Economic Order Quantity Model (EOQ)

As the name suggests, Economic order quantity (EOQ) model is the method that provides the company with an order quantity. This order quantity figure is where the record holding costs and ordering costs are minimized. By using this model, the companies can minimize the costs associated with the ordering and inventory holding. EOQ model was first developed by an American management scientist named F. W. Harris in 1913. He published it in the article "Economic Lot Size in Purchasing" in the journal "Journal of the American Statistical Association". The EOQ model is considered to be one of the earliest and most widely used quantitative models in inventory management. It is still widely used today by businesses and organizations to optimize their inventory management.

Definition

Economic Order Quantity (EOQ) is a model used to calculate the optimal quantity that can be purchased or produced to minimize the cost of carrying inventory and processing purchase orders or production setups.

EOQ is used in inventory management to determine the optimal order quantity that a company should purchase in order to minimize the total cost of ordering and holding inventory. It is commonly used in manufacturing and retail industries to balance the trade-off between the cost of ordering inventory and the cost of holding inventory. This model is used to determine the optimal order quantity, the optimal reorder point, and the total inventory cost.

Formula

Following is the formula for the economic order quantity (EOQ) model:

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

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.

Underlying Assumption of the EOQ Model

The following are the assumptions underlying the EOQ model. Without these assumptions, the EOQ model cannot work to its optimal potential.

• The cost of the order remains constant.

• The demand rate for the year is known and evenly distributed throughout the year.

• Lead time does not vary (lead time is the latency time it takes to initiate and complete a process).

• There are no cash or settlement discounts, and the purchase price is constant for each item.

• The optimal plan is calculated for only one product.

• There is no delay in replenishing inventory, and the order is shipped in the quantity demanded, i.e., in full.

These basic assumptions are the key to the Economic Order Quantity model, and these assumptions help companies understand the shortcomings they incur in applying this model.

Advantages of EOQ Model

Economic Order Quantity (EOQ) is a model used to determine the optimal order quantity for a company to purchase or produce in order to minimize the total cost of inventory. The main benefits of using EOQ include:

1. Minimization of total inventory cost: EOQ helps minimize the total cost of inventory by finding the optimal order quantity that balances the costs of ordering and holding inventory.

2. Efficient use of resources: EOQ helps ensure that resources are used efficiently by minimizing the number of orders placed and the amount of inventory held.

3. Improved forecasting: EOQ can help companies make more accurate forecasts of future demand by taking into account factors such as lead time, carrying costs, and ordering costs.

4. Simplicity: EOQ is a relatively simple model that is easy for companies to understand and implement.

5. Flexibility: EOQ can be easily adapted to consider specific factors such as inflation, changes in demand or cost, and other variables that may affect inventory decisions.

Disadvantages of EOQ

Economic Order Quantity (EOQ) model has some limitations and disadvantages, including:

Assumptions: The EOQ model assumes that demand is constant and known, lead time is constant and known, and there is no stockout or backorder costs. These assumptions are often not met in real-world situations, which can result in inaccurate results.

Ignores price changes: The EOQ model does not consider changes in the price of the item being ordered, which can have a significant impact on the optimal order quantity.

Does not consider quantity discounts: Many suppliers offer quantity discounts for large orders. The EOQ model does not take into account these discounts and may result in the company ordering less than the optimal amount.

Does not consider the impact of inflation: The EOQ model does not take into account the impact of inflation on the cost of ordering and holding inventory, which can result in inaccurate results over time.

Does not consider the impact of the carrying cost of capital: The EOQ model does not take into account the carrying cost of capital when determining the optimal order quantity.

Does not consider the impact of various transportation costs: EOQ model does not consider the impact of various transportation costs.

It is important to keep in mind that EOQ is a model and it should be used as a guide and not a definitive solution, the results should always be compared with the real-world situations.