Economic Order Quantity

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Economic order quantity

The level of inventory that minimises the total of inventory holding cost and ordering cost

Holding Costs

  • The more stock you hold the more it costs. 

    So you should keep stock low.

Ordering costs

  • The more orders you make the more it costs. 

    So you should order lots at a time, meaning fewer orders (but higher stock).

  • These two costs therefore work in opposite ways. 

    One suggests keep stocks low, the other keep stock high (to keep orders down).

So, this where the EOQ model will help.

It is mathematically the perfect position, the perfect amount to order.

The position where total ordering and holding costs are at their lowest

This happens also to be where holding costs = ordering costs.

So, to repeat, the EOQ level is where the total (ordering and holding) costs will be minimised.

How is this cute little baby calculated?:

(Well you lucky fruit nuts - this formula is given in the exam) - Anyway here it is….

Where Co = Order Costs; Ch = holding cost per unit and D = annual demand

Lets now see what these pesky HOLDING and ORDERING costs actually are

  • Holding costs

    1. Warehouse

    2. Insurance

    3. Obsolescence

    4. Opportunity cost of capital

  • Ordering costs

    1. Administration

    2. Delivery costs

HOLDING AND ORDER COSTS

  • Calculating Holding Costs:

    Holding Cost per unit x (Order amount / 2)

  • Calculating Order Costs:

    Order costs per unit x (Annual Demand / Order amount)

  • Assumptions/Criticisms:

    • The ordering cost is constant.

    • The annual demand for the item is constant and it is known to the firm.

    • Quantity discounts don’t exist.

    • The order is received immediately after placing the order.

    • No buffer stock is required

    • Ignores hidden stock holding costs (unreliable suppliers etc)

    • Ignores benefit of stock holding (choice etc)

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