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SILO MANUFACTURING CORPORATION SMC –

PART A, PART B
MANAGING WITH ECONOMIC ORDER QUANTITY
Dr. Ted Farris
University of North Texas

This two-part case illustrates the use of economic order quantity to manage conflicting

performance measures across different siloed functions in an organization. Part A requires students to

assess the costs of various order quantities and quantify the concept of “robustness.” Part B emphasizes

managing the variables of annual demand, ordering cost, inventory carrying cost, and unit price to

achieve strategic goals. The student must determine how to lower ordering costs to compensate for

increases in the other variables as well as to help guide just-in-time implementation efforts.

Completion of this case extends the traditional teaching of economic order quantity and offers the

instructor latitude in discussing:

1) Competing performance measures between different siloed functions

2) Total cost concept as it relates to inventory management

3) The impact of changing key variables of EOQ

4) EOQ robustness

5) Just-in-time implementation

Learning Objective and Appropriate Audience

The objective is to train students think beyond the traditional teaching of economic order quantity

to include real-life constraints and considerations. Part A has been effectively used at the introductory

level for undergraduate students. Part B has been used at the intermediate-to-advanced senior-level

capstone course for undergraduate students and introductory level for graduate students.

Deliverables of Support Materials for the Instructor

1. Print copy case study

2. Case introduction lecture slides

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3. Spreadsheet template to allow instructors to easily modify variables to customize/change the case.

4. Case solution slides for lecture/discussion package

Solutions and Teaching Notes:

Flexible design: The design of this case offers flexibility for the instructor to customize their

approach to meet a variety of course levels. For example:

 For a basic course: The instructor may choose to provide a lecture on key formulas and then use

this case as an application of these formulas.

 For a more advanced (or graduate) course: The instructor may lead the class discussion toward

which tools or information may be used to solve the problem, but leave it to the student to

complete the final step to put the pieces together.

 One- or two-part approach: The case introduction should take one class session if the instructor

includes basic lecture on economic order quantity. Discussion of the solution can be handled in an

additional class session. An instructor may opt to split the case into two separate activities with

Part A serving as a basic introduction to economic order quantity (class session for basic lecture,

partial class session to discuss results and introduce Part B) followed with a class session

discussing Part B results.

Emphasizes managing EOQ not deriving the formula: This case is intended to stimulate a

discussion about the manager managing EOQ. Some faculty may opt to utilize their own slides to

introduce economic order quantity in their own style—for example, a lecture on the calculus and

derivation of the EOQ formula. Others may consider lecturing or providing the formulas to the students to

sue to fill in the table.

Understanding conflicting measurement: We tell students many times that metrics need to be

aligned for the good of the corporation. This case helps to drive the point home by offering experiential

learning placing the student in a situation where they must achieve their logical performance goals, while

their effort is affected by others trying to accomplish their logical performance goals.
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Solutions to lower ordering cost: The notes provided for question #8 (“Provide three (3) viable

recommendations which would result in a lower cost to place an order.”) were collected from multiple

semesters testing this case and may offer the instructor additional material to further discussion. Key to

this discussion is the need for the student to move beyond classroom theory to identify viable practical

solutions for management to lower ordering costs.

Ability to change numbers: The supporting solution spreadsheet offers the instructor the ability

to easily change variables from term to term (or class to class). The spreadsheet is suitable for use in a

live lecture and offers interactive graphic results.

Irrelevant data?: Some data, such as the average lead time and the lead time standard variation,

may be irrelevant to many instructors. While this information is not used in the case, knowledgeable

instructors may use this as a basis to extend into the subject of safety stock.

Part A

Q #1: What is the cost difference between Ferguson's proposal to order 4 cases each
time and Patrachalski's proposal to order 32 cases each time?

A #1: $0

TEACHING Silo Manufacturing Corporation is appropriately named since, like many firms,
NOTE: the organizational functions operate in their own silos. Each area is focused on
improving their span of control and meeting their measurement goals, often at the
expense of the good of the corporation.

