The Decisions to be Made

One of the most frequent decisions

Economic Order faced by operations managers is
“how much” or “how many” of
Quantity something to make or buy in order to
satisfy external or internal
requirements for some item.
Many times, this decision is made with
little or no thought about its cost
consequences.

The basic model makes the

The Definition of EOQ
following assumptions:
 Demand is uniform, constant and
EOQ, or Economic Order continuous over time;
Quantity, is defined as the  The leadtime is constant;
optimal quantity of orders that  There is no limit on order size due either
minimizes total variable costs to stores capacity;
required to order and hold  The cost of placing an order is
inventory. independent of size of order;
 The cost of holding a unit of stock does
not depend on the quantity in stock;
 Exactly the same quantity is ordered
each time that a purchase is made.

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How to use EOQ in your
organization Costs

 EOQ accounts for 3 types of costs:

How much inventory  Unit Cost: the cost of the units
should we order each themselves, assumed to be fixed,
month? regardless of the number of units
ordered
 Inventory-Holding Cost: the cost of
holding units in inventory
 Fixed order cost: represents all the
costs associated with placing an order
excluding the cost of the units
The EOQ tool can be used to model the themselves (any administrative costs of
amount of inventory that we should order. placing and/or receiving an order)

Inventory Holding Costs EOQ Model

Reasonably Typical Profile

% of
Category Inventory Value Annual Cost
Housing (building) cost 6%
Material handling costs 3% Holding Cost
Labor cost 3%
Inventory investment costs 11%
Pilferage, scrap, & obsolescence 3%
Total holding cost 26%

Order Quantity

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 Why Order Cost Decreases EOQ Model

 Cost is spread over more units

Annual Cost
Example: You need 1000 microwave ovens

1 Order (Postage $ 0.35) 1000 Orders (Postage $350) Holding Cost

Purchase Order Purchase Order
Purchase
Purchase OrderOrder
Description Qty. Description
Purchase Qty.
Order
Description Qty.
Description
Microwave
Description Qty.
Qty.11 Order Cost
Microwave 1000 Microwave
Microwave
Microwave 11

Order Order Quantity

quantity

EOQ Model How EOQ Works

The Total Cost Formula

Annual Cost
Total Cost Curve

Total Cost = Purchase Cost

Holding Cost
+ Order Cost
Order Cost
+ Holding Cost

Optimal Order Quantity

Order Quantity (Q*)

3
How EOQ Works How EOQ Works
The Total Cost Formula
The Total Cost Formula

This represents the This represents the

unchanging fixed costs variable order costs
P = Purchase cost per unit
R = Annual usage in units
P = Purchase cost per unit C = Cost per order event (not per unit)
R = Annual usage in units Q = The number of units ordered

How EOQ Works How EOQ Works

The Total Cost Formula The EOQ Formula

Total
Cost
Formula

Taking the derivative of both sides of the equation and

This represents the setting equal to zero to find the minimum value of the
function, one obtains:
variable holding costs
P = Purchase cost per unit
R = Annual usage in units
C = Cost per order event (not per unit)
Q = The number of units ordered
F = Holding cost factor

4
How EOQ Works How EOQ Works

The result of differentiation

P = Purchase cost per unit

R = Annual usage in units
The Economic Order Quantity C = Cost per order event (not per unit)
F = Holding cost factor

How EOQ Works How EOQ Works

The graphic representation of the EOQ equation

Expected Number Orders = N = R/Q*

Expected time between orders:

Working days / Year

T=
N

5
Real Life Example: Real Life Example:

Real Life Example: Real Life Example:

Next let’s identify the correct

First, Recall
variables…
the EOQ
Equation:

P = Purchase cost per unit

R = Annual usage in units
C = Cost per order event
F = Holding cost factor

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Real Life Example: Real Life Example:

Forecasted Ordering
Amount Costs

Real Life Example: Real Life Example:

Cost per Holding

Unit Cost Factor

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Real Life Example: Real Life Example:

R = Annual demand R = 5200

C = Fixed ordering cost C = $10 per order
P = Cost per case P = $2
F = Holding Cost Factor F = 20% of value of inventory per year

Real Life Example: Wrapping It Up

EOQ, or Economic Order Quantity,
is defined as the optimal quantity of
orders that minimizes total variable
costs required to order and hold
inventory.

2 (10) (5200)
EOQ =
(2 )(.20)

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Conclusion EOQ Example

You’re a buyer for SaveMart.

 EOQ is useful for minor stock
items of low values with known SaveMart needs 1000 coffee makers
steady prices, demands and per year. The cost of each coffee
supply lead times; maker is $78. Ordering cost is $100
 Where there is demand variability, per order. Carrying cost is 40% of per
such as seasonality, EOQ can still unit cost. Lead time is 5 days.
be calculated but using shorter SaveMart is open 365 days/yr.
time period. What is the optimal order quantity?

SaveMart EOQ Homework

Calculate the EOQ of „A” materials if:

 The quartal demand for material "A" is
1.500 pieces
 The purchase price per unit is $80
R= 1000  The rate of storage cost is of 20% of the
C= $100 purchase price per unit
2 1000  $100
P= $ 78
EOQ   Fixed costs are $50 per order
F= 40% $31.20
H= PxF
H= $31.20 How many times should we order to meet
the annual demand for material "A"?
EOQ = 80 coffeemakers