Economic Order Quantity

The economic order quantity

(EOQ) is the fixed order quantity
(Q) that minimizes the total annual
costs of placing orders and holding
inventory (TC).

Economic Order Quantity

Assumptions

Demand (D) is known and constant

H is known and constant
Order costs (S) are constant
The order quantity arrives in a
single shipment
No quantity discounts are available
All demand will be met (no
shortages)

D
Q
1 H
TC S H DS Q
Q
2
Q 2

We want to minimize TC
D, S, and H are constant. TC is a function of Q.

Economic Order Quantity (3)

Let Q* be the economic order quantity. Then
Q
*

2DS
H

D
Q*
TC * S
H
2
Q

For Q*, annual order cost = annual inventory cost

D
Q*
S
H
*
2
Q

Simple Reorder Point

Use this method when daily demand is

constant.
R = reorder point
d = daily demand (may have to
compute this)
L = lead time (Caution: if lead time is
given in weeks, convert this to days).
R = dL

Reorder Point with Safety Stock

Safety stock (SS) is extra inventory that is

kept to meet unexpected demand.

Reorder point without

safety stock

Reorder point
with safety
stock

Reorder Point with Safety Stock

(2)
How much safety stock (SS) ?

d average daily demand

Reorder point with safety stock:
R d L SS
Service level is the probability of having
enough inventory to meet demand during
lead time
The probability of a stockout is (1 - service
level)
dL
Demand during lead time is normally
distributed with mean
and standard
deviation dL

Reorder Point with Safety Stock

(2)
How much safety stock (SS) ?

z is the number of standard deviations

required to meet the desired service level

SS = zdL

d L=
Reorder point with safety stock: R
zdL

Reorder Point with Safety Stock

Example
Given
D = annual demand = 10,000
N = number of business days per year = 250
The company operates 5 days per week

d = average daily demand

dL = standard deviation of demand during lead
time = 20
L = lead time = 1 week
Service level = 96%
dL
Find: reorder point with safety stock: R =

+ zdL

Computing Reorder Point

with Safety Stock
1.

If average daily demandd( ) is not

given, compute it.
Note: d = D/N and D =
d= 10,000/250 = 40

2.

Nd

If the lead time is given in weeks or

months, compute lead time in days.

L = 1 week = 1(5) = 5 days

Note: 1 week is the number of days per week
that the company operates. This may be 5,
6, or 7.

Computing Reorder Point

with Safety Stock (2)
3.

Find the z value for the service

Appendix B gives
level (96%)
this area.
Probability of
a stockout =
1 service
level = 4%

50%

46%

dL

Computing Reorder Point

with Safety Stock (3)
3.

Find the z value for the service level (96%)

(cont.)
(a) Write the service level as a decimal
96% = 0.9600
(b) Subtract 0.5000 from the service level
0.9600 0.5000 = 0.4600
(c) Use the table in Appendix B, page 652, to
find the area that is closest to 0.4600
The closest area in the table is 0.4599,
which occurs when z = 1.75
Use z = 1.75

Computing Reorder Point

with Safety Stock (4)
4.

Compute R

R = d L+ zdL
= 40(5) + 1.75(20) = 200 + 35
= 235
Note: If the computation gives a fractional
value, round up to nearest integer.
Example: Computed R = 210.2 R = 211

Economic Production Quantity

Key question: How many units of a

part or product should be made at
one time?
The economic production quantity
(EPQ) is the production quantity (lot
size) that minimizes the total annual
cost of setups and holding inventory.

Economic Production Quantity

(2)
Notation

Q = Amount to make (lot size)

D = annual demand for the item
d = daily demand for the item
p = daily production rate
S = cost of one setup
H = inventory holding cost per unit per year
(commonly called holding cost)
TC = annual cost of setups
+ annual cost of holding inventory
The EPQ is the quantity that minimizes TC

Economic Production Quantity (3)

Assumption: Daily demand < daily production.
When the item is being made, some is sold or used to
make a product. The remainder goes into inventory.
When production stops, the inventory is used until
there is no inventory left. Then production resumes.
Ending inventory
= beginning
inventory
+ production
- sales or usage

Economic Production Quantity

(4)

Length of production run = Q/p

During production, d units are sold or used each day. (p
d) units go into inventory.

Maximum
inventory:
Total cost: TC EPQ
Economic
production
quantity (EPQ):

I MAX

Q
d
( p d ) Q 1
p
p

D I MAX

S
H
Q 2

EPQ

2DS
d
1
p

EOQ vs. EPQ

When to use economic order quantity

(EOQ):

Demand is independent
Compute how much to order (order quantity)

When to use economic production

quantity (EPQ):

Parts or products will be produced: demand

is dependent
Compute how much to make at one time
(production lot size)