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Friday, January 28, 2011

Basic inventory decisions and EOQ

At the very basic level any firm faces two main decisions concerning the management of inventory: When should new stock be ordered and in what quantities? With regard to the order quantity, which minimises inventory related costs, we are familiar with the classical EOQ (economic order quantity) model. This remains the basic inventory model even when it is not applicable in real life business situations in most cases.

In inventory related literature, the answer to the question of when to order is given with reference to the ROP (reorder point), the point at which the replenishment order should be initiated so that the facility receives the inventory in time to maintain its target level of service. The ROP can be defined in terms of units of days or in units of inventory. In the static and deterministic model, the ROP is the simple multiplication of the number of lead days and the daily demand. It means that every time the inventory falls to the ROP level, an order must be initiated. And the order quantity is given by the EOQ model which is based on cost minimisation.

Figure 4.1 A simple deterministic inventory model based on fixed demand and fixed lead time

You are aware that the EOQ quantity is the balance between order and holding costs attached with the inventory. The order cost is made up of fixed and variable costs, whereas the holding cost consist of costs of insurance, taxes, maintenance and handling, opportunity costs and costs of obsolescence.

In your text

See Section 3.2.1 for a good discussion on the EOQ model.

The formula for EOQ or economic order quantity is well known:

Q is the order quantity per order.
K is the fixed set up cost which the warehouse incurs every time it places an order.
D is the demand per day.
h is the inventory carrying or holding cost per unit per day.

You will notice that your text highlights two important insights regarding the EOQ model. These are:

•Optimum order size is a good balance between the holding cost and the fixed order cost.
•Total inventory cost is related with order size, but the relationship is not very significant.
A discussion of the EOQ model would remain incomplete if the inherent assumptions on which the model is based are ignored. Bowersox (2001) explains that these major assumptions are:

•All demand is satisfied.
•The rate of demand is continuous, constant and known.
•Replenishment lead time is constant and known.
•There is a constant price of product that is independent of order quantity or time.
•There is an infinite planning horizon.
•There is no interaction between multiple items of inventory.
•There is no inventory in transit.
•There are no limits on capital availability.

The economic order quantity is a tool used in Operations Management to determine the most cost-effective purchase quantity. The variables within the formula are discussed in the article below.

The economic order quantity is used when goods or materials are purchased periodically.

The economic order quantity determines the appropriate number of product to order based on a number of different variables. The economic order quantity is the amount to purchase that will minimize the overall cost to the company. Small businesses do not have to compute this number on a regular basis, but understanding the logic behind the calculation can help your company make better purchasing decisions.

To begin, the different variables in the EOQ formula are; the annual demand of the product, the purchase cost per individual unit, the fixed cost per order, the order quantity and the holding cost of the product. By analyzing each of these variables, we can understand how it affects our purchasing habits and ultimately, our bottom line.

The annual demand for the product is an important piece to the puzzle. If it's a product that you use once or twice a year, you're probably not going to order it frequently or in large numbers. If it is a product that you use often, you may want to purchase in larger amounts to obtain a discount or arrange for frequent small deliveries with your supplier.

The purchase cost for individual unit is pretty straightforward. If an item cost thousands of dollars, we would expect to purchase it less frequently than an item that cost ten dollars. If the purchase price a unit increases, you may want to order it less frequently or wait until you have a customer commitment that requires the part.

The fixed cost per order is another key element, but it is often ignored in the purchasing process. Each time you place an order, it requires a fixed cost. You need to have an employee take the time to place the order. This may result from another employee taking the time to count the inventory and let your personnel know they need to order a product. Once an order is placed, there is the cost of tracking the order and receiving the order.

If these costs are high, you would want to order less frequently and in larger amounts. If your system is smooth, this fixed cost may be low and have a minimal impact on your purchasing habits.

The order quantity can be fixed or determined by your purchasing department. Sometimes lot sizes are fixed due to your supplier, and other times you have multiple pack sizes to choose from. If the order quantity is flexible, this is not too big of an issue. If the order quantity is large, depending upon your usage it can be costly to store. Understanding the order quantity versus your demand can greatly impact your purchasing decisions.

Finally, you need to consider the holding cost of the product. This can be difficult to calculate, especially for small businesses. The holding costs include the space the material is occupying as well as the labor to move it and count it in inventory. If your space is limited, your holding cost is high. As a result, you wouldn't want to have excess of a product that only gets used once or twice a year.

The EOQ formula can be easily found on the web. While it is not necessary for the small business to try and crunch these numbers, it is important that the small business understand the different variables and how they affect your company. If you understand the implications of the variables, you can find a nice balance that works best for your business.

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