EOQ Application in a Pharmaceutical Environment: A Case Study Roch Ouellet* Jacques Roy** Claude Cardinat*** ‘Yves Rosconi*** ABSTRACT This paper describes a successful application of classical inventory theory at a drug manufac- turing plant located in Monireal that has resulted in annual savings in the order of $110,800 and assisted management in its decision to invest in larger production equipment. The basic assump- tions underlying EOQ models are reviewed and dealt with. For instance, an algorithm was devised to handle the peaks in the demand of many A- class items. Following the implementation of this algorithm, buffer stocks were reduced signifi- cantly while maintaining the same high levels of service. INTRODUCTION The economic order quantity (E.O.Q.) formula, first derived by F. W. Harris [6] in 1915, is still demonstrated in most operations management textbooks and introductory courses. It is a quite simple formula but it cannot be applied blindly to real world problems because of its simplifying assumptions. However, we feel that it is still a very useful tool when applied carefully and this Paper illustrates one such application at a drug manufacturing plant located in Montreal. It resulted in annual savings in the order of $110,800 and assisted management in its decision to invest in larger production equipment. Inventory control problems have been studied extensively in the operations management and Management science literature in the past three decades. A recent survey (3] indicates that research Papers on inventory control accounted for 22% of articles published in four major journals dealing ‘Eoole des Hautes Etudes Commerciales, Montreal, Canada "Université du Québec & Montréal, Montreal, Canada ***RhGne-Poulene Pharma Ine, Montreal, Canada ournal of Operations Management with operations management subjects in the last 2 years. But, while a great deal of this research has proposed methods and techniques to improve inventory control, today’s real world problems still require more attention from researchers that will help close the gap between the academic and practicing worlds (2, 11, 12, 13]. Recently, many successful applications of clas- sical inventory theory were reported in the liter- ature [1, 5, 7, 8, 9]. But, at the same time, some authors were concerned with the validity of clas- sical theory [4] and others expressed the need for a better definition of the parameters used in these inventory models [12]. These aspects were con- sidered in this application and will be discussed later on. PROBLEM DEFINITION A drug manufacturing company (Rhéne-Poul- enc Pharma Inc.) wishes to reduce its operating costs while maintaining a high level of service to its customers. In this section, we briefly describe the company’s product line and production-inven- tory planning and control system. Product Line The company produces 31 drugs in one or many categories, e.g., tablets, capsules, creams, sup- Positories, parenterals and oral liquids. Each cat- egory refers to a specific production process. Fur thermore, in a given category, a drug may be pro- duced with varying doses, e.g., 10, 25, 50 or 100 mg per unit. These are produced independently and are therefore considered as different “‘prod- ucts” in our study. Finally, a drug falling into a specific category with a given dosage, e.g. 25 mg capsule, may be offered to the market in packages of different sizes, e.g. packages of 100 and 500 capsules of a drug with a 25 me dose. These are considered as different final products or “items” while their production follows the same basi Process except for the final packaging step. ”Therefore, the 31 drugs produced by the com- pany are in fact broken down into some 86 differ- ent products put into packages of different sizes for a total of 140 final products or items. Forecasting ‘The marketing department is responsible for producing forecasts. While they prepare point forecasts of the monthly demand for all items, the horizon and the revision period vary according to the item class. The monthly demand for A-class (see Figure 1, ABC Analysis) and seasonal items is forecasted on a 6-month time horizon and fore- casts are revised monthly. Forecasting for all other items is made on a time horizon of one year, at the beginning of each year. Production Processes We are dealing with standard products that are produced in batches for inventory. There is one production process for each of the product cate- gories referred to previously. These production processes involve efficient special-purpose equip- ment