Economic Order Quantity (EOQ)

EOQ is essentially an accounting formula that determines the point at which the combination of order costs and
inventory carrying costs are at the least. The result is the most cost effective quantity to order.  In purchasing,
this is known as the order quantity, in manufacturing it is known as the production lot size.

Economic order quantity is the level of the inventory that minimizes the total inventory holding costs and
ordering costs. It is one of the oldest classical production scheduling models. The framework used to determine
this order quantity is also known as Wilson EOQ Model or Wilson Formula. The model was developed by F. W.
Harris in 1913.

While EOQ may not apply to every inventory situation, most organizations will find it beneficial in at least
some aspects of their operation.  Anytime the firm has a repetitive purchasing or planning of an item, EOQ
should be considered. Obvious applications for EOQ are purchase-to-stock distributors and make-to-stock
manufacturers, however, make-to-order manufacturers should also consider EOQ when they have multiple
orders or release dates for the same items and when planning components and sub-assemblies. Though EOQ is
generally recommended in operations where demand is relatively steady, items with demand variability such as
seasonality can still use the model by going for shorter time periods for the EOQ calculation, making sure that
usage and carrying costs are based on the same time period.

While the calculation itself is fairly simple, the task of determining the correct data inputs to accurately
represent the inventory and operation is a bit of a difficulty.  Exaggerated order costs and carrying costs are
common mistakes made in EOQ calculations.  Using all costs associated with the purchasing and receiving
departments to calculate order cost or using all costs associated with storage and material handling to calculate
carrying cost will give highly inflated costs resulting in inaccurate results from the EOQ calculation. 

The basic Economic Order Quantity (EOQ) formula is as follows:  

Where:
S = sales usage
OC = ordering cost per unit
CC = carrying cost per unit

The variable number 2 is constant in the formula.

Example
POQ Corporation needs to know how frequently to place their orders. The information is as
follows:

Units per month needed = 500 units

Costs per order = P40 per order
Carrying cost per order = P 4 per unit

What is the economic order quantity (EOQ) of POQ?

Answer
 2 (500) (40)
4

= 100 units

It means that every time an order is placed, the firm should order 100 units to minimize the total ordering cost
and carrying cost.

One of the criticisms of EOQ is the absence of the possibility of stock-out. Although the company may use the
EOQ model to determine the number of times the firm will order and maximum quantity to be ordered,
management cannot always assume the delivery of suppliers to be always on time. In this case, stock out is
inherited resulting to losses in terms of sales and customers if the demand cannot be met.

The EOQ level is the scenario that the supplies needed are immediately delivered on the day the order is placed.
What if the supplier was not able to meet its demands or the supplier still has to order the goods from another
supplier or the goods have to be imported? In this case, a problem will arise since meeting the demands of the
firm’s customer rely on the supplies of materials or inventories needed. To avoid this kind of problem, the firm
has to estimate the number of inventories in which the company will place an order so as to meet the stock
needed during the period they place the order and receive the goods. Thus, a lead-time and a safety stock level
should be maintained. The minimum safety stock will increase the cost of inventory because of the increase in
carrying cost. However, the cost should be offset by avoiding the loss of sales and other unexpected sales that
the company would have.

Optimum Number of Orders

The optimum number of orders is the required number of times the company orders in a given period. This is on
the assumption that the inventory will be used at a constant rate throughout the period. The optimum number of
orders is crucial in minimizing the total inventory costs of any order, less than or greater than the required order
will result in higher inventory costs.

Formula for the optimum number of orders will be:

Optimum number of orders = Usage per period

EOQ

Example
Let us assume the same values of POQ Corporation from our previous example, compute for the optimum
number of orders and the total inventory cost.

Answer
Optimum number of orders = 500 units
100 units

= 5 times
Total inventory Costs = Total carrying cost + Total ordering cost

= EOQ x CC + optimum no. of orders x OC

2

= 100 x P4 + 5 x P40
2

= P200 + P200

= P400

The optimum number of orders is 5 times per month with total inventory cost of P400. Remember that the
carrying cost and ordering cost have an inverse relationship, thus an order of more than or less than 5 times will
result to a higher total inventory cost.

The table in the succeeding page illustrates that there is an inverse relationship between the carrying costs and
ordering costs. As the number of times the order is placed decreases from the optimum number of orders of 5,
the total ordering costs also decreases while the carrying costs continue to increase together with the total
inventory costs. Conversely, as the number of orders increases from the optimum number of orders, the total
carrying costs continuously decrease while the ordering costs together with the total costs increase. It is only at
the optimum number of orders of 5 that the total carrying costs and the total ordering costs are equal with a
minimized cost of P400.

No. of
times an Total Total Total
order is No. of units carrying ordering inventory
placed per order cost costs costs
1 500 1,000.00 40.00 1,040.00
2 250 500.00 80.00 580.00
3 167 333.33 120.00 453.33
4 125 250.00 160.00 410.00
5 100 200.00 200.00 400.00
6 83 166.67 240.00 406.67
7 71 142.86 280.00 422.86
8 63 125.00 320.00 445.00
9 56 111.11 360.00 471.11
10 50 100.00 400.00 500.00

The graph below shows, with an EOQ of 100 units, orders would be placed every 6 days (100/(500/30)) to fulfill
the usage requirement of 500 units per month. The average inventory is 50 units, which means that when the
inventory level reached 50 the company has to place an order of 100 units to replenish its inventory. It is
expected that by the time the inventory is at 0, the 100 units ordered would be received.
 6 12 18

Re-Order Point (ROP)

The ROP is the inventory level at which an order should be placed to replenish the inventory. It is computed by
multiplying the lead time by the normal lead time usage (Barfield, Jesse T., et. al., 2003). This formula is
computed only under the condition of certainty, meaning the lead time and lead time usage does not fluctuate.
To determine the re-order point under certainty the firm must know the following:

1. Lead time. It refers to the time normally taken in receiving the delivery of inventory after the order has been
placed.

