Economic order quantity
Economic order quantity is an optimal order quantity that minimizes the total inventory cost for instance holding cost and ordering cost. In inventory management economic order quantity that minimizes the total holding cost and ordering cost. It is the one of the old classical production scheduling models. The model was developed by Ford .W. Harris in 1913 but R .H. Wilson a consultant who applied it extensively and R. Andler are given credit for their depth analysis,
Examples of using EOQ
EOQ is determined as follows EOQ =
C = ordering cost per order
h = holding cost per
item per annum
For example
A factory requires
1,5oo units of an item per month. The cost of each unit is Tsh 2,700. The cost
per order is Tsh.15,000 and material carrying cost is 20% of the price per item
per annum.
Required: Calculate the
EOQ
Solution: Q=
Workings: d= 15,000 x 12 = 18,000 units
=
= 1000 units
EOQ takes into account
the timing of re-ordering, the cost incurred to plce an order and costs to
store merchandise. If the company is constantly placing small orders to maintain
a specific inventory level, the ordering cost are higher, along with the need
for additional storage space. Assume for example a retail clothing shop carries
a line of min jeans and the shop shells 1,000 pairs of jeans each year. It
costs the company $ 5 per year to hold a pair of jeans in inventory and the
fixed cost to place an order is $ 2. Therefore the EOQ formula is the square
root of (2x1000 pair x $2 order cost) / ( $5 holding cost) or 28.3 with
rounding. The ideal order size to minimize costs and meet customer demand
slightly more than more than 28 pairs of jeans. A more complex portion of the
EOQ formula provides the re-order point.
The following are the
roles of economic order quantity in the process of minimizing inventory cost,
Minimizes storage and
holding costs, inventory may be expensive for small business owners. The main
advantage of the EOQ model is the customized recommendations provided regarding
the most economical number of units per orders. The model may suggest buying a
larger quantity in fewer orders to take advantage of discount bulk buying and
minimizing order cost. Alternatively, it may point to more orders of fewer
items to minimize holding costs if they are high and ordering costs are
relatively low.
Specific to the
business, maintaining sufficient inventory levels to match customer demand is a
balancing act for many small businesses. Another advantage of the EOQ model is
that it provides specific numbers particular to the business regarding how much
inventory to hold, when to re-order it and how many items to order, This smooth
out the restocking process and results in better customer services as inventory
is available when needed.
The EOQ formula can be
used to calculate a re-order point which is a level of inventory that triggers
the need to place an order for more inventory. By determining a re-order point.
The business avoids running out of inventory and is able to fill all customer
orders. If the company runs out of inventory, there is a shortage cost which is
the revenue cost, because the company does not fill an order. Having an
inventory shortage may also mean the company loses the customer or the client
orders less in the future.
Economic order quantity is an
important tool for management to minimize the cost of inventory and the amount
of cash tied up in the inventory balance. For many companies, inventoryis the
largest asset owned by the company and these business must carry sufficient
inventory to meet the needs of customers. If EOQ can help to minimize the level
of inventory the cash savings can be used for some other business purpose
investment.
Generally, Economic
order quantity is an important tool in reducing inventory cost. Although it has
advantage in reducing cost Economic order quantity have challenges such as
involving complicated math calculations, it requires good understanding of
algebra also, Economic order quantity based on assumptions for instance it
assumes steady demand of a business product and immediate availability of items
to be re-stocked.
References;
1. Hax, AC; Candea, D.
(1984), production and operation management, Englewood Cliffs, NJ;
prentice-Hall P,135.
2. North Carolina State
University; Economic order quantity MODEL- Inventory management models: A
Tutorial.
3. Inc; Economic order
quantity (EOQ).
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