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Independent Demand and Economic Order Quantity

Inventory Management deals essentially with balancing the inventory

levels. Inventory is categorized into two types based on the demand
pattern, which creates the need for inventory. The two types of demand
are Independent Demand and Dependant Demand for inventories.

An inventory of an item is said to be falling into the category of

independent demand when the demand for such an item is not
dependant upon the demand for another item.
Finished goods Items, which are ordered by External Customers or
manufactured for stock and sale, are called independent demand
items.
Independent demands for inventories are based on confirmed
Customer orders, forecasts, estimates and past historical data.
 Dependant Demand
If the demand for inventory of an item is dependant upon another
item, such demands are categorized as dependant demand.
Raw materials and component inventories are dependant upon
the demand for Finished Goods and hence can be called as
Dependant demand inventories.

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 Take the example of a Car. The car as finished goods is an held
produced and held in inventory as independent demand item,
while the raw materials and components used in the manufacture
of the Finished Goods - Car derives its demand from the demand
for the Car and hence is characterized as dependant demand
inventory.
This differentiation is necessary because the inventory
management systems and process are different for both
categories.
While Finished Goods inventories which is characterized by
Independent demand, are managed with sales order process and
supply chain management processes and are based on sales
forecasts, the dependant demand for raw materials and
components to manufacture the finished goods is managed
through MRP -Material Resources Planning or ERP - Enterprise
Resource Planning using models such as Just In Time, Kanban
and other concepts. MRP as well as ERP planning depends upon
the sales forecast released for finished goods as the starting point
for further action.
Managing Raw Material Inventories is far more complicated than
managing Finished Goods Inventory. This involves analysing and co-
coordinating delivery capacity, lead times and delivery schedules of all
raw material suppliers, coupled with the logistical processes and transit
timelines involved in transportation and warehousing of raw materials
before they are ready to be supplied to the production shop floor. Raw
material management also involves periodic review of the inventory
holding, inventory counting and audits, followed by detailed analysis of
the reports leading to financial and management decisions.

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Inventory planners who are responsible for planning, managing and
controlling Raw Material inventories have to answer two fundamental
questions, which can also be termed as two basic inventory decisions.
a. Inventory planners need to decide how much of Quantity of
each Item is to be ordered from Raw Material Suppliers or
from other Production Departments within the Organization.
b. When should the orders be placed?
Answering the above two questions will call for a lot of back end work
and analysis involving inventory classifications and EOQ determination
coupled with Cost analysis. These decisions are always taken in
coordination with procurement, logistics and finance departments.
Independent vs. Dependent Demand
 Independent demand items are finished goods or other items sold
to someone outside the company
 Dependent demand items are materials or component parts used
in the production of another item (e.g., finished product)
Types of Inventory: How Inventory is Used
 Anticipation or seasonal inventory
 Safety stock: buffer demand fluctuations
 Lot-size or cycle stock: take advantage of quantity discounts or
purchasing efficiencies
 Pipeline or transportation inventory

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  Speculative or hedge inventory protects against some future
event, e.g. labor strike
 Maintenance, repair, and operating (MRO) inventories

Objectives of Inventory Management

 Provide acceptable level of customer service (on-time delivery)
 Allow cost-efficient operations
 Minimize inventory investment

Inventory procurement, storage and management is associated with

huge costs associated with each these functions.

Inventory costs are basically categorized into three headings:

1. Ordering Cost
2. Carrying Cost
3. Shortage or stock out Cost & Cost of Replenishment
a. Cost of Loss, pilferage, shrinkage and obsolescence etc.
b. Cost of Logistics
c. Sales Discounts, Volume discounts and other related costs.

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 1. Ordering Cost
Cost of procurement and inbound logistics costs form a part of
Ordering Cost. Ordering Cost is dependant and varies based on
two factors - The cost of ordering excess and the Cost of ordering
too less.
Both these factors move in opposite directions to each other.
Ordering excess quantity will result in carrying cost of inventory.
Where as ordering less will result in increase of replenishment
cost and ordering costs.
These two above costs together are called Total Stocking Cost. If
you plot the order quantity vs the TSC, you will see the graph
declining gradually until a certain point after which with every
increase in quantity the TSC will proportionately show an
increase.
This functional analysis and cost implications form the basis of
determining the Inventory Procurement decision by answering the
two basic fundamental questions - How Much to Order and When
to Order.
How much to order is determined by arriving at the Economic
Order Quantity or EOQ.
2. Carrying Cost

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 Inventory storage and maintenance involves various types of
costs namely:
 Inventory Storage Cost
 Cost of Capital

Inventory carrying involves Inventory storage and management

either using in house facilities or external warehouses owned and
managed by third party vendors. In both cases, inventory
management and process involves extensive use of Building,
Material Handling Equipment, IT Software applications and
Hardware Equipment coupled managed by Operations and
Management Staff resources.
c. Inventory Storage Cost
Inventory storage costs typically include Cost of Building
Rental and facility maintenance and related costs. Cost of
Material Handling Equipments, IT Hardware and
applications, including cost of purchase, depreciation or
rental or lease as the case may be. Further costs include
operational costs, consumables, communication costs and
utilities, besides the cost of human resources employed in
operations as well as management.
d. Cost of Capital
Includes the costs of investments, interest on working
capital, taxes on inventory paid, insurance costs and other
costs associate with legal liabilities.