and extensive quality control analyses that imply high setup costs. To illustrate, Table 1 shows the operations involved in the manufacturing of a given capsule in batches of different sizes. First, the ingredients are weighed and mixed together according to a predetermined formula. It can be seen from Table | that the time required to per- form these operations does not vary much with volume. The next operation is an in-process anal- FIGURE 1 ABC Analysis Percentage of sna ss lr sahe) Percentage eitems1008- Hotes) 50 ysis required to ensure that the previous oper- ations are performed correctly, especially with respect to product homogeneity. The drug is then fed into a capsule filling machine that is designed to operate at high speeds and high outputs. The production batch is then analyzed according to specifications before it is finally packaged in bot- tes of 100 and/or S00 capsules. Planning and Control We now briefly describe how the production inventory system is managed. Three levels of planning are used: aggregate on a yearly basis, intermediate on a three-month basis and detailed ona three-week basis. Production planning is based onsales forecasts (described earlier), on the estab- lishment of service levels that determine buffer stocks requirements, and on production capacity. The materials control department is responsible for placing orders to the production department: when stock levels for some item reach the reorder point, considering sales forecasts and production lead time, they place orders for each of the items of this product (see Appendix 1). This fixed reor- der quantity system triggers production orders of a fixed batch size that is determined, for each product, by computing the optimal quantity to produce, as shown later on in the text. This enables, the production department to plan its workload and requirements in terms of manpower and raw materials and to schedule production operations accordingly. The Impact of Government Regulations on Production Management ‘An important characteristic of the drug industry is that it is highly regulated; in particular, each production batch has to be clearly identified with TABLE 1 Production Process for a Given Capsule Time Variable (hours) Fixed |100,000]500,000| 1,500,000] 2,000,000 Operation | chours) | units | units | “units | units Weighing | 1.00 | 075 | o7s| 150 | 1.50 Mixing 1.75 | 200 | 200| 350 | 400 in-process | 325 | — | — 7 Es analysis. Icapsule | 480 | 5.00 | 2600 | 45.00 | 67.00 filling | Final 2600} — | — - - analysis, Packaging | 250 | 1.00 | 350 | 600 | 9.00 (Total 39.00 | 07s | 32.25 | 5600 | 6150 | American Production and Inventory Control Societya lot number and kept isolated from other batches Until its final approval. This situation motivates the production manager to standardize the pro- duction process and favours production runs of equal size for each product. This means that the size of the orders placed for a given product by the materials control department should be equal toa preset production quantity. It also means that the final products or items identified with a pro- duction batch cannot be stored away or shipped to the clients in part lots, as in many other man- ufacturing settings, until the whole batch has been approved. This feature enables us to determine the optimal number of production runs (cycles) for each product, by means of a model similar to the classical EOQ model. THE MODEL Assuming that shortages are not considered at this stage, the total incremental cost formula can be expressed as follows for a typical product packed into many (J) items: TC =(C,+ SCY-N+>DC,D2N (1) Where : TC C, Total costs Fixed cost related to the pro- duction of a lot Cy = Fixed cost related to placing an order for item j = Unit inventory holding cost per year for item j Annual demand for item j Number of items of a given product Number of production runs per year for the product. 