Start your solution lecture by pointing out the need to set the analysis into a table
so you can easily analyze the results.
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Consider pointing out to the students that the finance proposal will result in
smaller inventory carrying costs ($1,075.20) but the smaller ordering quantities
will also result in many more orders per year (179.2) and a high annual ordering
cost ($8,601.60). Likewise, the purchasing plan to order in large quantities meets
their goal of lower total ordering costs ($1,075.20) but at the expense of inventory
levels ($8,601.60).

Because the quantities have been “gamed” the conflicting proposals have identical
total cost ($9,676.80). Each proposal is beneficial to the functional area but
neither offers an advantage to SMC.
Q #2: Lewin suggested looking at economic order quantity. Based on the lowest total
annual cost, what order quantity should Martin recommend?

A #2: 169.7056 units

TEACHING Q* also known as the optimal economic order quantity results in a total annual
NOTE: cost $6,082.25. This is a total annual cost which is $3,594.55 lower than either of
the two proposals. You may note graphically this is the point where the ordering
cost and the inventory carrying cost lines cross.

Because ordering cost is non-linear, picking a point halfway between both

proposals (Q=270 units) will NOT result in the optimal solution ($6,749.87
instead of $6,082.25).

A student may ask the instructor about rounding since one must order in whole
units. Students may struggle that the optimal solution is not a whole number and
need to be reminded that it is a moot point because of the on-going nature of the
business. Ordering policies typically “bleed” over into the next calendar period.

This is a good time to discuss what Q* means in term of order frequency. If you
order 63.36 times in a 365 day year, this suggests you will be placing an order
with your supplier every 5.76 days. Extend a leading question to the students
“Would you want to order every 6 days and order Q*? What are the risks?”
Average daily demand is 29.458 units per day (10,752/365) or 176.75 unit every 6
days. Ordering 170 units every 6 days will result in running out of inventory
within a week!
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Discussion on the impact of rounding also leads into the third question concerning
robustness. Consider extending a leading question “Since Q* is the optimal
solution, what happens if we round away from Q* in terms of quantity or
frequency of order?”

Q #3: Let's explore the concept of "robustness." Lewin’s proposal to use economic order
quantity may be unrealistic since SMC would like to place orders in whole cases.
If the order quantity is decreased to the nearest whole case (which is a 2.78%
reduction) what percent would your total annual cost change? What percent would
your annual total cost change if the order quantity is increased to the nearest
whole case? [Hint: Use the formula ((New Total Cost/Old Total Cost)–1)].
A #3: 0.04%

TEACHING Rounding to the nearest case (165 units = 11 cases) is a 2.78% reduction in the
NOTE: order quantity ((169.706/165)-1). The total annual cost increases from $6,082.25
to $6,084.65 which is a 0.04% increase (($6084.65/$6,082.25)-1).

The concept of “robustness” is similar to the concept of economic price elasticity

which measures the responsiveness of the change in cost (price) to changes in
demand. Changes in the order quantity close to the optimal order quantity Q*
results in a very small change in total annual cost. Changes further away from Q*
will resulting much larger changes in total annual cost.

This suggests that one can violate the assumptions of EOQ and still be very close
to the lowest total cost.

Students may be interested in seeing an example of a variation of EOQ. A slide

example is provided which incorporates price discounts. Annual demand=1,000
units, ICC=32%, $10=cost to place an order, and a price of $12 per unit for orders
of less than 100, $10 per unit for orders between 100 units and 199 units, and $8
for orders exceeding 200 units. Ordering costs remain the same but inventory
carrying cost and total annual cost changes as the price changes. Without the
quantity discount Q* is 72.17 unit and a $277.13 total annual cost. Order 100
units benefits from lower ICC costs resulting in a lower total annual cost
($260.00).
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The instructor may consider entertaining discussion concerning additional costs of

receiving partial cases or partial pallets of items. These costs could include less
efficient counting, dealing with incorrect quantities, increased damage, increased
handling cost, alternative warehouse slotting, or filing claims

Part B

Davis is faced with a goal to reduce corporate inventories. To accomplish his inventory reduction

objective, Davis must lower his order quantities by lowering Q*, from 169.706 to 154.602. This will

permeate throughout the logistics system for anything that uses EOQ as a foundation—such as the MRP

system. Since Q* identifies the optimal order quantity resulting from the lowest annual total cost,

decreasing order quantities away from Q* will result in higher cost and be counter-productive. This is a

key point which students should understand.