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 The inventory storage costs as well as cost of capital is
dependant upon and varies with the decision of the
management to manage inventory in house or through
outsourced vendors and third party service providers.
Current times, the trend is increasingly in favour of outsourcing the
inventory management to third party service provides. For one thing the
organizations find that managing inventory operations requires certain
core competencies, which may not be inline with their business
competencies. They would rather outsource to a supplier who has the
required competency than build them in house.
Secondly in case of large-scale warehouse operations, the scale of
investments may be too huge in terms of cost of building and material
handling equipment etc. Besides the project may span over a longer
period of several years, thus blocking capital of the company, which
can be utilized into more important areas such as R & D, Expansion
etc. than by staying invested into the project.

Relevant Inventory Costs

Item Cost- Cost per item plus any other direct costs associated with
getting the item to the plant
Holding Costs- Capital, storage, and risk cost typically stated as a %
of the unit value, e.g. 15-25%
Ordering Cost- Fixed, constant dollar amount incurred for each order
placed

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Shortage Costs- Loss of customer goodwill, back order handling, and
lost sales

Order Quantity Strategies

Lot-for-lot-Order exactly what is needed for the next period

Fixed-order quantity-Order a predetermined amount each time an
order is placed
Min-max system- When on-hand inventory falls below a
predetermined minimum level, order enough to refill up to maximum
level
Order n periods- Order enough to satisfy demand for the next n
periods
======================================================

EOQ
How Is the Economic Order Quantity Model Used in Inventory
Management?
The economic order quantity (EOQ) refers to the ideal order quantity a
company should purchase in order to minimize its inventory costs, such
as holding costs, shortage costs, and order costs. EOQ is necessarily
used in inventory management, which is the oversight of the ordering,
storing, and use of a company's inventory. Inventory management is
tasked with calculating the number of units a company should add to its
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inventory with each batch order to reduce the total costs of its
inventory.
The EOQ model seeks to ensure that the right amount of inventory is
ordered per batch so a company does not have to make orders too
frequently and there is not an excess of inventory sitting on hand. It
assumes that there is a trade-off between inventory holding costs and
inventory setup costs, and total inventory costs are minimized when
both setup costs and holding costs are minimized.
KEY TAKEAWAYS
 The economic order quantity (EOQ) refers to the ideal order
quantity a company should purchase in order to minimize
its inventory costs.
 A company's inventory costs may include holding costs, shortage
costs, and order costs.
 The economic order quantity (EOQ) model seeks to ensure that
the right amount of inventory is ordered per batch so a company
does not have to make orders too frequently and there is not an
excess of inventory sitting on hand.
 EOQ is necessarily used in inventory management, which is the
oversight of the ordering, storing, and use of a company's
inventory.

Economic Order Quantity is the level of inventory that minimizes the

total inventory holding costs and ordering costs. It is one of the oldest
classical production scheduling models. Economic order quantity refers
to that number (quantity) ordered in a single purchase so that the
accumulated costs of ordering and carrying costs are at the minimum
level. In other words, the quantity that is ordered at one time should be
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so, which will minimize the total of. Cost of placing orders and receiving
the goods, and Cost of storing the goods as well as interest on the capital
invested.

Why you should be calculating EOQ

Calculating the EOQ for your business offers several benefits that
impact your bottom line. It’s a great way to grasp how much product
needs to be purchased to maintain an efficient ecommerce supply
chain while keeping costs down.

Here are the top benefits of calculating EOQ.

Minimize inventory costs

Storing extra inventory can quickly increase storage costs. Inventory
costs can also go up depending on how you order, what gets damaged,
and what products never sell. If you’re constantly re-ordering products

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that have low velocity, EOQ can help determine how much to order in a
certain time period.

Minimize stockouts
EOQ can help you better understand how much you need to re-order
and how often. By calculating how much you need based on how much
you sell in a given period of time, you can avoid stockouts without
having too much inventory on hand for too long. You may be surprised
that ordering in smaller quantities may be more cost-effective for your
business, or it could be the opposite — calculating EOQ can help
determine this.

Improve overall efficiency

Overall, calculating EOQ can help you make better decision when it
comes to storing and managing inventory. The truth is that many
ecommerce business place orders based on a “gut feeling” of how
much to order, instead of actually ordering how much product is
actually needed. Calculating EOQ is a smart way to better quantify how
much you need based on important cost variables.