2 vow Zz f Then, the optimal number of production runs (or cycles) per year can be found by classical optim- ization with the resulting formula: += [2x 7” Ne la + Soo] and the optimal quantity to produce, Q,*, simply becomes: Q*= DJN*. @ DISCUSSION In this section, the basic assumptions underly- ing classical EOQ models are reviewed and dealt with. Journal of Operations Management The Cost Elements Classical inventory theory models, like the one used in our application, are often criticized because of the problems faced when trying to define and effectively measure the relevant costs. A recent paper [4] suggests that these costs are “virtually impossible to measure” and that more emphasis should be placed on macro level policy analysis While recognizing the difficulties associated with costs measurements in general, we cannot agree with the impossibility of applying EOQ models and we will thus explain how the relevant costs were obtained in our application. Fixed costs associated with a production run— These consist of setup costs (C,) and ordering costs (C,) for each item j. Setup costs are found by computing the dollar value of the labor hours required for machine setups and batch analyses. Ordering costs (C,.) are incurred whenever an order placed for a specific item of a given product and, in our case, are the same for each item So the total fixed costs associated with a production run (C, + & C,) simply becomes (C, + J+ Ca). In our case, J is always very small: J = 1 or 2. Since C,, is much less than C,, the total ordering costs for a production run (JC,) are by far less important than the setup costs. (See appendix 2 for a detailed example.) While we are quite confident about the reliabil- ity and true marginality of setup costs (see Table |, for example), we nevertheless have some doubts about ordering costs. So we performed a sensitiv. ity analysis on the latter ones and found, as expected, that even drastic changes in their value would not change the optimal solution signifi- cantly for most products (see Table 2), Inventory holding costs— Inventory holding costs were set at 30% of the value of items carried in inventory. This cost was obtained by adding the Opportunity cost of capital (19%) to the ware- housing, insurance, obsolescence and damage costs (16%) for a total of 35%. This was then multiplied by the percentage of direct variable production costs (raw materials and labor) over the total pro- duction cost normally used to compute the inven- tory value, Indeed, as explained in Rhodes [10], all fixed costs should be excluded from the inven: tory values used when calculating the holding cost, In our case, fixed production costs represent only 15%, so we multiply 35% by 85% and obtain an inventory holding cost of 30% (rounded value). Of course, in a period where interest rates are fluctuating very rapidly, it is becoming more and more difficult to assess a proper value for the cost stTABLE 2 Sensitivity Analysis for Ten Products ecco Oeamanicn Sensitivity Analysis (+) 1 = 30% |i = 30% [1 = 25% ]I = 25% 1 = 85% [I = 40% Product C= $70 |C,=$70 | C,=$70 |C,= $0 ©., = $70 1 [Ne 2077 480 442, 468 5.08 520 557 5.90 Te | siesi7 6222 10.33% | 100.02% | 10.17% | 100.32% | 101.12% | 102.16% 2 [N 9.65 4.08 371 477 4a | 438 470 5.56 To | s27ea $2006 10.46% | 100.0% | 101.45% | 100.27% | 101.03% | 104.6% 3 [N 18.22 sa | 478 563 620 587 599 7.08 To | $4955 $2645 | 100.45% | to0.s9% | 101.35% | 100.18% | 10.84% | 10432% 4 [N 287 483, 441 5.13 5.62 522 5.58 649 To | $2954 $2593, 100.43% | 100.20% | to1.te% | 10031% | 101.04% | 10443% 3 [NT 24 a7 7.95 9.05 993) 942 10.03 11.43, To | $8257 $5300 100.43% | 10.07% | 10.87% | 10.32% | 101.01% | 103.73% é [N 18.38 715 652 aos | aes | 773 «| 823 10.15 To | $8630 $5835, 10.41% | 100.71% | 102.20% | 10.27% | 10.96% | 106.18% 7 [we | 1578 525 479 569 624 5.66 6.06 721 To | seae4 $5023 100.1% | 10093% | 101.50% | 100.29% | 107.09% | 108.08% a [N 25.44 895 817 10.19 11.16 9.66 10.33 1288 Te | $1216 $7024 100.42% | 10.83% | 102.45% | 10030% | 10103% | 106.71% o [N 1.15) 261 2.39) 258 281 282 301 325 Te | $9610 $2658, 100.3% | 100.02% | 100.33% | 10032% | 101.06% | 102.42% 10 [Nv 51.32 1981 1809 2092 22.82 21.40 22.88 28.46 Te | sa2675 | $21,960 100.41% | 10.18% | 101.07% | 10.90% | 101.04% | 104.22% with present production equipment Inventory holding cost (as a percentage of value) Ordering cost for one item Number of runs per year (+) with larger production equipment Total costs per year (dollar value or percentage of minimal total costs: see note below) Let TC{N|,C,) be the total costs per year, as given by 1), when N is the number of production runs per year, when the inventory holding cost is set at | percent of the value of the product, and when Cy, is the ordering cost for one item. The "TC" line for product 1 contains. —in column “Before,” the value of TC(27-77, 30%, $70) —in column “Optimum, the value of TC(4.80, 30%, $70) in the six columns of the sensitivity analysis the total costs using 4.80 runs per year, as a percentage of the minimal total costs. For example, if| = 25% and C., the minimal total costs are then TO(4.42, 25%, $70) 100.83% of the minimum TC: 70, the optimal