EOQ (and its derivatives) is used particularly in companies that deal with large volumes of stock as well as purchase-to-stock distributors and make-to-stock manufacturers. These are businesses that have multiple orders, specific release dates for their products and have requirements plan for their components. For manufacturers, EOQ is particularly applicable if the product utilizing the raw materials has a simple process structure and is produced continuously over time at a fairly uniform rate. By way of example, a chemical process manufacturer requires only a few major ingredients to yield a finished product because economic production run sizes are known and the production rate is relatively constant over a long time period. Therefore, many materials can be ordered in bulk on a quarterly or annual basis in container load, railcar load or truckload quantities. Additionally, business candidates for EOQ applications are those that have a steady demand for stock such as maintenance, repair and operating inventory (MRO). Such suitable candidates can include manufacturers with a highly repetitive production process with long runs; while retailers and high technology providers are the least likely candidates.
EOQ for order management
When using EOQ, it’s easy to understand that your total cost will increase if you order too much or too little of a stock item. Very simply, raising your order quantity increases inventory dollar investment and reduces the number of times each year you send in a replenishment order. Conversely, reducing order quantities lowers your inventory dollar investment and increases the number of times each year you send in an order. Remember that EOQ assumes that the entire order for an item is received into inventory at a given time. Whenever the order is received in increments, the EOQ must be revised to account for the change in quantities. These revisions are necessary whenever consumption (or production) simultaneously decreases or increases the stock level. For example, in situations where an item is produced rather than purchased, a variant of EOQ called Economic Purchase Quantity (EPQ) is often used because the lot may not be made available instantaneously. In EPQ, acquisition or purchase processing cost per order is replaced by a set-up cost per order, which is the cost of the time required to prepare the production equipment or work station to do the job and to disassemble it after it is done.
Know when and how to apply the EOQ formula to your business processes using the six guidelines below:
- The EOQ formula applies to products offered at a single price; therefore, if different prices or discounts are offered by your supplier based on quantity purchased, do not use EOQ.
- It works best with normal predictable demand items. If seasonality is involved, EOQ gives you the order quantity independent of the increased or decreased seasonal demand. For items with seasonal demand, you will have to make an adjustment in your demand.
- The EOQ formula assumes the price of goods acquired will not change during the time the order is in stock. If the item being ordered is subject to price volatility or the price is expected to increase or decrease, you should know how to stock ahead before a known upcoming price increase occurs and adjust the EOQ accordingly.
- If you deal in products that require disposition or use by a specified date (a limited shelf life), the EOQ formula may produce an order quantity that will allow on-hand stock to exceed the shelf life, based on the rate of usage or sales.
- The EOQ formula is based on your ability to send in a single order for an item at any time, not multiple items in a batch or group. If you must send in a group of orders or a multiple line buy at once to qualify for some type of volume, trade, or total order discount (or because the supplier will accept only a minimum order size), then you must have the wherewithal to conduct a cost-benefit analysis to determine the basis of a line buy minimum; the amount of benefit that results; and then select those line items to buy which cause the least or minimal extra carrying costs.
- EOQ assumes that freight is included in the purchase price. If not, then it must be added to the purchase price of the item. Hence, under JIT or lean approaches where the on-hand inventory investment may be reduced, the down-side may be a dramatic increase in your inbound freight and receipt handling costs.
Preferred methods for EOQ
JIT will be the preferred method for inventory items with higher purchase price, holding costs or ordering cost. EOQ is great for production where it is consistent, easy to forecast, the demand is fixed and lead times are both known and fixed. Under the concepts of JIT and Lean, EOQ is assumed to produce undesirable results. So let’s check that premise by experientially comparing the inventory costs of purchasing under EOQ with a quantity discount versus those costs under JIT.