The EOQ formula contains four changeable variables: annual demand, inventory carrying cost,

unit price, and the cost to place an order. By changing these variables one can influence Q*. However,

this is where performance improvement conflicts fit in. Three performance improvements are logical and

reasonable improvements but serve the purpose of increasing Q*: 1) increasing annual demand, 2)

reducing inventory carrying cost, and 3) reducing unit price. All that remains is to reduce the cost to place

an order, which is another logically reasonable goal. But how much?

Faced with four of five variables, it becomes a simple three-step algebraic manipulation of EOQ

to isolate “cost to place an order:”

1) Q* = SQRT([2 x AnnDmd x OrderCost]/[ICC x UnitPrice])

Square both sides

2) Q2 = ([2 x AnnDmd x OorderCost]/[ICC x UnitPrice])

Multiply both sides by (ICC x UnitPrice)

3) Q2 x (ICC x UnitPrice) = (2 x AnnDmd x OrderCost)

Divide both sides by (2 x AnnDmd)

4) Q2 x (ICC x UnitPrice) / (2 x AnnDmd) = OrderCost

After the cost to place an order has been isolated, it can be inserted into a spreadsheet allowing the

student to simply plug in numbers.

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Q #4: What would the cost to place an order need to be for Davis to meet his inventory
reduction objective if Vice President of Sales Steve Smith achieves his goal to
increase sales by 9.6% (HINT: a 10% increase in sales of 100 units results in sales
of 110 units).

A #4: The cost to place an order must be lowered from $48.00 to $36.3469 or less.

TEACHING Increasing Annual Demand from 10,752 units to 11,784 units will change Q* to
NOTE: 177.663. Davis must reduce the cost to place an order from $48.00 to $36.3469 to
make the new Q* 154.602.

Q #5: What would the cost to place an order need to be for Davis to meet his inventory
reduction objective if Vice President of Sales Steve Smith achieves his goal to
increase sales by 9.6% and Financial Comptroller Fred Ferguson achieves his goal
of reducing the cost to carry inventory from 32.0% to 29.4%.

A #5: The cost to place an order must be lowered from $48.00 to $33.3937 or less.

TEACHING If annual demand increases as in Q#4 and the Inventory Carrying Inventory (ICC)
NOTE: is reduced from 32.0% to 29.4% Q* will change to 185.353. Davis must reduce
the cost to place an order from $48.00 to $33.3937 to counter these
“improvements” and make the new Q* 154.602.

Q #6: What would the cost to place an order need to be for Davis to meet his inventory
reduction objective if Vice President of Sales Steve Smith achieves his goal to
increase sales by 9.6% and Financial Comptroller Fred Ferguson achieves his goal
of reducing the cost to carry inventory from 32.0% to 29.4% and Purchasing
Director Peter Patrachalski achieves his goal of reducing the average cost per unit
by 5.2% (HINT: a 10% reduction in a $10 unit cost results in a $9 unit cost).

A #6: The cost to place an order must be lowered from $48.00 to $31.6572 or less.

TEACHING If annual demand increases, and ICC decreases as in Q#5 and the average cost per
NOTE: unit is reduced by 5.2% Q* will change to 190.365. Davis must reduce the cost to
place an order from $48.00 to $31.6572 to counter these “improvements” and
make the new Q* 154.602.
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The "inventory minimizing" philosophy of just-in-time (JIT) and the "inventory carrying cost vs.

order cost trade-off" philosophy of economic order quantity (EOQ) are NOT contradictory philosophies.