number of runs per year for product 1, as given by (2) is 4.42: and $5729; under the hypothesis that the true values of | and Cx are 25% and $70 respectively, the TC obtained by setting N equal to the value 4.80 given in the column “Optimum,” are $5748, Le. 100,83 = 100 x 574815729 = 100 x TO(4.80, 25%, $70\TO(4.42, 25%, $70), Similary, 100.02 = 100 x TO(4.80, 25%, $0)TC(4.68, 25%, $0). Therefore, the total costs per year for product 1 are quite insensitive to the values of | and C,. of capital, which is a major element in the value of inventory holding costs. This is why a sensitiv- ity analysis was also performed on this cost com- ponent (see Table 2) in order to ensure that our solutions would remain valid inside a range of realistic inventory holding costs. 3 Shortage costs— Shortage costs are not known and are not considered in the model. However, the very important topic of customer service in terms of stock availability will be treated in the next section. American Production and Inventory Control Society‘The Demand A basic assumption for the use of EOQ models is that the demand and lead time are known and constant. In our case, the lead time consists mainly of the time required to produce a batch and is well known. However, the demand may vary signifi- cantly from month to month. Indeed, some prod- ucts are highly seasonal while others have a rather constant demand except for peaks in June and December. (These peaks arise from major custom- ers placing orders immediately before the regular price increase periods.) So we performed an ABC analysis (see Figure 1) in order to study more carefully the behaviour of the demand for the 20% of items falling into the A class and representing 70% of the dollar value of annual sales. We found that seasonal items were less important ones (B + C classes) and that they could be handled by computing two different lot sizes corresponding to the periods of high and low demands. ‘The demand for most A-class items was rather steady with peaks just before the two annual price increase periods. We decided to handle these peaks by scheduling one or more production runs of economic size which are to be ready and delivered Just in time to meet the extra demand. We will illustrate this approach with a typical product. To simplify, let us assume that it is put into a single size package, i.e. that there is only one item. We first use the forecast annual demand D, in the formula (2): we get the optimal number N.* of lots, and the economic lot size Q,* = DJN.*. Now, for each peak period, extra production runs of size Q,* are scheduled. But these extra lots are delivered immediately when ready: therefore, no holding cost should be charged for them and the cost function (1) should use the corrected demand D, = D, ~ kQ.* where k is the total number of extra lots and is now determined manually (but see below). Let us denote N,* the new optimal solution computed from (2) when using the corrected demand. This means that we are to produce a total of N;* + k lots: N,* to meet the normal demand, and k to meet the extra demand in peak periods. If N.* + k 4 N,*, the economic lot size is not Q,*, but Q,* = D,(N\* + k). And we should apply the formula (2) to the re-corrected demand D; = D, — kQ;*. So we iterate . . . This procedure can be formal- ized as the following algorithm (we assume here that D,, No*, Q.*, and k are already known): Step I. Seti =1 Journal of Operations Management Step 2. Set D; = D, — kQi, Step 3. Compute (2) with this demand D, and obtain N* Step 4. Define Q* = DJ(N* + k) Step 5. If the total number of lots for iteration i (that is, N\* + k) is nearly equal to the total number of lots for the previous iteration (that is, N,* when i = 1, and Ni, + k when i >'1), then go to step 6. If not, set i = i+1 and go back to step 2. Step 6. The current values of N* and Q* are optimal. Stop. This algorithm converges very fast: typically, only one or two iterations are needed. This comes as no surprise since the cost curve of the EOQ model is known to be quite flat near the optimum. In our application, the total number k of extra lots was always very small and was in fact chosen as one of the integers surrounding the quotient (Di + DigiQ.*, where Q,* is the economic lot size as given by (2) using the forecast annual demand D,, and where D; (Djs) is the extra demand in June (December), that is the difference between the demand in June (December) and the average demand for the other 10 months. For none of the products, the last Q,* obtained from the algorithm differed from Q,* enough to trigger a change in k. But if we had to change k, it would be easy to extend the algorithm to compute also the best value of k. We should only add a new step, num- bered as 0, and change the step 6: Step 0. Define k as the nearest integer to the quotient (Dz + Dj/Q,*. Step6. Iflk ~ (Dj + Div/Q#*!