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**Production Information System
**

Economic Optimal Order Quantity

Burcu BINBOGA

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..............................1 INVENTORY MANAGEMENT ...........................................................................................................................................................2 ECONOMIC ORDER QUANTITY FORMULAS ........................................................................11 5.......................................4 2 COST COMPONENTS .............................15 6.............................................................17 6...................................................15 SOLUTION ..............................................................................................................................................................................................................................................................................3 1..........................................................................................2 TYPES OF INVENTORY ........2 EXAMPLE 2 ..................................................................1 EXAMPLE 1 .................................4 2.................................................................................................12 5......................................................................8 THE STATISTICAL “ REORDER POINT “ WITH PROBABILISTIC DEMAND AND CONSTANT ORDER LEAD TIME ..........................................................................8 ...................................................................................................................................17 Production Information System 2 .................................................................8 4 REORDER POINT .............7 3 ASSUMPTIONS OF THE MODEL.......................................................3 EXAMPLE 3 .10 EXAMPLE 1 .11 EXAMPLE 2 ...........................................................4 LEAD TIME:.....................................................................................................................Table of Contents 1 WHAT IS INVENTORY ?....................1 HISTORY OF ECONOMIC ORDER QUANTITY .........................................................................................................................................................13 6 EXAMPLES...............3 1......................................................................................15 6..................................

1 What is inventory ? Inventory is the total amount of goods and/or materials contained in a store or factory at any given time. This simple form of inventory management is helpful so that materials can be purchased at opportune times when prices are low and nothing critical ever runs out. inventory management refers to the method by which businesses handle tangible resources and materials in order to make sure resources are readily available for use. 3 . Factory managers need to know how many units of their products are available for customer orders. All of these business rely on an inventory count to provide answers. a running inventory of the most important materials can be provided at any time. they are added to the list. As supplies accumulate. Inventories are generally managed using a paper list system or a computer software-enabled system.1 Inventory Management In general. The simplest form of inventory management is the hard-copy method whereby a list is kept of materials that are used on a regular basis. Another popular form of inventory administration is the computersoftware-based inventory managementsystem. Store owners need to know the precise number of items on their shelves and storage areas in order to place orders or control losses. By using an inventory management system. 1. a computer inventory management system can be used to keep track of large amounts of products and materials. a purchase is made to replenish materials. When supplies run low. When items are brought in. In this manner. the inventory-management software makes adjustments to correspond with these activities. a household can expect to keep necessary supplies on hand while a business can use resources more efficiently in order to generate revenues. Whenever an individual material is brought in or leaves the inventory.

entering the receipt and doing any other related paperwork would 4 .2 Components: Parts or subassemblies used in building the final product. incoming inspection.2 Order Cost: Also known as purchase cost or set up cost. 2 Cost Components 2. You simply input your forecasted annual usage. the cost to process the receipt.4 Finished goods: Completed products that will be delivered to customers.2. repair. For purchased items these would include the cost to enter the Purchase Order and/or Requisition. It is important to understand that these are costs associated with the frequency of the orders and not the quantities ordered. 1.2.2.1 Annual Usage/Demand: Expressed in units this is generally the easiest part of the equation. any approval steps. 1. These costs are not associated with the quantity ordered but primarily with physical activities required to process the order. 1.2.1.6 Maintenance.3 Work-in-process (WIP): Any item that is in some stage of completion in the manufacturing process.2 Types Of Inventory 1. 2. For example in your receiving department the time spent checking in the receipt.1 Raw materials: The purchased items or extracted materials that are transformed into components or products. and operational (MRO) inventory (often called supplies): Items that are used in manufacturing but do not become part of the finished product.5 Distribution inventory: Finished goods and spare parts that are at various points in the distribution system. invoice processing and vendor payment.2. this is the sum of the fixed costs that are incurred each time an item is ordered. and in some cases a portion of the inbound freight may also be included in order cost. 1.2. 1.