3 factors you’ll need to calculate EOQ

The EOQ formula is made up of three variables: holding costs,

demand, and order cost. We break down each variable below.
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1. Holding costs (H)
Holding cost (also known as carrying costs) refers to the total cost of
holding inventory. Minimizing inventory costs is an
important retail supply chain management strategy. How much do you
spend on holding and storing inventory, per unit, per year? In order to
properly calculate EOQ, you’ll first need to determine your holding cost.
To do so, you can refer to the simply formula below:
(Storage Costs + Employee Salaries + Opportunity Costs +
Depreciation Costs) / Total Value of Annual Inventory = Inventory
Carrying/Holding Cost

2. Annual demand (D)

How much demand do you get for a product each year? By looking into
historical order data, you can determine how much product you sell
year over year..

3. Order cost (S)

Also referred to as ‘setup cost,’ how much does an order cost per
purchase? This is done on a per-order basis and includes both the
shipping and handling costs.

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  EOQ Assumptions:

 Demand is known & constant - no safety stock is required

 Lead time is known & constant
 No quantity discounts are available
 Ordering (or setup) costs are constant
 All demand is satisfied (no shortages)
 The order quantity arrives in a single shipment

The Formula for Economic Order Quantity (EOQ)

EOQ: Total Cost Equation

 D  Q 
TCEOQ   S    H 
Q   2 
Where
TC  total annual cost
D  annual demand
Q  quantity t o be ordered
H  annual holding cost
S  ordering or setup cost

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1.
2 DS
EOQ 
H

2.
EOQ = Economic Order Quantity,

RU = Annual Required Units,

OC = Ordering Cost for one Unit

UC = Inventory Unit Cost,

CC = Carrying Cost as %age of Unit Cost

How to Calculate the Economic Order Quantity (EOQ)

To calculate the EOQ for inventory you must know the setup costs,
demand rate, and holding costs.
Setup costs refer to all of the costs associated with actually ordering
the inventory, such as the costs of packaging, delivery, shipping, and
handling. Demand rate is the amount of inventory a company sells
each year.
Holding costs refer to all the costs associated with holding additional
inventory on hand. Those costs include warehousing and logistical

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costs, insurance costs, material handling costs, inventory write-offs,
and depreciation.
Ordering a large amount of inventory increases a company's holding
costs while ordering smaller amounts of inventory more
frequently increases a company's setup costs. The EOQ model finds
the quantity that minimizes both types of costs.

Example of Economic Order Quantity (EOQ)

EOQ considers the timing of reordering, the cost incurred to place an

order, and costs to store merchandise. If a company is constantly
placing small orders to maintain a specific inventory level, the ordering
costs are higher, along with the need for additional storage space.
For example, consider a retail clothing shop that carries a line of men’s
shirts. The shop sells 1,000 shirts each year. It costs the company $5
per year to hold a single shirt in inventory, and the fixed cost to place
an order is $2.
The EOQ formula is the square root of (2 x 1,000 shirts x $2 order cost)
/ ($5 holding cost), or 28.3 with rounding. The ideal order size to
minimize costs and meet customer demand is slightly more than 28
shirts.
EOQ Example (Lecture Note Presentation)

 Weekly demand = 240 units

 No. of weeks per year = 52
 Ordering cost = $50
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  Unit cost = $15
 Annual carrying charge = 20%
 Lead time = 2 weeks
EOQ Example Solution

D  52  240  12,480 units / year

H  0.2 15  $3 per unit per year

2DS 2 12,480  50
Q   644.98  645 units
H 3

 D   Q   12,480   645 
TC   S    H     50     3
 Q   2   645   2 
 967.44  967.5  $1,934.94

R  dL  240  2  480 units

Disadvantages of Using Economic Order Quantity (EOQ)

The basis for the EOQ formula assumes that consumer demand is
constant. The calculation also assumes that both ordering and holding
costs remain constant. These assumptions make it difficult, if not
impossible, to account for unpredictable business events, such as
changing consumer demand, seasonal changes in inventory costs, lost
sales revenue due to inventory shortages, or purchase discounts a
company might get for buying inventory in larger quantities.

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Other factors that can optimize inventory

Things like seasonality or big sales can also affect your inventory
accuracy. In addition to EOQ, there are a few other ways to optimize
inventory.

Reorder points
Instead of manually checking inventory levels to reorder products, you
can set automatic reorder points that automatically place an order once
your inventory levels hit a certain threshold. Investing in an inventory
management software or partnering with a 3PL) makes this easy to do.

Safety stock measurements

There are times when demand can increase suddenly or there are
issues with a supplier that can prevent you from having enough
inventory. Safety stock is simply extra inventory beyond the expected
demand. Safety stock is also often used during busy shopping seasons
like the holidays or during a big promotion or flash sale.

Real-time inventory tracking

Easily monitor your and control stock levels and know where products
are stored in your warehouse by tracking inventory in real-time. That
way, you know how much product can be shipped now, make faster
inventory ordering decisions, and communicate any delays of out-of-
stock items quickly.

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