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# TOPIC 4:

## ECONOMIC ORDER QUANTITY

(EOQ)
MODEL
Inventory Management Questions

## What should be the order quantity (Q)?

When should an order be placed, called a reorder
point (ROP)?
How much safety stock (SS) should be maintained?
Economic Order Quantity
(EOQ) Models

EOQ
optimal order quantity that will
minimize total inventory costs
Basic EOQ model
Production quantity model
Assumptions of Basic
EOQ Model

## Demand is known with certainty and

is constant over time
No shortages are allowed
Lead time for the receipt of orders is
constant
Order quantity is received all at once
Inventory Costs

Carrying cost
cost of holding an item in inventory
Ordering cost
cost of replenishing inventory
Shortage cost
temporary or permanent loss of sales
when demand cannot be met
Deriving an EOQ

## 1. Develop an expression for setup or ordering costs

2. Develop an expression for holding cost
3. Set setup cost equal to holding cost
4. Solve the resulting equation for the best order
quantity
Inventory Order Cycle
Order quantity, Q
Demand
rate
Inventory Level

Reorder point, R

## 0 Lead Lead Time

time time
Order Order Order Order
placed receipt placed receipt
EOQ Cost Model
Co - cost of placing order D - annual demand
Cc - annual per-unit carrying cost Q - order quantity

Co D
Annual ordering cost =
Q
CcQ
Annual carrying cost =
2
CoD CcQ
Total cost = +
Q 2

EOQ Cost Model

## Deriving Qopt Proving equality of

costs at optimal point
CoD CcQ
TC = +
Q 2 Co D CcQ
=
TC CoD Cc Q 2
= +
Q Q2 2
2CoD
C0D Cc Q2 =
Cc
0= +
Q2 2
2CoD
2CoD Qopt =
Qopt = Cc
Cc
EOQ Cost Model (cont.)
Annual
cost (\$) Total Cost
Slope = 0
CcQ
Minimum Carrying Cost =
2
total cost

CoD
Ordering Cost = Q

## Optimal order Order Quantity, Q

Qopt
Why Holding Costs Increase

## Purchase Order Purchase Order

Description Qty. Description Qty.
Microwave 1 Microwave 1000

## Order quantity Order quantity

Why Order Costs Decrease
Cost is spread over more units
Example: You need 1000 microwave ovens
1 Order (Postage \$ 0.33) 1000 Orders (Postage \$330)

## Purchase Order PurchaseOrder

Purchase Order
Description PurchaseOrder
Description
Purchase OrderQty.
Qty. Description Qty.
Qty.
Microwave 1000 Description
Microwave Qty. 11
Description
Microwave
Microwave
Microwave 11
Order quantity
EOQ Model Equations
Optimal Order Quantity 2 D S
= Q* =
H
D
Expected Number of Orders =N =
Q*
Expected Time Between Orders Working Days / Year
=T =
N
D D = Demand per year
d =
Working Days / Year S = Setup (order) cost per order
H = Holding (carrying) cost
ROP = d L d = Demand per day
L = Lead time in days
EOQ Example
Cc = \$0.75 per yard Co = \$150 D = 10,000 yards

## 2CoD CoD CcQ

Qopt = TCmin = +
Cc Q 2
2(150)(10,000) (150)(10,000) (0.75)(2,000)
Qopt = (0.75) TCmin = 2,000 + 2

## Orders per year = D/Qopt Order cycle time = 311 days/(D/Qopt)

= 10,000/2,000 = 311/5
= 5 orders/year = 62.2 store days
Reorder Point
Level of inventory at which a new order
is placed

R = dL
where
d = demand rate per period
L = lead time
Reorder Point: Example

## Demand = 10,000 yards/year

Store open 311 days/year
Daily demand = 10,000 / 311 = 32.154
yards/day
Lead time = L = 10 days

## R = dL = (32.154)(10) = 321.54 yards

Production Quantity
Model

## An inventory system in which an order is

received gradually, as inventory is
simultaneously being depleted
AKA non-instantaneous receipt model
assumption that Q is received all at once is relaxed
p - daily rate at which an order is received over
time, a.k.a. production rate
d - daily rate at which inventory is demanded
Production Order Quantity Model
Answers how much to order and when to order
Allows partial receipt of material
Other EOQ assumptions apply
Suited for production environment
Material produced, used immediately
Provides production lot size

## Lower holding cost than EOQ model

POQ Model Inventory Levels
Inventory Level

## Demand portion of cycle with no

supply

Supply Supply
Time
Begins Ends
Production Quantity Model
(cont.)
Inventory
level

Maximum
Q(1-d/p) inventory
level

Average
Q inventory
(1-d/p)
2 level

0
Begin End Time
order order
Order
receipt receipt
receipt period
POQ Model Equations

## Maximum inventory level = Q - Q d

p

=Q1- d 2CoD
p
Qopt = d
Q d Cc 1 -
Average inventory level = 1- p
2 p

CoD CcQ d
TC = Q + 2 1 - p
Production Quantity Model:
Example
Cc = \$0.75 per yard Co = \$150 D = 10,000 yards
d = 10,000/311 = 32.2 yards per day p = 150 yards per day

2CoD 2(150)(10,000)
Qopt = = = 2,256.8 yards
Cc 1 - d 0.75 1 -
32.2
p 150

CoD CcQ d
TC = Q + 2 1 - p = \$1,329

Q 2,256.8
Production run = = = 15.05 days per order
p 150
Production Quantity Model:
Example (cont.)

D 10,000
Number of production runs = = = 4.43 runs/year
Q 2,256.8

d 32.2
Maximum inventory level = Q 1 - = 2,256.8 1 -
p 150
= 1,772 yards

## Copyright 2006 John Wiley & Sons, Inc. 12-24

Reasons for Variability in Production

## Most variability is caused by waste or by poor

management. Specific causes include:
employees, machines, and suppliers produce units that do
not conform to standards, are late or are not the proper
quantity
inaccurate engineering drawings or specifications
production personnel try to produce before drawings or
specifications are complete
customer demands are unknown