and setting up new items. this will increase overall set up time and reduce inventory investment. Associating actual costs to the activities associated with order cost is where many an EOQ formula runs afoul. There may be times when you want to artificially inflate or deflate set up costs. repacking. unloading trucks. getting quotes (unless you get quotes each time you order). machine set up time. For the most part Order cost is primarily the labor associated with 5 . In manufacturing the Order cost would include the time to initiate the work order. all production scheduling time. In the purchasing department you would include all time associated with creating the purchase order. expediting. time associated with picking and issuing components excluding time associated with counting and handling specific quantities. If you have inbound quality inspection where you inspect a percentage of the quantity received you would include the time to get the specs and process the paperwork and not include time spent actually inspecting. contacting the vendor. Production scrap directly associated with the machine setup should also be included in order cost as would be any tooling that is discarded after each production run. I have found it to be more accurate to determine what percentage of time within the department is consumed performing the specific activities and multiplying this by the total labor costs for a certain time period (usually a month) and then dividing by the line items processed during that same period. It is extremely difficult to associate inbound freight costs with order costs in an automated EOQ program and I suggest it only if the inbound freight cost has a significant effect on unit cost and its effect on unit cost varies significantly based upon the order quantity. approval steps. If you have excess capacity you may want to artificially decrease set up costs. If you lack the capacity to meet the production schedule using the EOQ you may want to artificially increase set up costs to increase lot sizes and reduce overall set up time. sourcing. and delivery to other departments would likely not be included. and reviewing order reports. The idea being that if you are paying for the labor and machine overhead anyway it would make sense to take advantage of the savings in reduced inventories. etc. you would not include time spent reviewing forecasts. and inspection time. Do not make a list of all of the activities and then ask the people performing the activities "how long does it take you to do this?" The results of this type of measurement are rarely even close to accurate.be included while the time spent repacking materials. however if you inspect a fixed quantity per receipt you would then include the entire time including inspecting. All time spent dealing with vendor invoices would be included in order cost.

If you are required to pay any taxes on the value of your inventory they would also be included. Below are the primary components of carrying cost. It is primarily made up of the costs associated with the inventory investment and storage cost. Since insurance costs are directly related to the total value of the inventory. the interest rate would be part of the carrying cost. Mistakes in calculating storage costs are common in EOQ implementations. If you did not borrow on the inventory however have loans on other capital items. if the cost does not change based upon the quantity of inventory on hand it should not be included in carrying cost. For the purpose of the EOQ calculation. Generally companies take all costs associated with the warehouse and divide it by the average inventory to determine a storage cost percentage for the EOQ calculation.3 Carrying Cost (Inventory Holding Costs): Also called Holding cost. carrying cost is the cost associated with having inventory on hand. carrying cost is represented as the annual cost per average on hand inventory unit. This tends to include costs that 6 . If by some miracle you are debt free you would need to determine how much you could make if the money was invested. etc. Insurance. you would include this as part of carrying cost. If you had to borrow money to pay for your inventory. Interest. you can use the interest rate on those loans since a reduction in inventory would free up money that could be used to pay these loans.processing the order however you can include the other costs such as the costs of phone calls. envelopes. In the EOQ formula. Storage Costs. faxes. 2. Taxes. postage.

2. data entry. A portion of the time spent on cycle counting should also be included in carrying cost. Operations that use purely random storage for their product would include the entire storage area in the calculation. Do not factor in these costs unless they are a direct result of the inventory levels and are significant enough to change the results of the EOQ equation. As your operation grows near a point at which you would need to expand your physical operations you may then start including storage in the calculation. which is the amount of time between the placement of an order to replenish inventory and the receipt of the goods into inventory. and theft. Carrying costs for the purpose of the EOQ calculation should only include costs that are variable based upon inventory levels. however if you have to add an additional warehouse just for overflow inventory then you would include all areas of the second warehouse as well as freight and labor costs associated with moving the material between the warehouses. this portion of the warehouse should not be included in carrying cost since changes to inventory levels do not effect costs here.are not directly affected by the inventory levels and does not compensate for storage characteristics. If you are running a pick/pack operation where you have fixed picking locations assigned to each item where the locations are sized for picking efficiency and are not designed to hold the entire inventory. There are situations where you may not want to include any storage costs in your EOQ calculation. If your operation has excess storage space of which it has no other uses you may decide not to include storage costs since reducing your inventory does not provide any actual savings in storage costs. remember to apply costs which change based upon changes to the average inventory level. If the lead time always is the same (a fixed lead time). and travel time between locations. Your overflow storage areas would be included in carrying cost. Other costs that can be included in carrying cost are risk factors associated with obsolescence. then the replenishment can be scheduled just when desired. Areas such as shipping/receiving and staging areas are usually not included in the storage calculations. So in cycle counting you would include the time spent physically counting and not the time spent filling out paperwork. damage. 7 .4 Lead Time: The lead time.

There isn ‘t safety stock. • • 4 Reorder Point The Statistical “ Reorder Point “ with Probabilistic Demand and constant Order Lead Time If the average demand during the order lead time is represented by μ and the reorder point is represented by x . There is no stockouts . 8 . Then if the probability of stockout is represented by a . in other words it does not make any difference how much we order . Quantity discounts are not possible . In oher words the inventory from an order arrives in one batch at one point in time .3 ASSUMPTIONS OF THE MODEL • • • • Demand is known and deterministic ( constant ) The Lead Time . then the safety stock is ( x-μ ) . Z = ( x-μ ) / σ . ie. ( the in – stock probability ) is 1-a . which can be derived from the standart deviation Formula . the probability that inventory is sufficient to cover demand . That the only costs pertinent to the inventory model are the cost of placing an order and the cost of holding or storing inventory over time . The in stock probability is commonly referred to as a service level . the price of the product will stil be the same . The receipt of inventory is instantaneous . The time between the placement of the order and receipt of the order is known and constant .

