A Case study on the determination of the Economic Order Quantity for

minimizing the inventory costs: Model, Analysis and Insights

Srinivasan Balan1
Deputy Manager – Industrial Engineering, Murugappa Morgan Thermal Ceramics Ltd,
1

Plot No 26 &27, SIPCOT Industrial Complex, Ranipet – 632403, Vellore district, Tamilnadu,
India
E-mail: balan.srinivasan @ thermalceramics.com

Abstract

This paper deals with the extended EOQ type inventory for the ceramic fibre
manufacturing where the demand rate is kept constant. The traditional parameters of unit
item cost and holding cost are kept constant. The ordering costs depend upon the type of
the material being ordered. EOQ was arrived at optimum parameters to evaluate the
reorder level, safety stock & Reserve stock. In order to validate this model, a simulation
was done in Microsoft Excel 2003 to understand the inventory trend and validate the
model. A case study was illustrated to understand the EOQ model and its impact in the
total inventory costs.
Keywords: EOQ, Inventory costs, Reorder level, Safety stock, Reserve stock,
Simulation.

1.0 INTRODUCTION

The major goal of the study was to assess a set of changes to the company current inventory processes that
allowed an achievement in its inventory costs optimization and system development in optimizing
Inventory costs for better control and monitoring. For that purpose, an inventory model with the reorder
level was developed, and the relevant performance measures were measured from the simulation outputs.
The outcome of the simulation study was then discussed with the management and a set of realistic
modifications to the inventory system was agreed. These changes were included in the simulation model,
and in ensuring the system, results obtained. Most of the changes were accepted and are being implemented

1.1 Literature Review

Effective inventory management is essential in the operation of any business. As explained below in the
case, improvements in inventory management can achieve worthwhile cost savings. At the same time,
small businesses require inventory management systems that are simple, easy to use, inexpensive, and
keyed to current data sources and modes of operation.

A basic inventory management device is the economic order quantity (EOQ) followed by Reorder level.
The basic philosophy behind this is to get the answer for how much to order and when to order? An EOQ
strategy minimizes the total cost of ordering and carrying cycle stocks. While EOQ strategies are
theoretically optimal, they present many practical problems of implementation, especially for small
businesses. First, as Blackstone and Cox (1) suggest, EOQ strategies require continuous monitoring of
inventory balances. Second, as noted by Lin, (2) keeping EOQ values current necessitates frequent
updating of ordering and carrying cost information. These problems can be quite serious if EOQ values are
being calculated separately for each item in the product line. Third, the computation of EOQ’s requires
accurate knowledge of ordering costs per order and carrying costs per rupees of inventory. Some rough
estimates of carrying costs exist However, ordering cost estimates are harder to come by. Silver and
Peterson (4) essentially argue that this is largely because ordering is a staff activity, and it is difficult to
allocate the time spent by various staff members to a given order.

Fig. 1: Concept of EOQ with minimum total Inventory Costs

EOQ attempts to determine the amount of inventory to purchase with each order to minimize total
inventory cost. Ordering inventory costs money in terms of purchasing, shipping & handling, receiving,
accounting and related operational expense. Carrying costs include housing, handling, insurance, shrinkage,
record keeping, cost of invested capital and related operational costs. The theory behind EOQ is that
ordering costs are inversely related to carrying costs. Small frequent orders increase ordering costs but
reduce carrying costs. Large, infrequent orders minimize ordering costs but increase carrying costs. EOQ
analyzes the cost of ordering inventory versus the cost of carrying inventory in an effort to determine the
optimal amount and frequency of ordering. In graphic form the optimal Economic Order Quantity is where
the cost of ordering line intersects the cost of carrying line as depicted below.

1.2 Development of EOQ model

Once the items have been prioritized, a modified Pareto analysis (commonly referred to as the “80/20 rule”)
is used to stratify the parts into categories. Typically three categories are used: “A”, “B”, and “C”, hence
the name “ABC Analysis”.

“A” items are the most critical ones. These items require tight inventory controls; frequent review of
demand forecasts and usage rates; highly accurate part data; and frequent cycle counts to verify perpetual
inventory balance accuracy. Typically, these comprise 5 – 10% of the total item count, and represent the
top 70 – 85% of the total annual dollar value of usage.

