THE ECONOMIC ORDER QUANTITY MODEL Panacea E0Q has little validity in a world of uncertain supply and demand. By James M. Noblitt, CPIM, CIRM ‘ou have (oo much inventory. The inventory you have is the wrong inventory and its not G2 caring, Obsolescence is at an all-time high Your manufacturing plants are strained to (| maximum capacity and customer service is declining. Profits are down and your return on assets is dismal. How do you turn this situation around? Could, it be remedied, in part, by implementing the economic order {quantity (OQ) model that purports to help control inventory? (Oris BOQ the culprit that caused the problem in the first place? The EOQ model has been around since the early 1920s. Rarely a panacea, i's generally more of a plague, creating and exacer~ Dating the situation described above, I generates excess inventory nd wast, while ereating an overall reduction in peeformance, ‘The economic order quantity formula seeks to ideatify how ‘much to order. This isa relevant question in an environment ‘where production rates exceed usage rates or where the mari Jactuting process, by design is done in batch of lots This is also in procurement of raw materials and components where the vendor charges a per-lot set-up fee. Determining how much to order or make, ie, the lot size, is evitical in deter ining the levels of inventory being carvied and altimately defines the company’s overall inventory busden. The question of when to order must be determined by using some other method, such as an order point, periodic review, Kank ‘material requirements planning (MRP), Abalancing act ANYONE INVOLVED IN THE management of inventory knows there are dhree main components of inventory cost—the actual cost of the inventory, the carrying cost of the inventory » Plague? and the cost of ordering the inventory. The BOQ formula attempts to calculate the optimum order size by balancing the cost of carrying inventory against the cost of placing an order, thus optimizing the use of eapital resources. This is done by calculating the point where these two costs are equal, where the carrying cos line intersects the ordering cost line (se gute 1) The actual calculation (se igue 2) is based on the assumption that the per-unit ordering cost i reduced as lot size increases and the unit carrying cost decreases as lot size decreases AtaGlance + FQ, around singe the early 1920s, i stil used by some practioner ta calculate how muct product to order. ‘today's world it often creates a sitvation were the ‘manufacturers strained to capacity producing too much imentory the wrong inventory, or mentor that is doomed to obsolesoence. ‘+ The EOQ formula operates on certain assumptions that no longer necessarily hold tue-relaively constant demand, manufacturing in batch, known costs and lead times, and instantaneous replenishiment. + The £0Q model is an elegant mathematical solution to the Drobiem of how muct to order, but itis unable to take into account a numberof unpredictable variables that would ve its results relevance, ‘+ MRP MPU JT, and Kanban wil always outperform EOQ as ' method of controling inventory.Fgue 1 cost § fae © isage xsetp Gal cast) + inventory carrying cost Although no one can argue with the forma, itis based on the following key assumptions * Demand is relatively constant and is known with some degree of accuracy The inventory in question is produced in batches, as opposed to continuous flow, * Lead-time and inventary costs, such as ordering cos, set-up ‘ost, carrying cost, and cost of obsolescence, are known and relatively constant or linear + Replenishment is instantaneous, ie items artive at an inf nite rate at a given time. {In today’s dynamic environment it is unlikely that any of these assumptions holds true with any certainty. Iti for this reason that the EOQ model can become a plague on a company’s inventory levels, costs, and ability to serve the customer. As product lfe cycles decrease and the likelihood of obsolescence increases, inventory can easily beconte a lability rather than an asset. High inventories do not necessarily ensure adequate customer service Icis rare today that demand is constant or known with any degree of confidence. Demand is more likely sporadic and rela tively short-lived, as inthe retail industry. Nor ean demanel be Forecasted with a high level of accuracy. Most companies have to live with a forecast accuracy of 70 percent, at bes. Since the EOQ. formula assumes steady demand, in quantities less than the replenishment quantity it calculates the earying cast over hall the ‘order quantity, th e inventory Inventory consump. tion is usually nether uniform nor consistent ancl is typically plagued with spikes in demand so this assumption proves false. Moreover th zeinventory” is not an actual demand oF consumption because the volatility of the actual desmand never really allows it to approach the calculated average lequate indicator of he second assumption, that inventory i produced in batches, is more realistic. However, in companies successtully practicing JIT, lean manufacturing, flexible manufacturing, and/or set-up reduction, manufacturing in batch an the need for lot sizing are becoming less relevant, Process industries continue to produce in batch, but these manufacturing methods way to Mexibe lot sizes. The latter coincide with actual ating the need to calculate an EOQ. are givin demand, ths elimi Aneducated guess os THE COSTS UPON WHICH the EOQ model is based ate also problematic. Determining an accurate ordering cost or here are simply too ‘carrying cost has never been achievable, many variables to consider and the costs are neither constant nor stable, In most cases, management typically picks an arbi trary number, usually more subjective than factual, which only considers part of the total ordering cost. Order and carrying costs have been mote of a policy decision than a calculated number, Purchase order cost has always been an educated guess at best, typically using some “industry standard” that appraxi- ‘mates actual cost by pure luck Moreover, with the advent of mote modern manufactuin strategies and methods, set-up costs are becoming a much sinaller component of the ordering cost, thus reducing the importance of the ordering cost vis-t-vis the carrying cost of the inventory. Carrying costs, such as the cost of obsolescence, are actually ising due in part to shorter product life cycles that endow obsolescence on slow moving inventory, Other carrying costs are dificult, if not impossible, to accurately quantify and ave certainly not linear, as assumed by the EOQ formula The last assumption, concerning instantaneous replenish- ‘ment, is not necessarily a good practice, Typically a JIT strategy is a more efficient method for purchased items, Although