>.5, setk equal to the nearest integer to the quotient (Dé + Di3/Q\*, and go back to step 1. Otherwise, stop. In practice, one may prefer to use in step 6 a constant greater than .5 (e.g. .7) in order to elim nate closed-loop situations. For almost all products, the items have parallel peak periods. The algorithm we described above can be applied to this generalized context with only minor and easy modifications. The demand for both items of the product referred to previ ously showed 2 peak periods, in June and December; each peak period necessitated one extra lot, so that here k = 2; in this example, we got N,* = 20, N\* = 19, Ns* = 19. (For the few products whose items have non-parallel peak peri- ods, the mix of the items in the extra lots would 53differ from the mix in the normal lot procedures are applied in such a case.) The fluctuations of the demand do not affect markedly the economic lot size, but they have a significant impact on the buffer stocks. For exam- ple, the actual monthly demand for some item of the product referred to in Table | has a standard deviation of 1291 units. After adjusting it by sub- tracting one extra lot to the demand of the two peak months, we got a standard deviation of 728 units, i.e. a standard deviation which was only 56% of the standard deviation for the unadjusted data. This result is of importance since the buffer stock B is usually computed as ad hoc B= no where o is the standard deviation of the demand during the lead time, and the safety factor n is a constant related to the predetermined service level. Therefore, the amount of inventory kept as a buffer against shortages due to the variability of demand could be reduced by almost half for a similar pro- tection (service level) IMPLEMENTATION AND RESULTS The model described above was implemented by the company management during the summer of 1981. On the basis of 1980 figures, the applica tion of formula (2) to the 86 products would result in potential savings of $85,800 due mainly to reductions in setup costs. Table 3 gives a break- down of savings by product category On the basis of these results, the company man- agement has decided to reconsider its production batch sizes. Through a cost-benefit analysis, it was, found that first year savings justified the invest- ment in the larger production equipment required to increase batch sizes. So far in 1981-82, these changes have led to a reduction of 164 man-hours per week in the pro- duction and quality control departments. This was TABLE 3 Breakdown of Savings by Product Category Product category Cost savings Tablets and capsules $50,100 Creams and suppositories $22,100 Parenterals $ 9,700 Oral liquids $ 3,900 Total $85,800 5 accomplished through normal attrition and rescheduling of some employees on four-day weeks. Following our analysis of the demand functions, buffer stocks were reevaluated and additional sav ings of $25,000 were identified while maintaining the present high standards of service in terms of stock availability. Finally, the production of larger lots facilitates production planning activities by reducing the number of production orders or cycles. CONCLUSION This paper demonstrates that a careful appli- cation of classical EOQ models can still generate substantial savings today. Such models are more readily understood and accepted by management than more complex “black box”’ types of inven- tory models. Furthermore, the computations required for the 86 products were quite easy and cheap to perform. As a matter of fact, all compu- tations were performed on a programmable hand- held calculator. ACKNOWLEDGEMENTS The authors wish to express their thanks to Pro- fessor Gilbert Laporte who read a first draft of thi paper and made helpful comments, and to the referees and editors of the journal for their valu- able comments and suggestions. REFERENCES 1. Austin, L. M., “Project EOQ: A Success Story in Implementing ‘Academic Research,” Interfaces, Vol. 7, No. 4 (August 1977, pp. I Bulla, E. S., "Research in Operations Management."