They MUST work together.

Both seek the same result—lowest total annual cost. Forcing smaller lot sizes under the banner of

JIT without addressing the other variables found in EOQ results in a higher total annual cost. Not

managing these costs is a clear case of sub-optimization. By managing ordering (or set-up) cost, one can

achieve JIT lot sizes AND it results in the lowest total annual cost to the company.

Q #7: What would the cost to place an order need to be if Davis implemented a just-in-
time approach so ordering one unit at a time is the optimal ordering quantity? Use
the original variables for part number 64-1909. Your answer must be accurate to
six decimal places (e.g. $47.123456)

A #7: The cost to place an order must be lowered from $48.00 to $0.001667 or less.

TEACHING Lowering Q* results in lower total annual costs. While it sounds virtually
NOTE: impossible, if one were able to get to Q*=1 the total annual cost would drop to
$35.85. You would have to order 10,752 times in a single year which is about 30
times in a single day. Not impossible but an aggressive goal.

A word about zero inventories. Many textbooks and trade articles mistakenly
suggest that a true JIT system is only achieved by the elimination of ALL
inventories, going so far as to state zero inventories. It is impossible to produce
anything without the parts necessary to assemble the product. Even if it is a single
unit, one still has inventory. Perhaps a better statement is “the goal of JIT is to get
as close to zero inventory as is reasonably possible. There is a huge difference.
The instructor may prompt the students to discuss exactly what the goal of JIT
is?”
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Quantifying what one has to do to lower the cost to place an order, directly leads
to the final question: “Just how the heck do we do that?”

Q #8: Provide three (3) viable recommendations which would result in a lower cost to
place an order. Keep in mind that providing a "viable recommendation" means
you must move beyond theoretical statements of academia and be immediately
actionable. Do not skimp on your details (but don't make anything up either)...you
must indicate how to lower the cost in order to receive full points.

A #8 This question offers the student freedom to speculate how to lower ordering costs.
TEACHING CAUTION: Students frequently stray/go off-track by suggesting changes to the
NOTE: other three variables of EOQ. For example, a student might suggest “increase
order size to spread your ordering costs across a larger base.” Unfortunately the
cost of ordering does not change. Ordering in larger amounts reduces the
frequency of the orders and increases inventory carrying costs. It changes total
annual ordering costs at the expense of higher inventory carrying cost and total
annual costs increase. The cost to place an order does not change, just the total
annual cost of ordering and with it, overall cost increases. Consider going back to
the basic EOQ table to reiterate the inverse relationships and the cost of moving
away from Q*. Shifting from Q*=169.706 to Q=480 decreases the annual
ordering cost from $3,041.12 to $1,075.20 but increases hold cost from $3,041.12
to 8,601.60 and total cost increases by $3,594.55 (6,082.25 to $9,676.80).

Consider an open class discussion and chalkboard time listing possible action to
reduce the cost to place an order. In each case the discussion should emphasize
how to realistically implement each action, the subsequent costs associated with
the implementation, and who should be responsible.

Generalized statements such as “do a better job of ordering” or “do more with
less” should be challenged for more detail. Past student suggestions have
included:
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• Technology (EDI, online ordering)

• Evergreen contracts
• Auto Replenishment programs/VMI
• Reduce or eliminate inspection or counting at receipt (careful…risk
management)
• Change when you place orders to avoid unnecessary expediting, overtime,
etc., by leveling when orders are placed and avoid clumping

LESSON PART A:
LEARNED: Economic order quantity is a robust tool which optimizes the trade-off between
inventory carrying cost and the cost to place an order. Utilizing this tool will
allow the user to manage the total costs of ordering and holding parts

PART B:
Corporations are full of conflicting, logical performance measurements.

Understanding the variables of the EOQ tool allows the manager to effectively
address these conflicts.

EOQ and JIT concepts are related and should be used in conjunction to effectively
drive cost out of the process.