Economic Order Quantity: Saurabh Kumar Sharma IMB2018002

ECONOMIC ORDER
QUANTITY
BY:-
SAURABH KUMAR SHARMA

IMB2018002
FIRST THINGS FIRST…
• Inventory is any stored resource that is used

to satisfy a current or future need.
Types of Inventory…
• Raw Materials Purchased but not processed
• Work-In-Process Undergone some change but not completed A function of cycle
time for a product
• Maintenance/Repair/Operating (MRO) Necessary to keep machinery and processes
productive
• Finished Goods Completed product awaiting shipment
WHY IS FORECASTING NEEDED FOR
INVENTORY?
By using this demand information, it is possible to
determine how much raw materials (e.g., sheet metal, paint,
and electric motors in the case of clothes dryers) and work-
in-process are needed to produce the finished product.
WHY IS FORECASTING NEEDED
FOR INVENTORY?
• Even though there are literally millions of different types of products
manufactured in our society, there are only two fundamental decisions that
you have to make when controlling inventory:
• 1. How Much to Order
• 2. When to Order
Components of Total Cost
• Some of the most significant inventory costs are as follows:
•
• 1. Cost of the items
• 2. Cost of ordering
• 3. Cost of carrying, or holding, inventory
• 4. Cost of stockouts
• 5. Cost of safety stock, the additional inventory that may be held to help avoid
stockouts
EOQ ASSUMPTIONS
• 1. Production is instantaneous – there is no capacity constraint and the entire
lot is produced simultaneously.
• 2. Delivery is immediate – there is no time lag between production and
availability to satisfy demand.
• 3. Demand is deterministic – there is no uncertainty about the quantity or
timing of demand.
• 4. Demand is constant over time – in fact, it can be represented as a straight
line, so that if annual demand is 365 units this translates into a daily demand
of one unit.
• 5. A production run incurs a fixed setup cost – regardless of the size of the
lot or the status of the factory, the setup cost is constant.
• 6. Products can be analyzed singly – either there is only a single product or
conditions exist that ensure separability of products.
COST STRUCTURE
• Order costs
a. fixed (Set-up cost, K)
b. variable, per-unit (c)
• Holding costs (h)
• Penalty cost (p)
a. if backordering allowed: loss of goodwill
b. if demand lost: loss of goodwill + loss of profit
EOQ - NOTATION
• Q = order quantity (we want to find the optimal Q)

• K = fixed order cost
• c = unit variable cost, Rs / unit
• h = holding cost, Rs / (unit * (unit time))
• h=Ic
• λ = demand rate, units / (unit time
EOQ – THE INTUITION
• “When” should we place a new order ?
• assume zero starting inventory
• demand is deterministic and at a constant rate
• lead time is negligible
• no backorders are allowed
EOQ – THE INTUITION
• “How much” we have to order each time ?

• parameters do not change over time
• there is no reason for ordering different quantities
• so, order the same quantity Q in each order
Lets Look at a Graph..
Holding, Ordering, and Setup Costs
• Holding Cost The cost of holding or “carrying” inventory over
time.
• Ordering Cost The cost of placing an order and receiving goods.
• Setup Cost The cost to prepare a machine or process for

