ECONOMIC ORDER

QUANTITY
 INVENTORY

store of goods or materials that are waiting to be used

considered as one of the most expensive and important
assets of the company
 Five basic costs associated with inventories:

Cost of the items

Cost of ordering
Cost of carrying, or holding inventory
Cost of safety stock
Cost of stockouts
Cost of the items

base cost or the amount paid for the certain

items acquired from the suppliers.
Ordering or Setup Cost
are the expenses incurred to create and process an order to a
supplier

Examples:
Cost to prepare a purchase requisition
Cost to prepare a purchase order
Cost of the labor required to inspect goods when they are received
Cost to put away goods once they have been received
Cost to process the supplier invoice related to an order
Cost to prepare and issue a payment to the supplier
Ordering or Setup Cost
Formula:

Annual Ordering Cost = (no. of orders placed per

year)(order cost per order)

Number of Orders = Annual Inventory/Economic

Order Quantity
Holding or Carrying Cost
the expense associated with holding inventory over
a period of time.

Examples:
capital cost
obsolescence cost
deterioration cost
taxes on inventory
insurance cost
storage & handling cost
Holding or Carrying Cost

Formula:

Annual Holding or Carrying Cost

= (Order Quantity/2)(Cost per unit per year)
(% of Carrying Cost)
Cost of Safety stock
is the additional carrying cost held by a company in
order to prevent stockouts.

Formula:
Safety Stock = (Maximum Daily Usage Average
Daily Usage) Lead Time

>Lead Time - is the time which supplier takes in

ordering the items.
Cost of stockouts
is the loss which occurs or which may
occur due to non availability of material.
It includes break down, delay in
production, back ordering, lost sales, loss
of service to customers, loss of goodwill
and etc.
 Annual Cost of Inventory

sum of the annual ordering cost and annual carrying cost

Formula:
Total Annual Inventory Cost = Total Annual Ordering Cost +
Total Annual Carrying Cost
Economic order quantity
Lets say your friend James James can buy the basketballs at
wants to buy basketballs from a $10 each from the factory, and
factory & sell them to his he plans to sell it in his
neighbourhood. neighbourhood shop for $20
each. He estimates hell sell
about 1,200 basketballs/year

REVENUE = 1,200 * $20= $24,000

COST = 1,200 * $10 = $12,000
$12,000
Economic order quantity
At first, James thought of just
buying around 100 basketballs
per month which will equal his
1,200 basketballs by the end of
the year.
However the factory charges
him a $90 ordering fee every
time he makes an order. (
Ordering cost or setup cost)

Annual ordering cost

= $90 * 12 months = $1080
Economic order quantity
So James comes up with a Where do we keep that many
clever plan of basketballs.

He needs to rent extra space from

his greedy rich neighbour who has
Ill just order all 1,200 a big garage. For any extra space
only once for the whole just enough to store a 1 basketball,
year , so Ill jus pay $90 his neighbour charges $3 per year .
instead of $1,080 ( Holding cost per unit per year,)

Annual Holding or carrying cost

1200*$3= $3,600
Economic order quantity
If James order s too few
then the number of order
would be more frequent,
meaning higher setup cost
If James orders too much
then holding cost would be
higher.
So what should James do
now?
What is the best number of
baketball should James
order at one time? Economic
order quantitity
Economic order quantity
To find out the best or
optimal number of
basketballs that James
should order at one time,
we use this formula:

EOQ=(2*1,200*90)
3
EOQ = 72,0000
EOQ=268.33 or 269 units
Economic order quantity
How to check for optimal solution?
Annual Holding or carrying cost= Annual ordering cost
Annual holding cost
=(72,000/2)($3)
=$402.49

Annual ordering cost

=(1,200/72,000)(90)
=$402.49
OTHER EXAMPLES
Other example.

The Plus! Corp. has a juice product that has a

constant annual demand rate of 200,000 boxes.
A box of juice costs Fresh Corp. 360.00.
Ordering cost is 330.00 per order and
inventory carrying cost is charged at 20% of
the cost per unit. Calculate the economic order
quantity, annual ordering cost, annual carrying
cost and total annual inventory.
Other example.
Other example.
Other example.