“B” items are of lesser criticality. These items require nominal inventory controls; occasional reviews of
demand forecasts and usage rates; reasonably accurate part data; and less frequent but regular cycle
counting. They typically comprise the next 15 – 25% of the total item count and represent the next 10 –
20% of the total annual dollar value of usage.

“C” items have the least impact in terms of warehouse activity and financials, and therefore require
minimal inventory controls. In fact, depending on the nature of the items, these may be good candidates for
free bin stores. Analysis of demand forecasts and usage rates on “C” items is sometimes waived in favor of
placing infrequent orders – often in large quantities – to maintain plenty of stock on hand. “C” items
typically comprise 65 – 80% of the total item count and represent the last 5 – 10% of the total annual dollar
value of usage. Because of low usage, any dead or inactive inventory will normally fall into the “C”
category.
There is no set rule for establishing the cutoffs between the categories. Generally, a good starting point
would be to define “A” items as those that represent the top 80% of total annual usage based on the
prioritized list; “B” items as the next 15%; and “C” items as the last 5%.

Table 1: ABC Classification system

Sl.No. Class of items % of costs
1 A 80%
2 B 15%
3 C 5%

The project work will be on the ‘A’ Class items which include raw material, consumables, and spares on
both imported and indigenous. Once the materials are identified as A Class items, the Ordering cost (CO),
carrying cost (CC), demand pattern (D) and the purchase price had been taken as a part of data collection.
The respective split ups of ordering costs components and the carrying costs components are shown below.

Costs of Inventory
Universal carrying costs percentage ranges: 15% to 50%
1. Carrying costs
(i) Cost of Money (Interest rate): 12%
(ii) Taxes: 1%
(iii) Insurance: 1%
(iv) Warehouse Expenses: 1%
(v) Physical handling: 1%
(vi) Clerical & Inventory control: 2%
(vii) Obsolescence costs: 1%
(viii) Deterioration & Pilferage costs: 1%

Total percentage of carrying costs: 20%

Thus the carrying costs for individual items will be 20% of the purchase price. The purchase price of all the
items were taken as a weighted average cost from the ERP system which approximates the

2. Ordering costs
All costs associated with preparing a purchase order is termed as ordering costs which include the cost of
preparing a purchase invoice, telephone, salaries of purchasing clerks and stationery. It does not include the
actual cost of the goods. These costs include cost of preparing the order or the invoice, the stationery used,
salary of the clerks, telephone costs etc. There is a cost involved in placing each order so firms try to avoid
ordering for items individually so what they do is that they place the combined order for many items in one
order to reduce the costs. Each order has a fixed costs associated with it and it is independent of the number
of items in the order. If the ordering cost is C, the total demand or the number of units required is D and the
number of items in an order is Q. Then, Total Ordering cost per year = C × D/Q

The following are the costs included for cost of ordering the materials. An approximate measure of the cost
was taken for each of the category and proper assumptions made for estimating the ordering costs (CO)

(i) The cost of preparing purchase requests

(ii) The cost of order processing
(iii) Negotiations and finalization of orders
(iv) Releasing orders
(v) Monitoring orders
(vi) Receiving orders
(vii) Inspections costs
(viii) Telephone charges / Fax
(ix) Cost of postage and correspondence
(x) Stationery and printing costs of purchase order and Goods Receipt Note
(xi) Tendering costs
(xii) Salaries of purchasing and stores officials
(xiii) ERP / IT Support cost

An average demand pattern was arrived at based on the sales forecast input from the sales team. The
demand was limited to per day consumption.

Basic EOQ Assumptions

(i) Demand is known, constant and independent
(ii) Demand during the lead time is the same as the normal demand
(iii) Lead time is known and constant
(iv) Receipt of inventory is instantaneous and complete
(v) Purchase price of the item is constant.
(vi) Quantity discounts are not applied to the model
(vii) Stock outs completely avoidable
(viii) The Process continues infinitely
(ix) There are no quantity constraints (on order quantity or storage capacity)
(x) Only variable costs are Setup and holding

Thus the Economic Order Quantity (EOQ) was calculated as represented below.

EOQ = SQRT ((2 * CO * D) / CC) ……………… (1)

After obtaining the EOQ, the safety stock (SS), reserve stock (RS), re order level (ROL) has to be
calculated.