a vendor may charge a fixed set-up fee for a given lot size itis, ‘more practical to have the supplier hold the lot and ship it in smaller quantities overtime, thus reducing the effective lot size held in inventory. The same holds true for items produced internally. There is no real justification for moving and stocking items in the produetion lot size. As production is manufac {uring produc, said product can be consumed on an ongoing Even if we could accurately determine all the components of inventory cost and satisly all the assumptions of the FOQ basis, again reducing the effective lot size ‘model, there are still other problems associated with it. The FOQ model is limited in its ability to optimize la product mixes and does not function well where the ordering costs, jt set-up costs, ry depending on product mix and production sequencing, For example, changing the order in which an identical group of items s produced could drastically affect the total set-up cost for that group of products. The basie EO does not consider thisand instead uses a fixed set-up cost, as the ordering cost. Depending on the sequencing of orders, the OQ may actually generate far move inventory than neces- thus creating eThe odd couple THE USE OF EOQ in an MRP environment is another itfsa gross mismatch of methodologies Ina true, prop erly functioning MRP process, forecast that ean, if necessary be age size in terms of actual oF forecast period lot sizing, this technique is superior to the EOQ method. The EOQ model was, after al, invented belore MRP, MRPU, and JIT Utilizing EOQ in conjunction with these more modern techniques simply degrades In a capacity-constrained environment, consumption of capacity to produce to an EOQ may result in manufacturing product that wil sit rather than sel, Inventory costs rise and customer service levels drop as the company attempts to build both the required sellable product and the tunnecessary EOQ stock. The EOQ formula does not recognize optimum use Of capacity nor the effect that such an oversight has on sales as it attempts to rinimize cost, I is common for compa- ries to pay high overtime and freight premiums to make and ship product to satisly existing customer order backlog, ‘while building inventory for prodact with little or no existing demand. In some cases these companies experience sales levels below that which woul have occurred had they not been using the EOQ model The EOQ model has its place in envi ronments where demand is steady and predictable over a long, period of time, Unfortunately, n today’s business environment, this is rarely the ease, The EOQ model ian elegant mathemal- ical solution to the problem of knowing how much to order, but itis incapable of taking into consideration all of the unpre~ dlctable variables necessary that would give its calculated results, relevance vis-A-vis real costs or demand, Since the basic formula is based on predicted demand, fore- casted or actually booked, and since that demand will always, change subsequent to establishing the lot siz, the probability of the EOQ being accurate is zero, Although the formula ealeu- lates a precise number, there is typically a significant range tha will produce a reasonable economy af sc that the total cost curve is relatively flat, which is common in _mast situations, This elaborate mathematical method usually docs no, in practice, yield any better results than having expe- rienced, intelligent people determine the ft sizes using good sound judgment For the unenlightened users of the EOQ technique, the comfort value of having a structured method of determining how much to order usually overshadows the in the method! brings sous, This filse feeling of security is usually accompanies! by & hilure to constantly evaluate and re-evaluate All dive requivem ated to determine an accurate lot sd demand. Known as fixed operating performance c. Figure | shows the values factored into the equation. Once the parameters ate set in the computer, they are rarely changed and the variables It is rare today that demand is constant or known with any degree of confidence. become fixed. Qver time these values become increasingly obsolete, rendering the results ofthe calculations useless. for example, a large manufacturer of retail goods. They make products for various chain stores and operate in a make to-stock environment. Their demand is fairly unpredictable and forecast accuracy is around 50 percent at best."The product has a specific shelf life in adlition to the relatively short lifespan of typical retail product. The manufacturer chooses the EOQ model to determine haw much product to produce ata given time, Even though they have a modern ERP system in place, they feel more comfortable allowing the computer, using th OQ, calculate the production lot sizes. There isa reluctance to ely on the MRP methodology, in part because they have not done an adequate job of setting up their ERP system and its data accuracy is unreliable. They have a higher level of comfort with the EOQ model simply because it works outside of the ERP environment Iisa stand-alone method of calculating the quantity to be produced and is assumed to be isolated from the inaccuracies ofthe ERP system. So what kind of results does the EOQ ‘model bring to this scenario? Inventory ‘urns are abysmal. Customer service is less than adequate and, when its acceptable, i is usually the result of overtime and premium shipping. The shelf life of the product combined with short product life cydles creates significant losses due t0 ‘obsolescence. Finally, the manufacturer is frequently strapped, for capacity problem exacerbated by producing products that are not needed, but were dictated by the EOQ. model Pecformance has cleatly suffered through use of the EOQ. It could be significantly improved by simply utilizing the ERP tools already in place. The cure_ = WHAT ISTHE REMEDY for the BOQ plague? To replace it with a method that is dynamic and continuously strives to match lot sizing with actual demand, Today's leading practi leverages the capabilities of MRP, |IY, and/or Kanban. Reduci or eliminating sot-up cost eliminates the need to actively ili lot sizing in discrete and many batch environments. If some sort of lot sizing is unavoidable, it shoul be developed around actual demanel used in conjunc ‘opposed to projected demand and should be with methods that consider capacity and ‘overall impact on sales. As a method of controlling inventory levels and customer service levels while actively managing cos MRP, MRP, JIT, and Kanban will always outperform FOQ. ¢ Jin otis amp ohan ‘consti ree, nanapols alana, His pinay res of fexpetse noite bashes pyoess inprovament and reangiee ing, suit mangement and ERP infomation sy ‘managing consultant i marc FIRS]