Economic Order

Quantity (EOQ)

Dr. S. Somokanta Singh

MIMS, Manipur University
[email protected]
Economic Order Quantity (EOQ)
• The inventory problems in which demand is assumed to be fixed and
completely pre-determined are usually referred to as the Economic
Order Quantity (EOQ) or Lot Size problems.
• By the ‘order quantity’ we mean the quantity produced or procured
during one production cycle.
• This is also termed as reorder quantity
• When the size of order increases, the ordering costs (cost of
purchasing, inspection etc.) will decrease whereas the inventory
carrying costs (cost of storage, insurance etc.) will increase.
• Thus in the production process there are two opposite costs, one
encourages the increase in the order size and the other discourages.
• Economic Order Quantity (EOQ) is that size of order which minimizes
total annual (or any other time period as specified by individual firms)
costs of carrying inventory and cost of ordering
The two opposite costs can be shown graphically by
plotting them against the order size as shown below
Costs

Total Costs Inventory Carrying Costs

Minimum total Cost

Ordering Costs

O EOQ Number of Units

Fig. Graph of EOQ

It is evident from the above that the minimum total cost occurs
at the point where the ordering costs and inventory carrying
costs are equal
The Deterministic Inventory
Problems
• Case 1. EOQ problem with no shortages
• Case 2. EOQ Problem with no Shortages and Several Production
runs of Unequal length
• Case 3. Production Problem with no Shortages
• Case 4. EOQ Problem with shortages
• Case 5. Production Problem with Shortages
Case 1. EOQ Problem with no
shortages
• The objective of the study of this problem is to determine an
optimum order quantity (EOQ) such that the total inventory cost is
minimized.
• We illustrate the problem under consideration, after making the
following assumptions:
i) Demand rate is uniform and is known in advance. Let it be ‘D’
units per unit time
ii) Shortages are not allowed; i.e. as soon as the level of
inventory reaches zero, the inventory is replenished. Thus the
cost of shortage is assumed to be negligible.
iii) Production time is negligible, i.e. production or supply of
commodity is instantaneous (lead time is zero)
iv) Production run is of ‘t’ time units
v) Set-up cost (or ordering cost) per production run is denoted
by ‘A’
vi) The holding cost is assumed to be proportional to the amount
of inventory, as well as the time inventory is held.
vii) Cost of holding one unit in inventory for a unit time is
denoted by ‘C’
viii) Inventory carrying cost, expressed as a percentage of the
value of average inventory is indicated by ‘I’
ix) Finance and space are unlimited
x) There is no constraint on the number of orders
• The above inventory situation can be illustrated schematically as
shown in the figure 1 below with order size ‘’ on the vertical axis and
time on horizontal axis:

Economic Order Inventory

Quantity ‘’

Average Inventory

O t 2t 3t (n-1)t nt Time

Fig. 1
• The total time period (say one year) is divided into n parts. It is being
assumed here that after each time, ‘t’, the quantity ‘’ is re-ordered.
• If n denotes the total number of runs of quantity re-ordered during
the year, then evidently

• Where D is the total annual demand

• It may be clear that the average amount of inventory at hand on any
day is given by , as shown by the dotted line in the Fig. 1.
• The total inventory in one cycle (i.e. over the time period of t days) is
clearly the area of the first triangle in Fig. 1
• Now the area of the first triangle = Base x Height = t
• Therefore, the average inventory at any time on any given day in the t
period is /t =
• Since each of the triangles in Fig. 1 over a year period looks the same,
remains the average amount of inventory in each review period
during the year
• Thus the Annual inventory carrying cost
= (Average inventory during period) x (Cost of one unit)
x (Inventory carrying cost per cent)
=
• Annual ordering cost associated with runs of size
= (Number of orders per period) x (Ordering cost per order)
= nA
= ( n= D/)
• Since the minimum total cost occurs at the point where the ordering
cost and inventory carrying cost are equal, equating the annual
inventory cost to annual ordering cost, we have

= or =

or EOQ = …………………….. (1)

This economic (optimum) lot size formula is due to R.M. Wilson
• The Economic Review Period (ERP) can now easily be obtained as
follows:
ERP or t = =
=
or ERP = ………………….. (2)
• Total Annual Expected Cost (TEC) is given by
TEC = Annual inventory carrying cost + Annual ordering cost
= + = +
or TEC = …………………….. (3)
Example
• A contractor has a requirement for cement that amounts to 300 bags
per day. No shortages are allowed. Cement costs Rs 12 per bag.
Inventory carrying cost is 10% of the average inventory valuation per
day and it costs Rs 20 to process a purchase order. Find the minimum
cost purchase quantity.
Solution:
We are given
D = Demand of cement per day = 300 bags per day
A = Ordering cost per order (or set up cost per run)
= Rs 20 per order
C = Cost of one unit = Rs 12 per bag
 I = Inventory carrying costs (expressed as a percentage of the
value of average inventory)
= Re 0.10
Thus the total inventory carrying cost over a period is given by,
= (Average inventory during the period) x (Cost of one unit)
x (Inventory carrying cost percentage)
=( ) x (Rs 12) x (Re 0.10) = (0.6)