The Brown Sugar Corporation sells baking supplies

to Foodies over the Internet. The companys largest
selling is Louisiana Hot Brown Sugar. The company
wants you to determine the optimal order size of
Louisiana Hot, given an annual demand of 10,400
pounds, a carrying cost of Php 2.00 per pound, and
ordering cost of Php 200.00 per order. In addition,
the President, Mr Elias has asked you for the total
cost (annual).
Other example.

Given:

Annual Demand (D) = 10,400 annually

Carrying cost (CL) = php 2.00 per pound
Order cost (CO) = php 200.00 per pound
Other example.

Required:

EOQ (Q)
= 2 (annual demand) (cost per order) / carrying cost

Total Annual Inventory Cost

= total annual ordering cost + total annual carrying cost
Other example.

Solution:

EOQ
2[(10,400)(200)]
= 2 = 1,442.22
4,160,00
= 2

= 2,080,000
Other example.

Solution:

Total annual inventory cost

= total annual ordering cost + total annual carrying cost
= [(Q/2) CL] + [(D/Q) CO)
= [(1,442.22 / 2) 2] + [(10,400 / 1,442.22) 200]
= 1,442.22 + 1,442.22
= 2,884.44 Where in:
Ordering cost = no. of orders placed per year (order cost per order)
Carrying cost = average inventory (per unit carrying cost)
OTHER EXAMPLES
(WITH DISCOUNTS)
Quantity Discount Model

Reduced places & larger

quantities.
Trade off
Q* = EOQ
D = Annual Demand
S = Set up or Ordering Cost
H = Holding or Carrying Cost
P = Purchase Cost
FORMULA:

TC= S + H + P*D

or
Total Annual Cost= Annual Setup cost + Annual Holding cost + Purchase Cost
Steps in Quantity Discount

1. For each discount, calculate first the Economic Order

Quantity.
2. If EOQ for a discount doesnt qualify, choose the smallest
possible order size to get discount.
3. Compute the total cost for each EOQ or adjusted value from
step 2.
4. Select the EOQ that gives the lowest total cost.
Example:

A & Q Distributors has an annual demand of

7000 paper slicer. The cost of a typical paper
slicer to A & Q Distributors is P2000. Carrying
cost is estimated to be 20% of the unit cost,
and the ordering cost is P125 per order. If A & Q
Distributors orders in quantities of 300 or more,
it can get a 5% discount on the cost of paper
slicers. Should A & Q Distributors take the
quantity discount?
GIVEN:
Annual demand (D) 7000
Carrying Cost (Cl ) 125
Cost per order (Co) 2000
Percentage of Cl 20%
 2( )( )
EOQ= (% )( )

270002000
EOQ =
.20 (125)

28000000
EOQ =
25

EOQ = 66.14 or 66
Total Annual Cost = AOC + ACC + P*D
= (66/2) * 2,000 + (7,000/66) * 125 + 0*7000
= 211,660.10 + 826.79 + 0
= P 212,486.79
Example:

GSB Department Store stocks toy cars. Recently, the

store was given a quantity discount schedule for the
cars. The normal cost for the car is P5.00. For orders
between 1,000 to 1,999 units, the cost is P4.80, and
for orders of 2,000 or more units, the unit cost is
P4.75. The ordering cost is P49 per order, the annual
demand is 5,000 race cars and the inventory carrying
charge as a percentage of cost, is 20%. What order
quantity will minimize the total cost?
Given:
D= 5,000 units
S= P 49
% of H = 20%
H = % of H * P

Q*=
 2(5000)(49)
Q1*=
.2(5.00) = 700 cars/order

2(5000)(49)
Q2*= .2(4.80) =
714 cars/ order = 1,000 adjusted

2(5000)(49)
Q3*= 718 cars/order = 2,000 adjusted
.2(4.75) =
 Discount Unit Price Order Annual Annual Annual Total Cost
Number Quantity Ordering Holding Product
Cost Cost Cost

1 P5.00 700 P25,000 P350 P350 P25,700

2 P4.80 1000 P24,000 P245 P480 P24,725

3 P4.75 2000 P23,750 P122.50 P950 P24,822.50

*Choose the Price and Quantity that gives lowest total cost.

BUY 1,000 units at P4.80 per units.