In view of instantaneous replenishment of stock the level of inventory jumps to the original level from zero level. Servic 9 .96 . The statistical reorder point ( x ) can be calculated as the average demand during the order lead time plus safety stock or . Let’s assume that a company’s reorder point for its Product X is 80 units. then the firm would expect to stockout 50 percent of the time prior to receiving the order .5 percent stockouts ( a = 2. Thus if no safety stock was incorporated into the ROP and the firm ordered when existing inventory level was equal to the average lead time demand .5 percent in stock probability or 2. a 97. ROP = dLT + Z σdLt The reorder point for replenishment of stock occurs when the level of inventory drops down to zero. For ex.Service level = Average demand during lead time ( μ ) Safety stock = ( x-μ ) Reorder point = x Probability of stockout = a The Z value can be determined from standardized normal curve and the desire for a spesific in stock probability . The reorder point is the quantity of units in inventory that will trigger an order to purchase additional units. the safety stock is zero and the probability of stockout is 50 percent . At the middle of the normal curve where the reorder point equals the average lead time demand . . the company places an order for additional units of Product X.5 percent ) corresponds to a Z value of 1. When the inventory of Product X drops to 80 units.

There is not stockout d = max daily or weekly or monthly usage L = Lead time Reorder point = ROP = d x L d Z σ I v tr nn y eo Oi a p l t m Oe rr d 10 .That is . There is a stockout ROP = LT + dLt 2. 1. We have two cases .

The ROP = 550 + 93 = 643 units Z σdLt = 2.Example 1 There is not any stockouts .65 x 40 = 66 units σdLt = 550 + 66 = 616 units dLT + Z 4. Past demand shows that the average demand during lead time ( μ ) for the part is 550 units and the standart deviation of demand during order lead time period ( dLt) is 40 units .33 x 40 11 . or an in stock probability of 95 percent .65 2. What would the ROP and required safety stock be if the manager decided to attain a 99 percent in – stock probablity ? Solution : 1.65 standart deviations above the mean Z = 1. The ROP = σ Z σdLt = 1. The normal table or Z table shows that a 95 percent in stock probability corresponds to a Z value of 1. Reorder point = ? Solution : Reorder level = Average daily usage rate x Lead time in days = 50 units x 7 days = 350 units Example 2 London Inc Stocks a crucial part that has a normal distribution demand pattern during the order lead time period . The required safety stock at a 99 percent in stock probability = = 93 units and . The required safety stock is then safety stock = 3. The manager wants determine the safety stock required and the statistical reorder point that would result in 5 percent stockouts . The average daily usage rate of a material is 50 units and the leadtime is seven days .

but he was not a ‘ graduate engineer ‘ . 1990 ) . 5. He retired from engineering and ‘ read the law ‘ with a Californa law firm . Total Cost = Holding Cost + Ordering Cost 12 . of constant replenishment. he held some 50 patents .H.W. It is therefore apparent that some balance or trade-off or compromise is needed in deciding how much inventory to hold. His formal schooling extended only through high school . The important costs are the ordering cost. There are costs of holding inventory and there are costs of reordering inventory and these two costs need to be balanced. 1989 . F. the purchase cost of the inventory itself. However. The articles gave a comprehensive review of the literature up to that time and moved the origin of the EOQ model from a 1934 Harvard Business Review article by R. Harris was an engineer with Westinghouse . and therefore how much inventory to order. Harris was phenomenally succesful . The purpose of the EOQ model is to minimise the total costs of inventory.Harris lived the American dream . are constant and therefore not relevant to the model.Wilson back to a 1913 article by Ford Whitman Harris in Factory : The Magazine of Management . the cost of placing an order. the time and the cost etc.1 History Of Economic Order Quantity Donald Erlenkotter published two articles on the history of the Economic Order Quantity ( EOQ ) model ( Erlenkotter . He was published over 70 articles . and the cost of carrying or holding a unit of inventory in stock.Harris seems like character out of an Horatio Alger hero . F. Our purpose is to minimize the total cost which is the sum of the inventory holding cost and the ordering cost . for example.W. He went on to be admitted to the California bar and become a succesful patent attorney . All other costs such as. Self – thought .5 WHAT İS EOQ ( Economic Order Quantity ) Inventory is held to avoid the nuisance. to replenish inventory only infrequently would necessitate the holding of very large inventories.