1.3 Modeling assumptions and Data collection

In order to evaluate the reorder quantity, the Lead time taken by the material to reach the factory was taken
for the past 15 transactions. Safety stock is defined as the amount of inventory needed to protect against
completely running out. From the Lead time details, the standard deviation for the LT and the maximum
occurrence of the Max LT was calculated which is used to find out the probability of delay of the goods
reaching the factory.

Fig. 2: General pattern of Inventory Levels

The calculations are as follows;
Safety stock (SS) = Demand / day * Average LT + Standard deviation of the LT * Demand / day ……. (2)

Reserve stock (RS) = Max LT * Probability of delay * Demand / day …… (3)

Reorder level (ROL) = Safety stock + Reserve stock …… (4)

Thus from the above, the list of figures for the implementation of the Optimal Inventory costs has been
calculated that includes EOQ, SS, RS, ROL, Demand pattern, Lot size, LT details etc.

Fig. 3: General pattern of Inventory Levels with ROL and RS

1.4 Verification & Validation

In order to validate the model with the actual track of the current way of operation, it has been found that
the EOQ is not matching with the lot size and the replenishing quantity. Hence reconsideration was done
with respect to the actual lot size and quantity of replenishment. This was done along with the purchase
team in considering the freight and other benefits. Results indicate that most of the calculated figures are
not EOQ values and it was getting revised closer to the EOQ quantity.

1.5 Simulation experiment and Results

The validation of this model was done by making a computer simulation of the entire data set for 20
transactions using MS Excel 2003. The Lead time data calculated before used as a uniform random variate
in the simulation model. The simulation model has resulted in the trend of the stock for the next 20
transactions and it is represented in the graphical form. The algorithm for this simulation model has been
enclosed. A case study was enclosed along with the calculations and the output from the simulation run.

Variables declaration
Current stock (CS)
Reorder level (ROP)
Demand/day (D)
Stock depleted till reorder level (A)
No of days till reorder level (d)
Minimum LT (LT)
Difference between Max LT & Min LT (diff)
Expected time of replenishment (n)
Expected date (n1)
Balance stock during replenishment (m)
Balance stock after replenishment (x)
Lot size (L)
No of replenishments (y)

Algorithm
For next 20 transactions
A=CS-ROP
D=A/D
Value = MOD (d, 1)
If (Value>0.4)
Actual days = INT (value) + 1
Else
Actual days = INT (Value)
Current stock date= date [ ] – Actual days
Date function called for stock updation (date function stores the stock at each transaction cycle)
Rand [ ] = rand ()*diff + LT (rand function called for uniform random variate with (a, b) as input)
N= rand [0] + date [0][1]
N1=date[n] [0]
M=Min (ROP, CS)-d*rand [0]
If (m<0)
Print (Stock out)
Else
Print (Smooth flow)
If (m<=0)
X=L*y
Else
X=m+L*y
CS=X

From the above algorithm, the date corresponding to the stock levels with respect to the replenishments and
current stock levels are taken out to represent the output in the graphical form.

Stock in Kgs
Product X
12000

Stock
10000

ROL
8000

SS - RS
6000

4000 RS

2000

0
4- 19- 3- 18- 2- 17- 2- 17- 1- 16- 1- 16- 31- 15- 30- 14- 1- 16- 31- 15- 30- 15- 30-
Jul- Jul- Aug- Aug- Sep- Sep- Oct- Oct- Nov- Nov- Dec- Dec- Dec- Jan- Jan- Feb- Mar- Mar- Mar- Apr- Apr- May- May- Days
09 09 09 09 09 09 09 09 09 09 09 09 09 10 10 10 10 10 10 10 10 10 10

Fig. 4: Simulation for product X

1.6 Numerical illustration for EOQ and ROL calculation

Table 2: Calculation of Ordering Cost

Sl.No. Description Product X
1 Classification A Class
2 Lot Size 3000 Kg
3 Ordering Cost 275
(Rs)/ Order

The carrying cost was fixed as 20 % of the purchase price.

