The concepts of Just-in-Time (JIT) and Lean have led many to question the continued relevance of Economic Order Quantity (EOQ), whose function is to identify the optimum order with the lowest cost parameter.
In response, yes, it is still valid as a basic analytic tool, however, many supply chain industry executives perceive it as “old school” or don’t even know about it. My experience has shown that many individuals and some companies cannot apply it—even if they wanted to—because they do not know their acquisition costs to place an order or their yearly inventory carrying cost rate.
EOQ is used today despite its highly restrictive assumptions that: demand is relatively constant and is known or predictable; the item is purchased in lots or batches and not continuously; the order and preparation costs (acquisition or purchase cost per order) and the inventory carrying costs are constant and known; and replacement of inventory occurs all at once. And knowing how to apply EOQ practically is just as important as being able to use the formula calculation itself.
Determine your metrics
EOQ involves determining the optimal quantity to purchase when orders are placed. For example, small orders result in low inventory levels and inventory carrying costs, frequent orders and higher ordering costs; while large orders result in higher inventory levels and inventory carrying costs and infrequent orders and lower ordering costs.
Alarmingly, many companies have never determined their cost of placing and processing a single purchase order (e.g., the time and extra cost to send in an order for an item, receive it, handle the supplier’s invoice and pay for it). This cost of placing and processing a single paper-based purchase order (PO) is often substantial—in the range of $35 to $200 per PO. The cost impact of placing and processing a single PO in many instances is further aggravated by the higher receipt handling processing and inbound freight charges that may incur for smaller and more frequently delivered orders. Worse yet is that some companies only use the holding cost as the extra cost of money invested in stock rather than an inventory carrying cost (ICC) rate. Normally, the holding cost portion is the actual out-of-pocket expense for money borrowed from a bank or interest which varies with the prime borrowing rate. For others, the holding cost may constitute the imputed “opportunity cost” on the use of equity capital earned by investing it in a high yielding security.
Ideally, the ICC should include the holding cost plus:
- Taxes paid on inventory
- Insurance on stock
- Stock quantity shrinkage losses due to handling, pilferage or theft
- Stock risk losses due to product obsolescence, deterioration or shelf life expiration
- Storage space occupancy
Advantageously, EOQ is very insensitive to parameter errors because those errors are muted by the presence of the square root function in the EOQ formula. Such insensitivity is advantageous whenever EOQs are computed with imprecise estimates, forecasts or costs. Can you remember the last time you worked with a valid forecast? By being insensitive to parameter errors, EOQs can be rounded off without a significant loss in economies; order sizes can be increased or decreased to the nearest pack, minimum, or unit of measure (UOM); and order intervals can be lengthened or shortened to the next interval. By way of example, EOQ suggests fractional values for things which come in discrete units, i.e. 2.7 truckloads or where suppliers are unwilling to split standard package sizes.