PL-­‐5

EOQ  MODEL  
 
Economic   order   quantity   is   the   order   quantity   that   minimizes   total   inventory   holding  
costs  and  ordering  costs.  It  is  one  of  the  oldest  classical  production  scheduling  models.    
Ford  W.  Harris  developed  the  model  in  1913,  but  R.  H.  Wilson,  a  consultant  who  applied  
it  extensively,  is  given  credit  for  his  in-­‐depth  analysis.  
 
We   want   to   determine   the   optimal   number   of   units   to   order   so   that   we   minimize   the  
total  cost  associated  with  the  purchase,  delivery,  and  storage  of  the  product.    
 
The  required  parameters  to  the  solution  are  the  total  demand  for  the  year,  the  purchase  
cost  for  each  item,  the  fixed  cost  to  place  the  order,  and  the  storage  cost  for  each  item  
per  year.    
Note  that  the  number  of  times  an  order  is  placed  will  also  affect  the  total  cost,  though  
this  number  can  be  determined  from  the  other  parameters.  
 
Underlying  assumptions  are:  
 
-­‐The  ordering  cost  is  constant.  
-­‐The  rate  of  demand  is  known,  and  spread  evenly  throughout  the  year.  
-­‐The  lead-­‐time  is  fixed.  
-­‐The  purchase  price  of  the  item  is  constant  (i.e.,  no  discount  is  available).  
-­‐The  replenishment  is  made  instantaneously;  the  whole  batch  is  delivered  at  once.  
-­‐Only  one  product  is  involved.  
 
Variables  for  the  function  are:  
 Q  =  order  quantity,    
Q*=  optimal  order  quantity,    
D  =  annual  demand  quantity,    
S   =   fixed   cost   per   order   (not   per   unit,   typically   cost   of   ordering   and   shipping   and  
handling.  This  is  not  the  cost  of  goods),    
H   =   annual   holding   cost   per   unit   (also   known   as   carrying   cost   or   storage   cost)  
(warehouse  space,  refrigeration,  insurance,  etc.,  usually  not  related  to  the  unit  cost).  
 
The  single-­‐item  EOQ  formula  finds  the  minimum  point  of  the  following  cost  function:  
 
TC=P*D+(D/Q)*S+(Q/2)*H  
 
Total  Cost  =  purchase  cost  +  ordering  cost  +  holding  cost  
 
Purchase  cost:  This  is  the  variable  cost  of  goods:  purchase  unit  price  ×  annual  demand  
quantity.  This  is  P×D.  
Ordering  cost:  This  is  the  cost  of  placing  orders:  each  order  has  a  fixed  cost  S,  and  we  
need  to  order  D/Q  times  per  year.  This  is  S  ×  D/Q.  
Holding  cost:  the  average  quantity  in  stock  (between  fully  replenished  and  empty)  is  
Q/2,  so  this  cost  is  H  ×  Q/2.  
To  determine  the  minimum  point  of  the  total  cost  curve,  partially  differentiate  the  total  
cost  with  respect  to  Q  (assume  all  other  variables  are  constant)  and  set  to  0,  then  we  
obtain:  
 
 
2* D* S
Qopt =
H  
 
 
 
€
Figure  1  

 
 
 
The   figure   1   describes   the   continuous   inventory   order   cycle   system   inherent   in   the   EOQ  
model.   An   order   quantity,   Q,   is   received   and   is   used   up   over   time   at   a   constant   rate.  
When  the  inventory  level  decreases  to  the  reorder  point,  R,  a  new  order  is  placed,  and  a  
period   of   time,   referred   to   as   the   lead   time,   is   required   for   delivery.   The   order   is  
received   all   at   once,   just   at   the   moment   when   demand   depletes   the   entire   stock   of  
inventory  (and  the  inventory  level  reaches  zero),  thus  allowing  no  shortages.  This  cycle  
is  continuously  repeated  for  the  same  order  quantity,  reorder  point,  and  lead  time.  
 
As   we   mentioned   earlier,   Q   is   the   order   size   that   minimizes   the   sum   of   carrying   costs  
and   holding   costs.   These   two   costs   react   inversely   to   each   other   in   response   to   an  
increase  in  the  order  size.  As  the  order  size  increases,  fewer  orders  are  required,  causing  
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the   ordering   cost   to   decline,   whereas   the   average   amount   of   inventory   on   hand  
increases   ,   resulting   in   an   increase   in   carrying   costs.   Thus,   in   effect,   the   optimal   order  
quantity  represents  a  compromise  between  these  two  conflicting  costs.  
 
If  we  represent  the  costs  curves,  as  figure  2  shows  the  general  upward  trend  of  the  total  
carrying   cost   curve.   As   the   order   size   Q   (shown   on   the   horizontal   axis)   increases,   the  
total   carrying   cost   (shown   on   the   vertical   axis)   increases.   This   is   logical   because   larger  
orders   will   result   in   more   units   carried   in   inventory.   Next,   observe   the   ordering   cost  
curve.  As  the  order  size,  Q  ,increases,  the  ordering  cost  decreases  (just  the  opposite  of  
what  occurred  with  the  carrying  cost).  This  is  logical  because  an  increase  in  the  size  of  
the  orders  will  result  in  fewer  orders  being  placed  each  year.  Because  one  cost  increases  
as  the  other  decreases,  the  result  of  summing  the  two  costs  is  a  convex  total  cost  curve.  
 
Figure  2  

 
 
An  example  is  presented  to  illustrate  the  application  of  this  model  EOQ:    
 
D:  Annual  demand  =  6,000  units    
S:  Cost  of  Emission  =  750  Euros    
H:  Annual  Storage  Cost  (per  unit)  =  400  Euros    
 
Substituting  the  parameters  in  the  formula  is  obtained    
 
Q*   =   150   [units   /   order]   is   the   order   quantity   that   minimizes   the   annual   cost   of  
inventory.    
 
CT  =  (6,000  /  150)  *  750  +  (150/2)  *  400  =    60,000.  Eurps  
 
You   can   confirm   that   any   order   quantity   provides   an   annual   cost   greater   than   that  
obtained  with  EOQ  inventory.    
 
This  is  because  the  size  of  the  order  obtained  explicitly  EOQ  balances  order  costs  with  
the  costs  of  storage.    
 
Note   that   for   sizes   of   "large"   order   issuance   costs   are   minimized   (will   require   fewer  
orders   in   the   year)   and   storage   costs   are   maximized   (as   a   higher   average   inventory   in  
stock  will).    
Similarly,   for   "small"   orders   issuance   costs   are   maximized   while   storage   costs   are  
minimum.