Table 3: Calculation of Carrying Cost

Sl.No. Description Product X
1 Purchase price (Rs. / Kg) 19.30
2 Annual Carrying Cost (Rs. / 3.86
Kg)

Calculation of demand
The Demand was calculated based on the predicted forecast of products requirement from the
market information. From the forecast, the demand per day = 464 Kg. Because of the Global meltdown, the
maximum number of working days per month is 25 days. Annual demand (Kg) = 139200

Calculation of EOQ
Using the equation (1) the Economic Order Quantity can be calculated for product X as follows,
EOQ = √ (2 * 275 * 139200 / 3.86) = 4453 Kg

The Safety Stock is calculated using the equation (2)

Table 4: Safety Stock Calculation
Sl.No. Item Product X
1 Average Lead Time 15 Days
2 Min Lead Time 13 Days
3 Max Lead Time 17 Days
4 Std Dev (σ) 1.27 Days
5 Demand during LT 6960 Kg
6 Safety Stock (SS) 7549.28 Kg

The Reserve Stock is found out using the equation (3)

Table 5: Reserve Stock Calculation
Sl.No. Item Product X
1 Max Lead Time 17 days
2 Probability of occurrence 0.1
3 Reserve Stock (RS) 788.8 Kg.

The Reorder level is found out using the equation (4)

Table 6: Reorder Level Calculation
Sl.No. Item Product X
1 Safety stock (SS) 7549.28 Kg
 2 Reserve stock (RS) 788.8 Kg
3 Reorder Level (ROL) 8338.08 Kg.

Table 7: Inputs taken for the Simulation of Inventory model

Sl.No. Item Product X
1 Re Order Level 8338 Kg
2 Safety Stock 7549 Kg
3 Reserve Stock 788 Kg
4 Demand / day 464 Kg
5 Lot size 3000 Kg
6 Min Lead Time 13 Days
7 Max Lead Time 17 Days

Thus a small change in the no. of replenishments will impact the stock level. The optimal level of number
of replenishments and the lot size were obtained by doing several combinations of the factors lot size and
the no. of replenishments to avoid stock outs and minimum cost of Inventory.

2.0 CONCLUSION

Applying these EOQ and ROL model for 33 ‘A’class items which includes Raw material, stores and
consumables, the results were yielding a good reduction in the total inventory cost. Although the lot sizes
and EOQ values were altered for better flexible inventory practice, the result is not much affected by the
changes. Hence the optimal lot size with least cost has been obtained. Thus it leads to the objective of how
much to order and when to order with least inventory cost and no stock outs situation. An inventory system
was formulated and periodic checks every month leads to the successful implementation of this system.
The result indicated that the overall Inventory costs were drastically reduced by 50% which in turn used for
other capital expenses.

ACKNOWLEDGEMENT

I would like to thank the management and staff for allowing me to freely access all the information used
and for their contribution to the project. I am thankful to the management team who extended their support
for the successful completion of the model in a more scientific way to minimize the total Inventory costs. I
am also in debt to the company’s management for their willingness to allow me to share this experience. I
feel grateful to the referees for their valuable comments and suggestions.

REFERENCES

Conference Proceedings:

[1] Lisete Silva, Ana Luisa Ramos and Pedro M Vilarinho, “Using Simulation for manufacturing process
Reengineering”, Proceedings of the 2000 Winter Simulation Conference.
Books:

[1] Hadley G and T M Whitin, “Analysis of Inventory Systems” 1963. Englewood Cliffs, Prentice Hall;
New Jersey

[2] Premkumar Gupta and D S Hira, “Operations Research”, S Chand publishers, New Delhi, India

[3] R Panneerselvam, “Production and Operations Management” Eastern Economy edition, Prentice Hall of
India, New Delhi, India.

[4] B Kumar, “Industrial Engineering and Management”, Khanna publishers, New Delhi, India.

[5] David J Piasecki, “Inventory Management Explained - A focus on forecasting, Lot sizing, Safety stock
and ordering systems”.

[6] Hamdy A Taha, “Operations Research: An Introduction”, Eighth edition, Pearson prentice Hall, New
Jersey

[7] Hillier and Lieberman, “Introduction to Operations Research”, Seventh edition,

Mc Graw Hill publication.

Technical Reports:

 [1] Bill Roach, "Origins of the Economic Order Quantity Formula", Washburn University, School of
Business, Working paper series, Number 37.January 2005

[2] REM Associates Management consultants, "Methodology of Calculating Inventory Carrying Costs", 20,
Nassau street, suite 244, Princeton, New Jersey – 08542

[3] Garrett J van Ryzin, "Analyzing Inventory Cost and Service in Supply Chains", Columbia Business
School