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Economic order quantity

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Economic order quantity (EOQ) is the order quantity that minimizes 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 Modelor Wilson Formula. The model was developed by Ford W.
Harris in 1913,[1] but R. H. Wilson, a consultant who applied it extensively, is given credit for his in-depth
analysis.[2]
Contents
[hide]

1 Overview

2 Variables

3 The Total Cost function

4 Quantity Discounts
o

4.1 Design of Optimal Quantity Discount Schedules

5 Other Extensions

6 Example

7 Multi-Criteria EOQ

8 See also

9 References

10 Further reading

11 External links

Overview[edit]
EOQ applies only when demand for a product is constant over the year and each new order is delivered in full
when inventory reaches zero. There is a fixed cost for each order placed, regardless of the number of units
ordered. There is also a cost for each unit held in storage, commonly known as holding cost, sometimes
expressed as a percentage of the purchase cost of the item.
We want to determine the optimal number of units to order so that we minimize the total cost associated with
the purchase, delivery and storage of the product.
The required parameters to the solution are the total demand for the year, the purchase cost for each item, the
fixed cost to place the order and the storage cost for each item per year. Note that the number of times an
order is placed will also affect the total cost, though this number can be determined from the other parameters.

Variables[edit]

= purchase price, unit production cost

= order quantity

= optimal order quantity

= annual demand quantity

= fixed cost per order, setup cost (not per unit, typically cost of
ordering and shipping and handling. This is not the cost of goods)

= annual holding cost per unit, also known as carrying cost or


storage cost (capital cost, warehouse space, refrigeration, insurance, etc.
usually not related to the unit production cost)

The Total Cost function[edit]

Classic EOQ model: trade-off between ordering cost (blue) and holding cost (red). Total cost (green) admits aglobal
optimum. Purchase cost is not a relevant cost for determining the optimal order quantity.

The single-item EOQ formula finds the minimum point of the following cost function:
Total Cost = purchase cost or production cost + ordering cost + holding cost
- Purchase cost: This is the variable cost of goods: purchase unit price annual demand quantity. This is P D
- Ordering cost: This is the cost of placing orders: each order has a fixed cost K, and we need to order D/Q
times per year. This is K D/Q
- Holding cost: the average quantity in stock (between fully replenished and empty) is Q/2, so this cost is h
Q/2
.

To determine the minimum point of the total cost curve, partially differentiate the total cost with respect to Q
(assume all other variables are constant) and set to 0:

Solving for Q gives Q* (the optimal order quantity):

Therefore:
Economic Order Quantity

Q* is independent of P; it is a function of only K, D, h.


The optimal value Q* may also be found by recognising that [3]

where the non-negative quadratic term disappears for

which provides the cost minimum

Quantity Discounts[edit]
An important extension to the EOQ model of Wilson is to accommodate
quantity discounts. There are two main types of quantity discounts: (1) allunits and (2) incremental. [4]Here is a numerical example.

Incremental unit discount: Units 1-100 cost $30 each; Units 101-199
cost $28 each; Units 200 and up cost $26 each. So when 150 units
are ordered, the total cost is $30*100 + $28*50.

All units discount: An order of 1-1000 units costs $30 each; an order of
1001-5000 units costs $45 each; an order of more than 5000 units
costs $40 each. So when 1500 units are ordered, the total cost is
$45*1500.

Design of Optimal Quantity Discount Schedules[edit]


In presence of a strategic customer, who responds optimally to discount
schedule, the design of optimal quantity discount scheme by the supplier is
complex and has to be done carefully. This is particularly so when the
demand at the customer is itself uncertain. An interesting effect called the
reverse bullwhip takes place where an increase in consumer demand
uncertainty actually reduces order quantity uncertainty at the supplier.[5]

Other Extensions[edit]
Several extensions can be made to the EOQ model developed by Mr.
Pankaj Mane, including backordering costs and multiple items. Additionally,
the economic order intervalcan be determined from the EOQ and
the economic production quantity model (which determines the optimal
production quantity) can be determined in a similar fashion.
A version of the model, the Baumol-Tobin model, has also been used to
determine the money demand function, where a person's holdings of
money balances can be seen in a way parallel to a firm's holdings of
inventory.[6]

Example[edit]

Suppose annual requirement quantity (D) = 10000 units

Cost per order (K) = $2

Cost per unit (P)= $8

Carrying cost percentage (h/P)(percentage of P) = 0.02

Annual carrying cost per unit (h) = $0.16

Economic order quantity =

= 500 units

Number of orders per year (based on EOQ)

Total cost

Total cost

If we check the total cost for any order quantity other than 500(=EOQ), we
will see that the cost is higher. For instance, supposing 600 units per order,
then
Total cost

Similarly, if we choose 300 for the order quantity then


Total cost

This illustrates that the Economic Order Quantity is always in the best
interests of the entity.

Multi-Criteria EOQ[edit]
Malakooti (2013) [7] has introduced the multi-criteria EOQ models where the
criteria could be minimizing the total cost, Order quantity (inventory), and
Shortages.

See also[edit]

Costant fill rate for the part being produced: Economic Production
Quantity

Demand is random: classical Newsvendor model

Demand varies over time: Dynamic lot size model

Several products produced on the same machine: Economic Lot


Scheduling Problem

Reorder point

References[edit]

1.

Jump up^ Harris, Ford W. (1990) [Reprint from 1913]. "How Many Parts
to Make at Once". Operations Research (INFORMS) 38 (6): 947
950. doi:10.1287/opre.38.6.947. JSTOR 170962. Retrieved Nov
21, 2012. edit

2.

Jump up^ Hax, AC and Candea, D. (1984), Production and Operations


Management, Prentice-Hall, Englewood Cliffs, NJ, p. 135

3.

Jump up^ Grubbstrm, Robert W. (1995). "Modelling production


opportunities an historical overview". International Journal of
Production Economics 41: 114. doi:10.1016/0925-5273(95)00109-3.

4.

Jump up^ Nahmias, Steven (2005). Production and operations analysis.


McGraw Hill Higher Education. edit

5.

Jump up^ Altintas, N.; Erhun, F.; Tayur, S. (2008). "Quantity Discounts
Under Demand Uncertainty". Management Science 54 (4): 777
792. doi:10.1287/mnsc.1070.0829. edit

6.

Jump up^ Andrew Caplin and John Leahy, "Economic Theory and the
World of Practice: A Celebration of the (S,s) Model", Journal of Economic
Perspectives, Winter 2010, V 24, N 1

7.

Jump up^ Malakooti, B (2013). Operations and Production Systems with


Multiple Objectives. John Wiley & Sons. ISBN 978-1-118-58537-5.

Further reading[edit]

Harris, Ford W. Operations Cost (Factory Management Series),


Chicago: Shaw (1915).

Wilson, R. H. "A Scientific Routine for Stock Control" Harvard


Business Review, 13, 116-128 (1934).

External links[edit]

The EOQ Model

http://www.inventoryops.com/economic_order_quantity.htm

http://www.scmfocus.com/supplyplanning/2014/04/10/economic-orderquantity-calculator/

Plossel, George. Orlicky's Material Requirement's Planning. Second


Edition. McGraw Hill. 1984. (first edition 1975)
Categories:

Management

Production and manufacturing

Supply chain management

Operations research

Production economics

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This page was last modified on 21 February 2015, at 18:36.

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