Economic Order Quantity Model (EOQ)

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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. In 1913, Ford W. Harris developed this formula whereas R. H. Wilson is given credit for the application and in-depth analysis on this model.

Definition

The economic order quantity (EOQ) is a model that is used to calculate 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.

Formula

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

EOQ.png

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

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

  • The cost of the ordering remains constant.
  • The demand rate for the year is known and evenly spread throughout the year.
  • The lead time is not fluctuating (lead time is the latency time it takes a process to initiate and complete).
  • No cash or settlement discounts are available, and the purchase price is constant for every item.
  • The optimal plan is calculated for only one product.
  • There is no delay in the replenishment of the stock, and the order is delivered in the quantity that was demanded, i.e. in whole batch.

These underlying assumptions are the key to the economic order quantity model, and these assumptions help the companies to understand the shortcomings they are incurring in the application of this model. 

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Quote Guest, 6 September, 2013
thanks but what if there is quantity discount
Quote Guest, 20 September, 2013
thanks it is understandable
Quote msk king, 31 October, 2013
is there consider , half of order quantity as safety stock ?
Quote Mahendra Joshi, 6 November, 2013
How can i calculate the cost incurred to place a single order ?
Quote Sarath, 26 November, 2013
Thank you for the nice explanation...;)
Quote Guest, 20 January, 2014
good job
Quote Guest, 30 April, 2014
Thanks for the brief explanation.
Quote Guest, 14 May, 2014
A firm consumes annually 12500 small screws at an even rate of 2500 per week. The cost of the screw is N40.00 per 1,000. The cost of placing an order irrespective of the quantity ordered is N50.00. The risk obsolescence is negligible and the cost of storage has been estimated atN10.00 per 1,000 screws per annum. the firm's minimum required rate of return on capital is 20%
ROQ:
(1) Calculate the EOQ and state the optimum ordering policy from supplier who can guarantee immediate delivery
(2) State the change required in the re=ordering policy if there were a lead time of two weeks.
Quote
Guest wrote:
in what types of inventories can the EOQ and order level policies be used
Quote Guest, 2 May, 2015
Very satisfactory explanation...  Thanx

Short and sweet
Quote Guest, 6 January, 2016
Thanks
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