Economic Order Quantity

The optimal quantity that can be purchased or produced to

minimize the cost of both the carrying inventory and the
processing of purchase orders or production set-ups.
There are two categories of inventory costs

a. Ordering cost
i. The costs that are incurred on obtaining additional inventories
ii. They include costs incurred on communicating the order,
transportation cost, etc.

b. Carrying cost
iii. The costs incurred on holding inventory in hand
iv. They include the opportunity cost of money held up in
inventories, storage costs, spoilage costs, etc.
Comparison
Ordering costs and carrying costs are quite opposite to each other
If we need to minimize carrying costs we have to place small
order which increases the ordering costs
If we want minimize our ordering costs we have to place few
orders in a year and this requires placing large orders which in
turn increases the total carrying costs for the period
We need to minimize the total inventory costs and EOQ model
helps us just do that
Total inventory costs = Ordering costs + Holding costs
By taking the first derivative of the function we find the following
equation for minimum cost
EOQ = SQRT (2XQuantityx Cost Per Order/Carrying Cost Per Order)
Example
ABC Ltd. is engaged in sale of footballs. Its cost per order is $400 and its carrying cost
unit is $10 per unit per annum. The company has a demand for 20,000 units per year.
Calculate the order size, total orders required during a year, total carrying cost and total
ordering cost for the year.
Solution

EOQ=

Where, Q = optimal order quantity

D = units of annual demand
S = cost incurred to place a single order or setup
H = carrying cost per unit

This formula is derived from the following cost function:

Total cost = purchase cost + ordering cost + holding cost
Continued
EOQ = SQRT (2 20,000 400/10) = 1,265 units
Annual demand is 20,000 units so the company will have to place
16 orders (= annual demand of 20,000 divided by order size of
1,265). Total ordering cost is hence $64,000 ($400 multiplied by 16)
Average inventory held is 632.5 ((0+1,265)/2) which means total
carrying costs of $6,325 (i.e. 632.5 $10)

Limitations of the economic order quantity model:

It is necessary for the application of EOQ order that the demands
remain constant throughout the year. It is also necessary that the
inventory be delivered in full when the inventory levels reach zero