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Description of THE BASIC ECONOMIC ORDER QUANTITY.

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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.

1.

2.

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.

the quantity ordered,Q.

4.

stored; that is, the holding cost per unit per unit time, ch is

independent of the inventory level.

5.

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

2.

back to maximum.

The slope of the utilization line gives an idea of the rate at

which stock is used up.

3.

Stock will be continued to be used until it reaches to the

minimum level. At this point the order is delivered.

4.

is called the lead time.

a.

b.

What should be the reorder point?

Total Costs

Annual Costs

Holding Cost

Minimum

Total Cost

Set up/ordering

cost

Optimal

Order

Quantity

Order

Quantity

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.

(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 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

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.

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.

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

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.

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

= 1.28 x 44

= 56.32

Example

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:

10

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

11

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.

12

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

13

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