EOQ and ABC Analysis: Economic Order Quantity

EOQ and ABC Analysis
Economic Order Quantity
Designed by:
Hitesh Kumar Sharma

Assistant Professor
Anand Engineering College, Agra
Sharda Group of Institution (SGI)
EOQ Assumptions
• Known & constant demand

• Known & constant lead time
• Instantaneous receipt of material
• No quantity discounts
• Only order (setup) cost & holding cost
• No stockouts
Inventory Holding Costs
Reasonably Typical Profile
% of
Category Inventory Value
Housing (building) cost 6%
Material handling costs 3%
Labor cost 3%
Inventory investment costs 11%
Pilferage, scrap, & obsolescence 3%
Total holding cost 26%
EOQ Model
Annual Cost
Order Quantity
EOQ Model
Annual Cost
Holding Cost
Order Quantity
Why Order Cost Decreases
• Cost is spread over more units
Example: You need 1000 microwave ovens
1 Order (Postage $ 0.35) 1000 Orders (Postage $350)
Purchase Order PurchaseOrder

Purchase Order
PurchaseOrder
Order
Description
Purchase Qty.
Description Qty. Description Qty.
Microwave 1000 Description
Microwave
Description Qty.1
Qty.
Microwave 11
Microwave
Microwave 1
Order
quantity
EOQ Model
Annual Cost
Holding Cost
Order (Setup) Cost
Order Quantity
EOQ Model
Annual Cost
Total Cost Curve
Holding Cost
Order (Setup) Cost
Order Quantity
EOQ Model
Annual Cost
Total Cost Curve
Holding Cost
Order (Setup) Cost
Optimal Order Quantity

Order Quantity (Q*)
EOQ Formula Derivation
D= Annual demand (units)
C= Cost per unit ($) Total cost = (Q/2) x I x C + S x (D/Q)
Q= Order quantity (units) inv carry cost order cost
S= Cost per order ($)
I = Holding cost (%) Take the 1st derivative:
H= Holding cost ($) = I x C
d(TC)/d(Q) = (I x C) / 2 - (D x S) / Q²
Number of Orders = D / Q To optimize: set d(TC)/d(Q) = 0

Ordering costs = S x (D / Q)
DS/ Q² = IC / 2
Average inventory
units = Q / 2 Q²/DS = 2 / IC
$ = (Q / 2) x C
Q²= (DS x 2 )/ IC
Cost to carry
average inventory = (Q / 2) x I x C Q = sqrt (2DS / IC)
= (Q /2) x H
2 D S
EOQ 
H
C= Cost per unit ($)
I = Holding cost (%)
EOQ Model Equations
2 D S
Optimal Order Quantity  Q * 
H
D
Expected Number Orders  N 
Q*
Working Days / Year
Expected Time Between Orders  T 
N
D
d D = Demand per year
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
You’re a buyer for SaveMart.
SaveMart needs 1000 coffee makers per year.

The cost of each coffee maker is $78. Ordering
cost is $100 per order. Carrying cost is 40% of
per unit cost. Lead time is 5 days. SaveMart is
open 365 days/yr.
What is the optimal order quantity & ROP?

SaveMart EOQ
2 D  S
EOQ 
H
D= 1000
2  1000  $100
S= $100 EOQ 
C= $ 78 $31.20
I= 40%
H= CxI
H= $31.20 EOQ = 80 coffeemakers
SaveMart ROP
ROP = demand over lead time
= daily demand x lead time (days)
=dxl
D = annual demand = 1000

Days / year = 365
Daily demand = 1000 / 365 = 2.74
Lead time = 5 days
ROP = 2.74 x 5 = 13.7 => 14

SaveMart
Average (Cycle Stock) Inventory
Avg. CS = OQ / 2
= 80 / 2 = 40 coffeemakers
= 40 x $78 = $3,120
Inv. CC = $3,120 x 40% = $1,248
Note: unrelated to reorder point

2 D S
EOQ 
H
C= Cost per unit ($)
I = Holding cost (%)
2 D  S
EOQ 
H
What if …
1. Interest rates go up ?
2. Order processing is automated ?
3. Warehouse costs drop ?
4. Competitive product is introduced ?
5. Product is cost-reduced ?
6. Lead time gets longer ?
7. Minimum order quantity imposed ?
ABC Analysis
• ABC analysis is a business term used to define an inventory
categorization technique often used in materials
management.
• It is also known as Selective Inventory Control.
• ABC analysis provides a mechanism for identifying items that

will have a significant impact on overall inventory cost, while
also providing a mechanism for identifying different
categories of stock that will require different management
and controls.
ABC Analysis
• When carrying out an ABC analysis, inventory items are
valued (item cost multiplied by quantity issued/consumed in
period) with the results then ranked. The results are then
grouped typically into three bands. These bands are called
ABC codes.
ABC Codes
• "A class" inventory can be any thing which is used to reflect
adhoc material management requirement.
• "B class" inventory can be any thing which is used to reflect

semi adhoc material management requirement.
• "C class" inventory can be any thing which is used to reflect

permanent material management requirement.

EOQ and ABC Analysis: Economic Order Quantity

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EOQ and ABC Analysis

Economic Order Quantity

Hitesh Kumar Sharma

• Known & constant demand

Example: You need 1000 microwave ovens

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

Purchase Order PurchaseOrder

Total Cost Curve

Total Cost Curve

Optimal Order Quantity

Number of Orders = D / Q To optimize: set d(TC)/d(Q) = 0

SaveMart needs 1000 coffee makers per year.

What is the optimal order quantity & ROP?

D = annual demand = 1000

ROP = 2.74 x 5 = 13.7 => 14

Inv. CC = $3,120 x 40% = $1,248

Note: unrelated to reorder point

• It is also known as Selective Inventory Control.

• ABC analysis provides a mechanism for identifying items that

• "B class" inventory can be any thing which is used to reflect

• "C class" inventory can be any thing which is used to reflect

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