* Journal ‘of Operations Management, Vol. 1, No. 1 (1980), pp. 1-7 3. Chase, R. B., “A Classification and Evaluation of Research in Operations Management,"* Journal of Operations Management, Vol. 1, No. 11980) pp. 9-14 4. Gardner, E. 8., Jr, "Inventory Theory and the Gods of Olym pus," Interfaces, Vol. 10, No. (August 1980), pp. 42-85 5. Gross, D., Harris, C. M., and Robets,P. D., “Bridging the Gap. Between Mathematical Inventory Theory and Construction of a ‘Workable Model," International Journal of Production Research, Vol. 10, No, 3 (1972), pp. 201-214 6, Harris, F., Operations and Cost, Factory Management Series, A.W, Shaw Co., Chicago, 1915. 7. Jaikumat, R.and Ran, U. R., "An On-Line Inte Management System," Interfaces, Vol.7, No.1, ber 1976), pp. 19-30. 8. Laurence, M. J., “An Integrated Inventory Control System,” Interfaces, Vol. 7, No. 2 (February 1977), pp. 5 9, Liberatore, M.J., “Using MRP and EOQ\Safety Stock for Raw Materials Inventory Control: Discussion and Case Study. Interfaces, Vol. 9, No.2, Part | (February 1979), pp. 1-6. 10. Rhodes, P_, “Iaventory Carrying Cost May Be Less than You've Been Told.” Production & Inventory Management Review and APICS News, Oct. 981, pp. 35-36 American Production and Inventory Control Society11, Silver, E. A.. “Operations Research in Inventory Management: ‘AReview and Critique,” Opas. Res., Vol.29, No. 4(Uuly-August 1981), pp, 628-648. 12, Wagner, H. M., “Research Portfolio for Inventory Management and Production Planning Systems." Opns. Res., Vol. 29, No. 3, Part 1 (May-June 1980), pp. 445-475, 13, Zanakis, S. H. etal. “From Teaching to Implementing Inven- tory Management," interfaces, Vol. 10, No.6 December 198), pp. 103-110. APPENDIX 1. REORDER POINT SETTING ler point setting procedure is used by the yn department t¢ itiate the manufactur- ing of a product batch. This procedure, as illus- trated in the following example, takes into account the randomness of the demand during the lead time period by adding a buffer stock to the average demand. Product Y Pharmaceutical form: Capsules Item : Bottle of 100 capsules Average sales per month : 421 bottles Standard deviation 60 bottles 1) Production lead time : 8.9 days weighing: 0.5 days mixing : 0.6 days sieving 0.9 days, encapsulating : 4.7 days cleaning 1.3 days packaging —: 0.9 days 8.9 days 2) Lead time related to production variations : 3 days The encapsulating step requires a three-day buffer stock. 3) Analytical testing lead time : 3.7 days 4) Total lead time and buffer stock : Total lead time: L = 8.9 +3 + 3.7 = 15.6 days Standard deviation for lead time: a = om x VERO = 60 x VI5.620 = 53 bottles Buffer stock to implement a service level of 95% (under the normality hypothesis) B = no, = 1.65 x 53 = 87.5 bottles 5) Reorder point: Average demand for lead time: D = 421 x 15.6/20 = 328.4 bottles Reorder point R =D + no, = 328.4 + 87.5 = 416 bottles Journal of Operations Management APPENDIX 2. FIXED COSTS FOR A TYPICAL PRODUCT We compute here the fixed costs associated with a production run for a typical product. Setup Costs: They amount to $577.42 and are found as fol- lows: 1) Total Analysis Costs ($553.30) i) Biology laboratory costs ($434.50). These costs were found by computing the total fixed hours of analysis required per batch and mul- tiplying by the hourly rate of operation at the biology laboratory: 11 hours/batch x $39.50/hour = $434.S0/batch ii) Control laboratory costs ($118.80). These costs were found as described above: 6hours/batch x $19.80/hour = $118.80/batch 2) Production setup costs ($24.12). These costs were found by computing the total fixed operation time associated with a production run and multiplying by the hourly rate paid to production employees. Fixed operations consist of setting up weighing and mixing operations, raw material transportation from storage, weight adjustments, equipment cleaning and internal transfer of in-process inventories. For our typical product, these fixed operations required 2.75 hours at an hourly rate of $8.77, for a total cost of $24.12 per production run 3) Total setup costs (C,). Total setup costs are then simply found by adding total analysis costs to production setup costs: C, = $553.30 + $24.12 = $577.42 Ordering Costs: ‘They are allocated in the following manner: —Personnel originating the order: $ S/order —Computer processing : $25/order —Placing raw materials and production orders $15/order —Packaging and control $25/order Total ordering costs: $70/order This typical product is offered in two different packages. Therefore, each production run requires two orders, one for each item, and the total order- ing costs per production run is $140. This figure is by far less important than the amount of $577.42 which represents the total setup costs. 55