UV3574

Rev. Dec. 1, 2010

MANAGING INVENTORIES: DETERMINING ORDER QUANTITY

A large amount of information is reported in the literature of inventory management on

the development of rules for deciding how much to order (lot size) under various conditions.
Regardless of the particular situation, constructing a cost model of the problem that captures the
relevant characteristics of the situation shapes nearly all decision rules.

In some situations, mathematical procedures like differential calculus are applied to

obtain specific decision rules. The Economic Order Quantity rule (EOQ) presented in the
following pages is one such rule that is used in business situations. It is important to understand
the specific mathematical model used to develop the decision rules to avoid using the rules
incorrectly. Studying the mathematical model allows us to understand the assumptions that are
being used. We can then ask whether those assumptions are realistic in the specific situation of
interest. From a managerial perspective, the specific mathematical techniques used to determine
the decision rules are less important.

Ordering in batches or lots is often economically advantageous. This policy creates cycle-
stock inventory. Under the simplest assumption of level demand, the optimal rule is given by the
EOQ formula, which is usually credited to Wilson because he first developed the model around
1915.

Choosing a lot size Q based on annual costs

The decision variable to be determined is the lot size quantity to be ordered (Q). The
important cost components are the costs associated with ordering and the costs associated with
carrying inventory. Typically, the costs of ordering are those costs that vary with the number of
orders placed and the costs associated with the quantity ordered. So let:

S = cost of ordering, independent of the size of the order size, and

C = cost per unit ordered.

This note was prepared by James R. Freeland, Sponsors Professor of Business Administration, and Robert D.
Landel, Henry E. McWane Professor of Business Administration, and revised by Elliott N. Weiss, Ethyl Corporation
Professor of Business Administration. It was written as a basis for class discussion rather than to illustrate effective
or ineffective handling of an administrative situation. Copyright 2009 by the University of Virginia Darden
School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to
sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system,
used in a spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying,
recording, or otherwisewithout the permission of the Darden School Foundation.
 -2- UV3574

If an item is being purchased, then the cost of ordering is calculated by adding up the
costs associated with preparing the order, processing the invoice, and receiving and inspecting
the item. If an item is being manufactured, then the cost of ordering is the cost incurred for
preparing the paperwork, setting up the machines, and any scrap created during the set-up
operation and testing activities.

Figure 1 shows the relationship between the ordering cost and the lot size Q. Having
large lot sizes can minimize ordering costs.

Figure 1: Total annual costs versus lot size.

Annual Cost Or Total Annual Cost (TAC)

(in dollars) de
r KC Q/2)
(R ing C Cost (
S/
Q) ost olding
tory H
Inven
Item Cost (CR)

Q*
Lot Size, Q

Each time an order of size Q is placed, the cost is represented by S + CQ. If R represents
the annual requirement for the item, then the annual costs for the ordering activity and the item
purchased (manufactured) is:

Annual Ordering and Item Costs =

R R
Number of Orders (S + CQ) = (S + CQ) = S + CR
Q Q

The costs of carrying (holding) inventory are typically modeled as the cost of carrying a
unit in inventory for a year times the average inventory level for the year. There are two
categories of inventory carrying cost; out-of-pocket expenses and opportunity costs. Out-of-
pocket expenses include such items as the cost of storage space (rental or alternative-use value),
insurance costs, costs associated with obsolescence, spoilage, or theft, and taxes. Opportunity
costs are the costs of forgone opportunities for the money that is invested in inventory, i.e., the
money invested in inventory that could be used in other areas of the company to earn some
return.

Under the assumption of constant demand, the inventory level over time will appear as
the saw-toothed pattern in Figure 2. When an order of size Q arrives, the inventory is at the
maximum level (Q, the lot size) and then will drop to zero just before the next order is to arrive.
Thus, the average inventory level is Q/2. The average inventory is referred to as average cycle
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stock, as it represents the inventory stock held between ordering cycles. The cost of carrying a
unit in inventory is typically modeled as per-unit cost of the item times some fraction that
represents the annual holding-cost charge.

Figure 2: Inventory level versus time.

Inventory
Q Average Inventory Level
Level
2

Time

Let K = annual inventory carrying costs as a fraction of the unit cost. Thus, the annual
cost of holding inventory is:
Q
Annual Costs of Holding Inventory = KC
2
Recall the chart for the annual costs of holding inventory as a function of the lot size in
Figure 1. The inventory holding costs can be minimized by ordering in smaller Q lot sizes.

Thus, combining the several costs componentsordering, item annual cost, and
holdingas a function of the lot size Q yields the following:

R Q
S + CR + KC (1)
Q 2

For any lot size (Q) quantity, the total of annual ordering costs, item costs, and holding
costs can be calculated using equation (1).

We want a rule for Q that minimizes the costs in equation (1). It is apparent that the term
CR, the annual cost of the units, does not vary with the lot size Q in this case. (If there are price
discounts associated with purchasing in quantity, CR will vary.) Figure 1 shows the graph of
equation (1) versus Q.
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Differential calculus can now be used to find the formula. Taking the derivative of
equation (1) with respect to Q and setting it equal to zero yields the minimum-cost solution:

d (Equation (1) ) R KC
= 0= 2 S +
dQ Q 2

* 2 RS
The economic order quantity is given by Q*: Q =
KC

As an example, consider a company that sells replacement lamp bulbs. Demand for the
bulbs is level throughout the year and has been forecast as 2,000 units. The cost of preparing an
order is $14, and the unit cost of the bulbs is $4. The inventory holding charge is 35% per year of
the unit cost. Thus, we have:

R= 2000 (annual requirements)

S= 14 (cost of ordering)
C= 4 (cost per unit ordered)
K= .35 (annual inventory carrying cost as a fraction of unit cost)

The optimal lot size is:

* 2(2000) (14)
Q= = 200
(.35) (4)
Thus if this order policy is used, the average-cycle inventory level will be Q*/2 or 100
units. We will place R/Q = 2000/200 = 10 orders per year assuming the actual demand is
constant over the year (2000 units).

Using equation (1) and Q*, the cost will be $8,280.