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Economic order quantity

From Wikipedia, the free encyclopedia

In inventory management, economic order quantity (EOQ) is the order quantity that minimizes the total
holding costs and ordering costs. It is one of the oldest classical production scheduling models. The model
was developed by Ford W. Harris in 1913,[1] but R. H. Wilson, a consultant who applied it extensively, and
K. Andler are given credit for their in-depth analysis.[2]

Contents
1 Overview
1.1 Variables
1.2 The Total Cost function and derivation of EOQ formula
1.3 Example
2 Extensions of the EOQ model
2.1 Quantity discounts
2.2 Design of optimal quantity discount schedules
2.3 Backordering costs and multiple items
3 For improving fuel economy of internal combustion engines
4 See also
5 References
6 Further reading
7 External links

Overview
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

= purchase unit 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

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space, refrigeration, insurance, etc. usually not related to the unit production cost)

The Total Cost function and derivation of EOQ formula

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

Where:

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, calculate the derivative of the total cost with respect
to Q (assume all other variables are constant) and set it equal 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

Example

annual requirement quantity (D) = 10000 units

Cost per order (K) = 40

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Cost per unit (P)= 50

Yearly Carrying cost percentage (h/P)(percentage of P) = 10%
Yearly carrying cost per unit (h) = 50 * 10% = 5

Economic order quantity = = 400 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 400(=EOQ), we will see that the cost is higher.
For instance, supposing 500 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 firm.

Extensions of the EOQ model

Quantity discounts

An important extension to the EOQ model is to accommodate quantity discounts. There are two main types
of quantity discounts: (1) all-units and (2) incremental.[4][5] Here is a numerical example:

Incremental unit discount: Units 1100 cost $30 each; Units 101199 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 11000 units costs $50 each; an order of 10015000 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

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.[6]

Backordering costs and multiple items

Several extensions can be made to the EOQ model developed by Mr. Pankaj Mane, including backordering
costs and multiple items. Additionally, the economic order interval can be determined from the EOQ and the
economic production quantity model (which determines the optimal production quantity) can be determined
in a similar fashion.

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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.[7]

Malakooti (2013)[8] has introduced the multi-criteria EOQ models where the criteria could be minimizing
the total cost, Order quantity (inventory), and Shortages.

A version taking the time-value of money into account was developed by Trippi and Lewin.[9]

For improving fuel economy of internal combustion engines

Recently an interesting similarity between EOQ of Melon picking and fuel injection in Gasoline Direction
Injection has been proposed.[10]

See also
Constant 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
Revised Wilson Formula by Daniel CRETOIS [1] (https://www.linkedin.com/pulse/revised-wilson-
formula-daniel-cretois)

References
1. Harris, Ford W. (1990). "How Many Parts to Make at Once". Operations Research. 38 (6): 947.
doi:10.1287/opre.38.6.947 (https://doi.org/10.1287%2Fopre.38.6.947).
2. Hax, AC; Candea, D. (1984), Production and Operations Management (http://catalogue.nla.gov.au
/Record/772207), Englewood Cliffs, NJ: Prentice-Hall, p. 135
3. 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
(https://doi.org/10.1016%2F0925-5273%2895%2900109-3).
4. Nahmias, Steven (2005). Production and operations analysis. McGraw Hill Higher Education.
5. Zipkin, Paul H, Foundations of Inventory Management, McGraw Hill 2000
6. Altintas, Nihat; Erhun, Feryal; Tayur, Sridhar (2008). "Quantity Discounts Under Demand
Uncertainty". Management Science. 54 (4): 77792. JSTOR 20122426 (https://www.jstor.org/stable
/20122426). doi:10.1287/mnsc.1070.0829 (https://doi.org/10.1287%2Fmnsc.1070.0829).
7. Caplin, Andrew; Leahy, John (2010). "Economic Theory and the World of Practice: A Celebration of
the (S, s) Model". The Journal of Economic Perspectives. 24 (1): 183201. JSTOR 25703488
(https://www.jstor.org/stable/25703488). doi:10.1257/jep.24.1.183 (https://doi.org
/10.1257%2Fjep.24.1.183).
8. Malakooti, B (2013). Operations and Production Systems with Multiple Objectives. John Wiley &
Sons. ISBN 978-1-118-58537-5.
9. Trippi, Robert R.; Lewin, Donald E. (1974). "A Present Value Formulation of the Classical Eoq
Problem" (https://www.ncbi.nlm.nih.gov/pmc/articles/PMC4020723). Decision Sciences. 5 (5):
20811. PMC 4020723 (https://www.ncbi.nlm.nih.gov/pmc/articles/PMC4020723) .
PMID 24843434 (https://www.ncbi.nlm.nih.gov/pubmed/24843434).
doi:10.1111/j.1540-5915.1974.tb00592.x (https://doi.org/10.1111%2Fj.1540-5915.1974.tb00592.x).
10. Ventura, Robert; Samuel, Stephen (2016). "Optimization of fuel injection in GDI engine using
economic order quantity and Lambert W function". Applied Thermal Engineering. 101: 11220.
doi:10.1016/j.applthermaleng.2016.02.024 (https://doi.org

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Economic order quantity - Wikipedia https://en.wikipedia.org/wiki/Economic_order_quantity

/10.1016%2Fj.applthermaleng.2016.02.024).

Further reading
Harris, Ford W. Operations Cost (Factory Management Series), Chicago: Shaw (1915)
Camp, W. E. "Determining the production order quantity", Management Engineering, 1922
Wilson, R. H. (1934). "A Scientific Routine for Stock Control". Harvard Business Review. 13:
11628.
Plossel, George. Orlicky's Material Requirement's Planning. Second Edition. McGraw Hill. 1984.
(first edition 1975)
Andriolo, Alessandro; Battini, Daria; Grubbstrm, Robert W.; Persona, Alessandro; Sgarbossa, Fabio
(2014). "A century of evolution from Harriss basic lot size model: Survey and research agenda".
International Journal of Production Economics. 155: 1638. doi:10.1016/j.ijpe.2014.01.013
(https://doi.org/10.1016%2Fj.ijpe.2014.01.013).
Erlenkotter, Donald (2014). "Ford Whitman Harris's economical lot size model". International
Journal of Production Economics. 155: 1215. doi:10.1016/j.ijpe.2013.12.008 (https://doi.org
/10.1016%2Fj.ijpe.2013.12.008).
Tsan-Ming Choi (Ed.) Handbook of EOQ Inventory Problems: Stochastic and Deterministic Models
and Applications, Springer's International Series in Operations Research and Management Science,
2014. doi:10.1007/978-1-4614-7639-9 (https://doi.org/10.1007%2F978-1-4614-7639-9).
Ventura, Robert; Samuel, Stephen (2016). "Optimization of fuel injection in GDI engine using
economic order quantity and Lambert W function". Applied Thermal Engineering. 101: 11220.
doi:10.1016/j.applthermaleng.2016.02.024 (https://doi.org
/10.1016%2Fj.applthermaleng.2016.02.024).

External links
The EOQ Model (http://www.logisitik.com/learning-center/inventory-management/item/466-
economic-order-quantity-eoq-model.html)
http://www.inventoryops.com/economic_order_quantity.htm
http://www.scmfocus.com/supplyplanning/2014/04/10/economic-order-quantity-calculator/

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