manufacturing an order.
THE EOQ MODEL FOMULA
• Q = Number of Units in each Order
• Q* = Optimal Number of Pieces per Order (EOQ)
• D = Annual Demand in Units for the Inventory Item
• S = Setup or Ordering Cost per Order
• H = Holding or Carrying Cost per Unit per Year
Notes: The unit holding/carrying cost, H, is usually expressed in one of two ways:
1. As a fixed cost. For example, H is Rs 100 per unit per year.
2. As a percentage (typically denoted by I) of the item’s unit purchase cost or price.
For example,
H is 20% of the item’s unit cost.
In general, H = I x P
I = Annual Carrying Cost as a Percentage of the Unit Cost of the Item
P = Purchase Cost per Unit of the Inventory Item
• Annual Setup Cost = (Number of Orders Placed per Year) x (Setup or
Order Cost per Order)
=(Annual Demand /Number of Units in each Order) x (Setup/Ordering Cost
per Order)
= (D/Q) x (S)
• Annual Holding Cost =(Average Inventory Level) x (Holding Cost per Unit
per Year)
= (Average Inventory level) x (Setup/Ordering Cost per Order)
=(Order Quantity/2) x (Holding Cost per unit Per Year)
= (Q/2) x (H)
• Optimal Order Quantity is found when Annual Setup Cost Equals Annual
Holding Cost
(D/Q) x S = H x (Q/2)
Solving for Q* (EOQ)
(D/Q) x S = (Q/2) x H
2DS/Q x Q x H
Q*= sqrt (2DS/H)
EOQ Example
• Let us now apply these formulas to the case of SBC, a
company that buys alarm clocks from a manufacturer and
distributes to retailers. SBC would like to reduce its
inventory cost by determining the optimal number of
alarm clocks to obtain per order. The annual demand is
1,000 units, the ordering cost is $10 per order, and the
carrying cost is $0.50 per unit per year. Each alarm clock
has a purchase cost of $5. How many clocks should SBC
order each time?
T.C (min) = Sqrt (2 DFC) , Where D=demand, F= Ordering Cost, C=unit carrying cost
Reorder Point Curve
Reorder Point (ROP)
Now that we have decided how much to order, we look
at the second inventory question: when to order. In
most simple inventory models, it is assumed that we
have instantaneous inventory receipt. That is, we
assume that a firm waits until its inventory level for a
particular item reaches zero, places an order, and
receives the items in stock immediately
Reorder Point (ROP)
In many cases, however, the time between the
placing and receipt of an order, called the Lead
Time, or Delivery Time, is often a few days or
even a few weeks. Thus, the when to order
decision is usually expressed in terms of a reorder
point (ROP), the inventory level at which an
order should be placed
Reorder Point (ROP)
EOQ answers the “How Much” question.
The Reorder Point (ROP) tells “When” to order.
ROP = Demand per Day * Lead Time for a New Order in Days
=dxL
Where d = Demand in total /Number of Working Days in a Year
Reorder Point (ROP)
• Example 1
• XYZ Ltd. is a structural steel retailer. The average daily sales of reinforcing
bar is 25 tons. The inventory’s daily consumption rate is constant, and the
lead time of 7 days is also constant. The management of XYZ Ltd. has
refused to hold safety stock.
• To compute the reorder point, we should put all data available in the formula
above.
• Reorder point = 25 × 7 = 175 tons
Reorder Point (ROP)
• Example 2
• Let’s assume that XYZ Ltd. has irregular sales of reinforcing bar:
• minimum daily sales: 15 tons
• average daily sales: 25 tons
• maximum daily sales: 40 tons
• The lead time also varies between 5 and 9 days. To avoid disruption in sales, we should use
both maximum daily usage and maximum lead time. Thus, the reorder point should be in
tons.
• Reorder point = 40 × 9 = 360 tons
• As we can see, irregular daily usage forces companies to have more stock to avoid disruption
in sales or production.
Reorder Point (ROP)
• Example 3
• To avoid overstocking and an increase in cost, a company’s management can hold
safety stock and use it to compensate for the extra usage of inventory.
• Let’s consider Example 2 and assume that XYZ Ltd. has set up safety stock for an
average usage of 5 days. Because the company has safety stock, it can use both
average daily sales and average lead time to determine reorder point.
• Reorder point = 25 × 7 + 5 × 25 = 300 tons
• As we can see, the setup of safety stock allows holding a lower stock balance and
reducing holding costs.
• If the lead time is constant but the demand rate is variable, the following
formula can be used:
Safety Stock = (Daily Maximum Usage - Daily Average Usage) × Lead Time
• If the demand rate is constant but the lead time is variable, the following
formula can be used:
Safety Stock = (Maximum Lead Time - Average Lead Time) × Daily Average
Usage
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ECONOMIC ORDER

SAURABH KUMAR SHARMA

• Inventory is any stored resource that is used

• 1. How Much to Order

• Q = order quantity (we want to find the optimal Q)

• “How much” we have to order each time ?

• Ordering Cost The cost of placing an order and receiving goods.

• Setup Cost The cost to prepare a machine or process for

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