2. Lead time usage. It refers to the number of units to be used during the lead time. This is a situation where
the company is using stocks sufficient enough until the arrival of the materials to be used.

Example
FLT placed an order on December 1 and normally receives the order after 9 days. If the company has a normal
usage of 10 units per day, what is the re-order point?

Answer
ROP = lead time x lead time usage

= 9 days x 10 units

= 90 units for 9 days

Safety Stock

To serve as a cushion to cover for uncertainties during the lead time and lead time usage, an additional inventory
must be on hand. Maintaining safety stock depends on the following factors:

1. The higher the risk associated with the perceived demand in the inventory, the higher the safety stock to be
required by the company.

2. Lead time. The higher the risk of not receiving the goods needed, the higher the risk of stock-out and
therefore, requires a higher level of safety stock.
3. Cost of stock-outs. Stock-outs result in the inability of the company to deliver the goods required. To avoid
such occurrence, a safety stock is maintained to avoid the risk of losing sales.

Maintenance of a safety stock requires that the ROP based on normal usage be increased by the amount of the
safety stock. ROP with safety stock shall be computed as follows:

Re-order point = Lead time x usage per day + Safety stock

Example
FLT placed an order to MAI and normally receives the order after 9 days. If the company has a normal usage of
10 units per day and requires a safety stock of 10 units, what is the re-order point?
Answer
ROP = lead time x usage per day + safety stock

= 9 x 10 + 10

= 100 units - FLT has to place an order when the level of inventory reaches 100 units.

Determining Safety Stock

To determine the required safety stock, the firm must have the necessary information in handling and keeping of
inventories. The firm may use the maximum usage basis and the frequency distribution basis.

Maximum Usage Basis

The firm’s safety stock is determined by identifying the normal usage during lead time and deducting it from the
maximum usage during lead time. Safety stock using maximum usage is computed as:

Maximum usage during lead time xxx

Less: Normal usage during lead time. xxx
Safety stock xxx

Example
FLT Corp. is frequently loosing sales due to stock-outs. In order to avoid this problem, the owner would like to
implement a new system of maintaining an inventory level which will include safety stock. Looking at the past
records of the company, it was found out that the normal usage during lead time of 12 days is 120 units while
the maximum usage is 150 for 15 days. Based on the given information, what should be the safety stock of FLT
Corp.? ROP?

Answer
Maximum usage during lead time 150
Less: Normal usage during lead time. 120
Safety stock 30

ROP = (lead time x lead time usage) + safety stock

= 120 + 30
= 150
It is noticeable from the above computation that the maximum usage is also the ROP; thus, the maximum usage
was only split into normal usage and safety stock.

Determination of Optimal Transaction Size

William J. Baumol was the first one to observe that the Economic Order Quantity (EOQ) applied to inventory
management may also be applied to the management of cash balances where it will be considered as a particular
type of inventory. Firms will seek the order point in which cash will be replenished and an investment point
where the cash level is reduced by buying marketable securities.

The cash management model recognized two types of costs relative to the level of working cash balances and
they are: the transaction costs and the opportunity costs. The transactions costs are fixed costs in buying or
selling the securities while opportunity costs refer to the interest income if marketable securities are obtained.
The main objective of the cash management model is to minimize transaction costs and the opportunity cost of
retaining cash balances. The relevant costs take the following form:

Relevant costs = transaction cost + opportunity cost

= FC x CR + I x MS
MS 2

Where:
MS = the amount of marketable securities sold each time the cash balance is replenished
FC = the fixed cost associated with the transaction
CR = the total cash required for the given period of time
I = rate of return on the marketable securities

The optimum transaction size is

MS = 2 (FC)(CR)
I

Example:
Astra Corporation is expecting a cash requirement of P5,000 over a 1-month period in which cash is expected to
be paid constantly. The opportunity interest rate is 15 percent per annum. The transaction cost associated with
each borrowing or withdrawal is P75.

Requirement:
1. What is the optimal transaction size?
2. What is the average cash balance?
3. What is the relevant cost of the transaction?

Answers:
1. Optimal transaction size:

MS = 2 (FC)(CR)
I
 = 2 (P75) (P5,000)

0.15 /12

= P7,746.00

2. Average cash balance:

MS = P7,746 = P3,873
2 2

3. Total relevant costs

= FC x CR + I x MS
MS 2

= P75 x P5,000 + (0.15/12) x P7,746

P7,746 2

= P48.41 + 48.41

= P 96.82

Decision: The entity must borrow or withdraw the amount of P7,746 every time the cash balance is replenish.
The relevant cost in this transaction size will be the lowest. If the company withdraws bigger amount, the
opportunity cost will increase faster than the decrease in transaction cost. On the other hand, if the company
withdraws smaller amount, transaction cost will grow higher than the opportunity cost. In both cases, relevant
cost will be more than P96.82.