Inventory Management

What is the 'Economic Order Quantity - EOQ'

Economic order quantity (EOQ) is the ideal order quantity a company should purchase for its inventory given a
set cost of production, demand rate and other variables. This is done to minimize variable inventory costs, and
the equation for EOQ takes into account storage, ordering costs and shortage costs. The full equation is:

EOQ = √(2SD / H), or the square root of (2 x S x D / H).

S = Setup costs (per order, generally includes shipping and handling)

D = Demand rate (quantity sold per year)
H = Holding costs (per year, per unit)

Example
The material DX is used uniformly throughout the year. The data about annual requirement, ordering cost and
holding cost of this material is given below:

 Annual requirement: 2,400 units

 Ordering cost: $10 per order

 Holding cost: $0.30 per unit

Required: Determine the economic order quantity (EOQ) of material DX using above data.

Solution

The economic order quantity for material DX is 400 units. Now, we can compute the number of orders to be
placed per year, annual ordering cost, annual holding cost and combined annual ordering and holding cost as
follows:

Number of orders per year

= Annual demand/EOQ
= 2,400 units/400 units
= 6 orders per year

Ordering cost

= Number or orders per year × Cost per order

= 6 orders × $10
= $60

Holding cost

= Average units × Holding cost per unit

= (400/2) × 0.3
= $60
Combined ordering and holding cost at economic order quantity (EOQ):

= Ordering cost + Holding cost

= $60 + $60
= $120

Notice that both ordering cost and holding cost are $60 at economic order quantity. The holding cost and
ordering cost at EOQ tend to be the same.

Examples 1

A local TV repairs shop uses 36,000 units of a part each year (A maximum consumption of 100 units
per working day). It costs Rs. 20 to place and receive an order. The shop orders in lots of 400 units. It
cost Rs. 4 to carry one unit per year of inventory.

Requirements:

(1) Calculate total annual ordering cost (2) Calculate total annual carrying cost

(3) Calculate total annual inventory cost (4) Calculate the Economic Order
Quantity

(5) Calculate the total annual cost inventory cost using EOQ inventory Policy

(6) How much save using EOQ (7) Compute ordering point assuming the lead time
is 3 days
1. An auto parts supplier sells Hardy-brand batteries to car dealers and auto mechanics. The annual
demand is approximately 1,200 batteries. The supplier pays $28 for each battery and estimates that
the annual holding cost is 30 percent of the battery’s value. It costs approximately $20 to place an
order (managerial and clerical costs). The supplier currently orders 100 batteries per month.

a. Determine the ordering, holding, and total inventory costs for the current order quantity.

b. Determine the economic order quantity (EOQ).

c. How many orders will be placed per year using the EOQ?

d. Determine the ordering, holding, and total inventory costs for the EOQ. How has ordering cost
changed? Holding cost? Total inventory cost?

Solution

We are given the following information: annual demand: D = 1200 batteries per year

item cost: c = $28 per battery

holding cost: H = ic = 0.30(28) = $8.40 per battery per year

order cost: S = $20 per order

current order quantity: Q = 100 batteries

a. The current ordering and holding costs are: D Q S + Q 2 H = 1200 100 (20) + 100 2 (8.40) = 240 +
420 = $660.

b. The EOQ is Q∗ = q 2DS H = q 2×1200×20 8.40 = 75.6 → 76 batteries.

c. The company will place D Q∗ = 1200 76 = 15.8 orders per year.

d. The new ordering and holding costs are: D Q∗ S + Q∗ 2 H = 1200 76 (20) + 76 2 (8.40) = 315.79 +
319.20 = $634.99. The company will save $25.01 by using the EOQ.