The Basic Economic Order Quantity Model

The Economic Order Quantity (EOQ) is the order quantity that would
result in the lowest cost of stock control. The main aim of the EOQ
model is to minimize the total cost of stock control by suggesting when
to place an order and how much to order. These can affect the cost of
stock control. The EOQ model has broad applicability. It can be used in
planning purchases of raw materials and supplies and in planning
purchases for wholesalers and retailers who resell products.

Assumptions of the EOQ model

1.
2.

The demand for or usage of the item is relatively constant over

time at a rate of D units per unit time.
The items cost (price), P, is independent of the quantity
ordered; that is, there are no quantity discounts.

3.

There is fixed cost, co for executing an order that is independent of

the quantity ordered,Q.

4.

The holding cost for inventories is proportional to the quantity

stored; that is, the holding cost per unit per unit time, ch is
independent of the inventory level.

5.

No shortages are allowed; all demand must be satisfied when

requested.

6.

The lead time (LT) for deliveries, which is the time from when
an order is placed until it is delivered, is known with certainty
and constant.

7.

All items ordered are delivered at the same time; there are no
split deliveries.

EOQ Model

Delivery
Depletion/utilization
Inventory
Level

Reorder
level
Time

Lead time

In the above diagram, the following can be seen:1.

2.

Deliveries are received all at once to carry the inventory level

back to maximum.
The slope of the utilization line gives an idea of the rate at
which stock is used up.

3.

When stock level reaches reorder level an order is placed.

Stock will be continued to be used until it reaches to the
minimum level. At this point the order is delivered.

4.

The period of time between stock being ordered and delivered

is called the lead time.

The issues facing the firm are:-

a.
b.

What quantity should be ordered each time?

What should be the reorder point?

Total Costs as a Function of Order Quantity

Total Costs

Annual Costs

Holding Cost

Minimum
Total Cost
Set up/ordering
cost

Optimal
Order
Quantity

Order
Quantity

Minimizing Inventory Management Costs

The objective of this model is to minimize the total costs of inventory
control. To do this, the holding costs and the ordering costs must be
minimized. AS quantity ordered increases, the ordering cost per annum
will decrease because there will be fewer orders. However, the holding

cost will increase since there will be more items in the inventory at any
one time. The opposite is also true for decreased order quantity.
The optimal order quantity occurs at the point where the ordering costs
and the holding costs intersect; that is where total holsing cost equals
total ordering cost. At this point the total costs for inventory control is
minimized.

An expression for annual ordering cost is

(D/Q)*S
An expression for Annual holding cost is
(Q/2)*H
Where:Q =Number of items per order
D = Annual demand for the item
S = setup or ordering cost per order
H = Holding or carrying cost per unit per year
If we set ordering cost equal to holding cost and make Q the subject of
the expression, we can develop a formula for the EOQ.
(D/Q)*S = (Q/2)*H
2DS = Q2H
Q2 = (2DS)/H
EOQ = (2DS)/H

Total Cost (TC) = (D/Q)*S + (Q/2)*H

Total cost = total ordering cost + total holding cost

Total inventory cost can be writen to include the total cost of the items.
In this case, P*D should be added to the formula where P is the price
per item and D is the annual demand for the item.
You must also note the following formule:Number of orders = (D/EOQ)
Time between orders = (No.of working days per year)/ No. of orders

Regardless of the quantity ordered, the reorder point should be chosen

so that the inventory level reaches Zero at the end of each reordering
cycle. If the RP is set higher than this level, the average inventory level
and associated costs increase without any benefit. Thus, RP should be
set equal to the number of units used during the lead time called
Demand During Lead Time (DDLT).
RP = DDLT = Rate of demand per time period* lead time . Usually, this
is given in days.
Demand per day = (Annual Demend)/ No. of working days in a year.

The Probabilistic EOQ Model

In the basic EOQ model, one of the assumptions was that demand is known and constant.
We will now relax this assumption. So, we will say that demand is not known for certain
and it varies. In this case, variations in demand will follow a normal probability
distribution. Thus, this model is called a probabilistic model.

One of the objectives of management is to maintain an adequate service level to satisfy

their customers. The service level is the complement of the probability of a stock out. So,
if the probability of a stock out is 10%, the service level is 90%. The probability of a
stock out increases when demand is not known and when demand varies greatly. One
way to reduce the probability of a stock out is to hold a reserve stock or safety stock. This
stock acts as a buffer against variations in demand. Based on the service level required, a
manager can determine the reorder point and the amount of safety stock that should be
kept.
RP =Expected Demand During Lead Time(DDLT) + (ZDDLT)
Where
Z= the number of standard deviations
= standard deviation of demand during lead time
Safety stock = ZDDLT
Example
If average Demand During Lead Time (DDLT) is 250 units and the Standard Deviation of
Demand During Lead Time is 15 units, determine the Safety Stock (SS) level and the Re
Order Point (ROP). Service level is 95%
SS= ZDDLT
= 1.65*15
= 24.75
ROP = Average Demend During Lead Time + ZDDLT
= 250 + 24.75
= 274.75

How to find the Z value for 95% service level

Look in the body of the normal tables for 0.95 which is 95%. In this case, you will not
find the exact number, but look for the value that is closest to 0.95. That value is
0.95053. If you go across in that row until you reach the Z column you will see 1.6. If
you go to the top of the column where 0.95053 is found you will see .05. When you add
1.6 and .05 you will get a Z value of 1.65.

Another Probabilistic Model

Example
The daily demand for bags at ABC store is normally distributed with a mean of 200 bags
and a standard deviation of 20 bags. The lead time for receiving the hats from the

manufacturer is 5 days and is constant. The manager wants a 90% service level. What
should be the reorder point and the amount of safety stock to be kept?
RP =Expected Demand During Lead Time(DDLT) + (ZDDLT)
Demand During Lead Time (DDLT) = Average Daily Demand x Lead Time
=200x5 = 1000
Z value for 90 % = 1.28
Since demand is variable and lead time is constant, the DDLT = D lead Time
=20* 5 = 20* 2.2= 44
RP =Expected Demand During Lead Time(DDLT) + (ZDDLT)
=1000 + 1.28*44
=1000 + 56.32
=1056.32

Safety stock = ZDDLT

= 1.28 x 44
= 56.32

Another Probabilistic Model

Example

Another Probabilistic Model

Questions

Problem 1:
Assume you have a product with the following parameters:
Demand 360
Holding cost per year $1.00 per unit
Order cos t: $100 per order
What is the EOQ?
Problem 2:
Given the data from Problem 3, and assuming a 300-day work year; how many orders
should be processed per year? What is the expected time between orders?
Problem 3:

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What is the total cost for the inventory policy used in Problem 3?
Problem 4:
Assume that the demand was actually higher than estimated (i.e., 500 units instead of 360
units). What will be the actual annual total cost?
Problem 5:
If demand for an item is 3 units per day, and delivery lead-time is 15 days, what should
we use for a re-order point?

Answers

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Sources:
Render B., Heizer J. Priciples of Operations Management. 6th edition. Pearson Prentice
Hall.
Martinich J.S, 1997. Productions and Operations Management An Applied Modern
Approach. University of Missouri St. Louis.
Gaither N. 1992. Productions and Operations Management. 5th edition. Dryden Press
International.
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Useful Links

http://www.usfca.edu/~villegas/classes/984-307/307ch12/sld022.htm

http://www.google.com.vc/search?hl=en&q=EOQ+model
http://scm.ncsu.edu/public/inventory/6eoq.html

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