usually not related to the unit cost ) ROP= Reorder Point Number of Orders = D / Q Ordering costs = S x (D / Q) Average inventory units = Q / 2 $ = (Q / 2) x C Cost to carry 13 .. The purpose of model is to minimize the sum of inventory holding cost and the ordering cost ..Holding cost curve with ordering cost curve is opposite each other . average inventory holding cost increases . 5.2 Economic Order Quantity Formulas D = Annual demand (units) C = Cost per unit ($) Q = Order quantity (units) S = Cost per order ($) I= Holding cost (%) H = Holding cost ($) = I x C (also known as carrying cost or storage holding cost ( warehouse space .. refrigeration . insurance. If order the total ordering cost decreases and if the average order quantity increases .

d(TC)/d(Q) = (I x C) / 2 .(D x S) / Q² To optimize: set d(TC)/d(Q) = 0 DS/ Q² = IC / 2 Q²/DS = 2 / IC Q²= (DS x 2 )/ IC Q = sqrt (2DS / IC) EOQ = 2 ×D ×S H D= S= C= I = H= Annual demand (units) Cost per order ($) Cost per unit ($) Holding cost (%) Holding cost ($) = I x C 2 × D ×S H Optimal Order Quantity =EOQ = Q= Expected Number Orders = N = D / Q Expected Time Between Orders = T = Working Days – Year / N 14 .average inventory = (Q / 2) x I x C = (Q /2) x H Total cost = (Q/2) x I x C + S x (D/Q) inv carry cost order cost If We take the 1st derivative .

d = D / Working Days – Year ROP (REORDERING POINT ) = d x L 6 EXAMPLES 6. while interest and storage costs amount to 6 euro a year for each unit held . Demand = D = 6000 units Unit Cost = C = 30 euro Holding Cost = H = 6 euro Ordering Cost = 125 euro Substituting these figures into the economic order quantity equation gives . EOQ = 2 ×D ×S H = sqrt {( 2 x 6000 x 125 ) / 6 } EOQ = Q = 500 units The inventory holding cost = Q / 2 x H = 250 x 6 = 1500 euro for a year Ordering Cost = S x ( D / Q ) = 125 x ( 6000 / 500 ) = 1500 euro Total Cost = Inventory Holding Cost + Ordering Cost 15 . What is the best ordering policy for the item ? Solution Listing the values we know in consistent values .1 EXAMPLE 1 Jaydep Company buys 6000 units of an item every year with a unit cost of 30 euro . It costs 125 euro to process an order and arrange delivery .

Total Cost = 1500 + 1500 = 3000 euro for a year ECONOMİC ORDER QUANTITY MODEL Problem Jaydeep Company $ 125.0 00 6000 $ 30 $6 Parameter Values : Fixed Cost per Order S = Annual Number of Items Demanded D = Unit Cost of Procuring an Item C = Annual Holding Cost per Dollar value H = Decision Variables : Optimal Order Quantity Q = Results : Holding Cost H = Order Cost = Total Cost = $ 1500 $ 1500 $ 3000 500 16 .

For this lot quantity to be optimal .000 X 12 = 12.2*500 ) = 980 Annual Holding Cost = ( Q/2 ) * I * C = (980/2)*0.59 = $ 97980 6.3 EXAMPLE 3 The store manager at Best Buy would like to reduce optimal order quantity from 980 to 200 . Annual demand D = 1. Each computer costs Best Buy $ 500 and the retailer has a holding costs of 20 percent . Annual demand D = 1000 X 12 = 12000 Order cost per lot S = $ 4000 Price per unit C = $ 500 Annual Holding cost I = 0. transportation . Best Buy incur a fixed order placement.000 Price per unit C = $ 500 Annual Holding cost I = 0.6.2 Desired optimal order quantity Q* = 200 Desired order cost per lot S = ((IC(Q*)(Q*))/(2D) S = (0.2*500*200*200)/(2*12000) S = $ 166.59 Total Cost = Annual Holding Cost + Order Cost Total Cost = $ 49000 + 48979.2 Optimal Order Quantity Q = SQRT ( ( 2DS)/IC ) SQRT ( ( 2*12000*4000 ) / 0.2 EXAMPLE 2 Demand for the Deskpro computer at Best Buy is $ 1000 units per month .67 17 . the store manager wants to evaluate how much the order cost per lot should be reduced . and receiving cost of $ 4000 each time an order is placed .2*500 = $ 49000 Order Cost = ( D/Q ) * S = ( 12000 / 980 ) * 4000 = $ 48979.

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