Xavier Institute of Management, Jabalpur (M.P.

An assignment on Economic Order Quantity in Production and Operations Management.

Submitted to: Mr. MehulChauhan Submitted by: Sujit Dutta Mazumdar Roll No.: Batch: 57 PGDM-II (2011-13)

INTRODUCTION: Economic ordering quantity was first developed by Ford. W. Harris in 1916. As we know that every company worries about two things when deciding how to manage their inventory i.e. how much should we order? And how often should we order? These represent variables that come with their own changing costs. The Economic Order Quantity, or EOQ, is that number that represents the optimal quantity of orders that minimizes total variable costs required to order and hold inventory. The EOQ helps us to determine the appropriate amount and frequency when ordering and holding inventory. Let me show you how this helps a business.

For most businesses, there is a large amount of inventory that has a constant unit price and a known demand rate that happens every month. But holding too much or ordering too often will increase our holding and purchasing costs. So, the question arises, how much should we order each month? The solution is to use the EOQ model. We can use the EOQ model to determine the quantity of that inventory that should be purchased at each time we place an order to minimize the purchasing and holding costs of this item.

DEFINITION OF EOQ:

Economic order quantity (EOQ) is that size of the order which gives maximum economy in purchasing any material and ultimately contributes towards maintaining the materials at the optimum level and at the minimum cost. Thus,EOQ is the balance of the cost of carrying versus the cost of ordering.In other words, the economic order quantity (EOQ) is the amount of inventory to be ordered at one time for purposes of minimizing annual inventory cost.

The formula of calculating EOQ is:

EOQ =

2 x Annual Demand x Average Cost of order Penetration Annual Carrying Cost Percentage x Unit Cost

Or EOQ = 2xAxS IxC

Ordering costs consists of costs associated with requisitioning, ordering, tracking, expediting, and receiving. Physical handling costs are also a part of the ordering costs. Other ordering costs are machine set ups, scheduling costs, accounts payable, production control, purchasing, inspection, and yields.

Carrying cost percentages are calculated by applying the per cent against the value of inventory per time period. The yearly per cent is prorated, according to the time span being usedday, week, or month. Carrying costs consist of the following: Cost of Money Taxes Insurance Obsolescence Shrinkage and deterioration Scrap Damage Theft Rent Utilities Warehouse Stockroom Personnel Maintenance Building and Equipment Security Carrying Costs can vary from 18% to 35%, depending on the tax base and the location of the property. Economic Order Quantity is used to determine lot sizes. Assumptions made are: A known annual usage Receipt of a whole lot size at a specified time Constant Usage rate Usage in small increments Accurate costs

Disadvantages of using the Economic Order Quantity formula in determining the order size:

Erratic usages: The formulae we have used assumed that usages of materials are both predictable and evenly distributed. When this is not the case, the formulae are useless. Different and far more complex formulae can be developed for wide swings in usage, so long as these swings can be predicated. But if usage varies unpredictably as it often does, no material will work. Faulty Basic Information: EOQ calculations are only as accurate as the order cost and carrying cost information in which they are based. It is no easy job to calculate order cost. In practice, order cost varies from commodity to commodity. Carrying cost can vary with the companys opportunity cost of capital. Costly Calculations: it is not easy job to estimate cost of acquisition and cost of possession accurately. This requires hours of work by skilled cost accountants. Actual calculation of EOQ can be time-consuming even when the simple formulae for steady usage are used.

No formula is Substitute for commonsense: it is therefore desirable to include a number of modifiers. The formula may suggest that we order six years supply, based on the assumption that we will continue to require the item at the same rate for the next six years. The modifier is a maximum limit, not more than one years supply. Or two years supply perhaps. It may suggest that we order every week, for these volumes we would adopt a different ordering method. EOQ ordering must be tempered with judgment: certain corporate operating goals must be followed in managing an inventory. Sometimes, the guidelines provide a conflict in ordering. Where an order strategy conflicts with an operating goal, order strategy restrictions should be developed to permit honoring the goal. Materials Requirement Planning (MRP): MRP is the new solution to an old problem having stock of materials always on hand when needed without carrying access inventory. Highly depend upon computer technology. The annual usage is normally not predictable and is uncertain for MRO parts and operating supplies. The annually usage becomes just a number that cannot be substantiated. At times the shipment may be separated into more than one. The consistency of the economic order quantity is broken, and the data skewed. Under most circumstances, there is no uniform rate of demand, so the usage rate varies. Smaller lot sizes are more difficult to predict using the Economic order quantity. Because of the unpredictability, costs are harder to calculate and predict.

Advantages of using the Economic Order Quantity formula in determining the order size:

The economic order quantity (EOQ) is the order quantity that minimizes total holding and ordering costs for the year. Even if all the assumptions dont hold exactly, the EOQ gives us a good indication of whether or not current order quantities are reasonable. EOQ technique is highly useful in as much it answers the question of how much to order and in so doing establishes the frequency with which orders are placed. EOQ is applicable to both single items and to any group of stock items with similar holding and procurement costs. Its use causes the sum of the two costs to be lower than under any other system of replenishment. An inventory-related equation that determines the optimum order quantity that a company should hold in its inventory given a set cost of production, demand rate and other variables. This is done to minimize variable inventory costs. While EOQ may not apply to every inventory situation, but most organizations will find it beneficial in at least some aspect of their operation. Anytime we have repetitive purchasing or planning of an item, EOQ should be considered. Obvious applications for EOQ are purchase-to-stock distributors and make-to-stock manufacturers, however, make-to-order manufacturers should also consider EOQ when they have multiple orders or release dates for the same items and when planning components and sub-assemblies. Repetitive buying, maintenance, repair, and operating (MRO) inventory is also a good application for EOQ. Though EOQ is generally recommended in operations where demand is relatively steady, items with demand variability such as seasonality can still use the model by going to shorter time periods for the EOQ calculation.

Limitations of Economic Order Quantity: The EOQ derived in equation has 2 limitations on account of the restrictive assumptions made. The cost assumptions are rational and are not found in real life. The unit cost of purchased varies in practice. The lead time is not constant. The demand is erratic. The rate of consumption is not uniform. The application, therefore, of this formula, as it is not possible. Discount on quantity also distort the formula. Lead time variation is pretty common. If the usage rate is not uniform there will be stock outs. The formula will have to adapt to meet these limitations, but then it becomes complicated.

References:

Sharma, S. D. (2005), Operations Research,KedarNath Ram Nath& Co. New Delhi. http://www.investopedia.com/terms/e/economicorderquantity.asp#axzz1ozEMD0Qxaccessed on 12/03/12 http://smallbusiness.chron.com/advantages-disadvantages-economic-order-quantity-eoq35025.htmlaccessed on 12/03/12 Aswathappa,K, (2010), Production and Operations Management, Himalaya Publishing House, Mumbai