Where is the quantity order

• The total ordering cost is given by

x = x 20 = (6000)/Q

Thus we have,
(0.6) =(6000)/Q
or 2
= 10,000
or = 100 bags
Total minimum cost of purchasing is given by,
TEC = Total Inventory carrying cost + Total ordering cost
= Rs [(0.6) + (6000)/]
= Rs [(0.6) + (6000)/]
= Rs 120.00/-
Inventory problems with uncertainty
• In many practical situations, it is observed that neither the
consumption rate of material is constant, throughout the year nor is
the lead time.
• To face these uncertainties in consumption rate and lead time, an
extra stock is maintained to meet out the demands, if any.
• This extra stock is termed as Safety stock, or Buffer Stock. Sometimes
it is also referred to as the Insurance Stock or Cushion Stock
• Safety stock, therefore is the additional stock needed to allow for
delay in delivery or for any above average demand that may arise
during lead time (the time between deciding to place an order and
receiving replenishments).
• If demand remains constant and lead time is invariable, then there
would be no fear of shortages and hence no need for safety stock. In
this case a fixed quantity would be re-ordered at fixed intervals called
the re-order level. (R.O.L.)
• However, in real life situations, requirements (demand)do not follow a
uniform rate. Again lead time varies.
• The variations in demand and lead time cause both shortages and
surpluses.
• Higher demand -> Inventory consumes faster ->Shortages (Stock out)
• Low demand -> Low consumption of inventory -> Surpluses
• Longer lead time -> More time taken for replenishment -> Shortages (Stock
Out)
• Shorter lead time -> Less time taken for replenishment -> Surpluses
• The following Figure 2 demonstrate how inventory would fluctuate
with variation in demand and lead time

Inventory
Quantity ‘’

Stock arrived
before lead

O Zero Time
Inventory
Stock Out

Fig. 2
• Here, Q is same but because of fluctuating demand and/or lead time,
we are out of stock twice and overstocked twice.
• This brings us to the conclusion that one of the characteristics of
inventory is that it should be divided into two parts:
• Working Stock – Which is generated by the quantities that are ordered
• Safety Stock – which reduces the probability of stock-outs.
• When safety stock is provided, the re-order level is not just the
demand anticipated during the lead time, but the sum of such
demand and the safety stock i.e.,
R.O.L. = S + Ld
• Where Ld denotes the total requirements for inventory during lead
period and S is the safety stock.
Determination of Safety Stock
• Based on the nature of demand and its fluctuations, standard
formulae are available to decide the extent of safety stock.
• Generally statistical methods are used for calculating safety stock and
R.O.L.
Computation of Safety Stock
The various methods to determine the safety stock are as follows:
(a) Variation in Lead Time
• When the variation in lead time is more predominant, as compared to
demand variation, then safety stock would be equal to the difference of
maximum and normal lead times multiplied by the consumption rate of
that item during the lead time, i.e.,
Safety stock = (Maximum lead time – Normal lead time) x
Consumption rate
= Ld x r
Example
• Suppose for an item the monthly consumption is 150 units, the
normal lead time is 15 days, and the maximum lead time is estimated
as one month (30 days). The safety stock is then
S = x 150 = 75 units
(b) Variation in Demand
When the demand variation is more predominant, as compared to lead
time variation, then the following methods are used:
(i) From actual data. The actual data is plotted and then safety
stock is calculated. Then the demand curve provides a rationale
basis for the determination of safety stock by helping to establish
reasonable maximum usage rate during the lead time.
Demand

Time
 (ii) From probability distribution. The demand distribution is
assumed and then safety stock is decided upon, using the
properties of the distribution. The consumption pattern may be
either Normal or Poisson. Here the safety stock varies directly as a
square root of lead time consumption, i.e.,
Safety stock = K
Where is the demand during the lead time and ‘K’ is the safety
factor which depends on the desired service level
For Normal distribution, the standard deviation can be computed as
follows:
Standard deviation (σ)=
• Where stands for average consumption during lead time and denotes
the consumption during different cycles of lead time.
• The safety stock, therefore, will be Kσ.
• The value of K is chosen depending upon the importance of the item
and the degree of protection desired by the management.
• The values of K are generally obtained from the normal distribution
tables
• When the pattern of usage approximates to Poisson distribution, the
safety stock will be K,
• where is the average usage and K is a constant depending upon the
importance of the item and degree of protection required by the
management.
Optimum Safety Level
• The safety stock determines the service level or standard of services
• When the safety stock maintained is very low, the inventory holding
cost would be low but the shortage will occur very frequently and the
cost of shortages would be very high
• As against this, if the safety stock maintained is large, shortages would
be rare, resulting into low shortage costs but the inventory cost would
be high.
• Hence it becomes necessary to strike balance between the cost of
shortages and cost of inventory holding to arrive at an optimum
safety stock
Example
• In certain food grains store, it takes about seven days to get stock
after placing order, whereas daily 750 tones of wheat are dispatched
by the store to neighboring markets. On ad-hoc basis, safety stock is
assumed to be 20 days’ stock. Calculate the re-order point.
Solution:
We have, Normal lead time = 7 days
Since 20 days’ safety stock is needed, we must have
Safety stock = 750 x 20 = 15,000 tones
Re-order point = Safety stock + (Normal Lead time) x Daily
Consumption
= 15,000 + 7 x 750 = 20, 250 tones