AD=$5000
S=$20
i=20%=0.20

4.QuantityDiscounts
Whenmaterialispurchased,suppliersoftengiveadiscountonordersoveracertainsize.Thiscanbe
donebecauselargerordersreducethesupplierscoststogetlargerorders,theyarewillingtooffer
volumediscounts.Thebuyermustdecidewhethertoacceptthediscount,andindoingso,must
considertherelevantcosts:
Purchasecost.
Orderingcosts.
Carryingcosts.

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a.ExampleProblem
Anitemhasanannualdemandof25,000units,aunitcostof$10,anorder
preparationcostof$10,andacarryingcostof20%.Itisorderedonthebasisofan
EOQ,butthesupplierhasofferedadiscountof2%onordersof$10,000ormore.
Shouldtheofferbeaccepted?

Answer
AD=25,000x$10=$250,000
S=$10
i=20%

Discountedorderquantity=$l0,000X0.98=$9,800

Nodiscount

UnitPrice

Discount
lotsize

$10

$9.80

LotSize

$5000

$9800

AverageLotSizeInventory(Qc
2)

$2500

$4900

NumberofOrdersperYear

50

25

$250,000

$245,000

InventoryCarryingCost(20%)

500

980

OrderPreparationCost($10
each)

500

250

$251,000

$246,230

PurchaseCost

TotalCost

Fromtheprecedingexampleproblem,itcanbesaidthattakingthediscountresults
inthefollowing:
Thereisasavinginpurchasecost.
Orderingcostsarereducedbecausefewerordersareplacedsincelarger
quantitiesarebeingordered.
Inventorycarryingcostsrisebecauseofthelargerorderquantity.
Thebuyermustweighthefirsttwoagainstthelastanddecidewhattodo.What
countsisthetotalcost.Dependingonthefigures,itmayormaynotbebesttotake
thediscount.

5.UseOfEoqWhenCostsAreNotKnown
TheEOQformuladependsuponthecostoforderingandthecostofcarryinginventory.Inpractice,
thesecostsarenotnecessarilyknownoreasytodetermine.However,theformulacanstillbeusedto
advantagewhenappliedtoafamilyofitems.
Forafamilyofitems,theorderingcostsandthecarryingcostsaregenerallythesameforeachitem.
Forinstance,ifwewereorderinghardwareitemsnuts,bolts,screws,nails,andsoonthecarrying
costswouldbevirtuallythesame(storage,capital,andriskcosts)andthecostofplacinganorder
withthesupplierwouldbethesameforeachitem.Incasessuchasthis,thecostofplacinganorder
(S)isthesameforallitemsinthefamilyasiscostofcarryinginventory(i).
Now

whereA(annualdemand)isindollars.
SinceSisthesameforalltheitemsandiisthesameforallitems,theratio2Simustbethesame
forallitemsinthefamily.Forconvenience,let:

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a.ExampleProblem
Supposetherewereafamilyofitemsforwhichthedecisionrulewastoordereach
itemfourtimesayear.Sincethecostofordering(S)andthecostofcarrying
inventory(i)arenotknown,orderingfourtimesayearisnotbasedonanEOQ.Can
wecomeupwithabetterdecisionruleeveniftheEOQcannotbecalculated?

Thesumofallthelotsis$2636.Sincetheaverageinventoryisequaltohalfthe
orderquantity,theaverageinventoryis$26362=$1318.
Sincethisisafamilyofitemswherethepreparationcostsarethesameandthe
carryingcostsarethesame,thevaluesforK=(2Sj)h/2shouldbethesameforall
items.Theprecedingcalculationsshowthattheyarenot.ThecorrectvalueforKis
notknown,butabettervaluewouldbetheaverageofallthevalues:

ThisvalueofKcanbeusedtorecalculatetheorderquantitiesforeachitem.

Theaverageinventoryhasbeenreducedfrom$1318to$726whilethenumberof
ordersperyear(12)remainsthesame.Thus,thetotalcostsassociatedwith
inventoryhavebeenreduced.

6.PeriodOrderQuantity(P00)
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Theeconomicorderquantityattemptstominimizethetotalcostoforderingandcarryinginventoryand
isbasedontheassumptionthatdemandisuniform.Oftendemandisnotuniform,particularlyin
materialrequirementsplanning,andusingtheEOQdoesnotproduceaminimumcost.
Theperiodorderquantitylotsizeruleisbasedonthesametheoryastheeconomicorderquantity.It
usestheEOQformulatocalculateaneconomictimebetweenorders.Thisiscalculatedbydividing
theEOQbythedemandrate.Thisproducesatimeintervalforwhichordersareplaced.Insteadof
orderingthesamequantity(EOQ),ordersareplacedtosatisfyrequirementsforthecalculatedtime
interval.Thenumberofordersplacedinayearisthesameasforaneconomicorderquantity,butthe
amountorderedeachtimevaries.Thus,theorderingcostisthesamebut,becausetheorder
quantitiesaredeterminedbyactualdemand,thecarryingcostisreduced.

EOQ
Periodorderquantity=
.
averageweeklyusage

a.ExampleProblem
TheEOQforanitemis2800units,andtheannualusageis52,000units.Whatisthe
periodorderquantity?

Answer

Whenanorderisplaceditwillcovertherequirementsforthenextthreeweeks.

b.ExampleProblem
GiventhefollowingMRPrecordandanEOQof250units,calculatetheplannedorder
receiptsusingtheeconomicorderquantity.Next,calculatetheperiodorderquantities
andtheplannedorderreceipts.Inbothcases,calculatetheendinginventoryandthe
totalinventorycarriedoverthetenweeks.
Week

Net
100 50 150
Requirements
PlannedOrder
Receipt

75 200

10 Total

55

80

150

30

890

10 Total

Answer
EQQ=250units
Week

Net
100 50 150
Requirements

75 200 55

PlannedOrder 250
Receipt

Ending
Inventory

250

250

80 150 30

250

890

150 100 200 200 125 175 120 40 140 110 1360

Week

Net
100 50 150
Requirements
PlannedOrder 300
Receipt
Ending
Inventory

200 150

75 200 55

80

330

0 255 55

10 Total

150 30

890

260

180

30

870

Noticeintheexampleproblemthetotalinventoryisreducedfrom1360unitsto870
unitsoverthetenweekperiod.

c.PracticalConsiderationsWhenUsingtheEOQ
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Lumpydemand.
TheEOQassumesthatdemandisuniformandreplenishment
occursallatonce.Whenthisisnottrue,theEOQwillnotproduce
thebestresults.Itisbettertousetheperiodorderquantity.

Anticipationinventory.
Demandisnotuniform,andstockmustbebuiltahead.Itisbetterto
planabuildupofinventorybasedoncapacityandfuturedemand.

Minimumorder.
Somesuppliersrequireaminimumorder.Thisminimummaybe
basedonthetotalorderratherthanonindividualitems.Oftenthese
areCitemswheretheruleistoorderplenty,notanEOQ.

Transportationinventory.
AswillbediscussedinChapter13,carriersgiveratesbasedonthe
amountshipped.Afullloadcostslesspertontoshipthanapart
load.Thisissimilartothepricebreakgivenbysuppliersforlarge
quantities.Thesametypeofanalysiscanbeused.

Multiples.
Sometimes,ordersizeisconstrainedbypackagesize.For
example,asuppliermayshiponlyinskidloadlots.Inthesecases,
theunitusedshouldbetheminimumpackagesize.

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