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Logistics and Supply Chain World | July 2012

Cover Story
How to Make EOQ Relevant
Again
by Thomas L. Tanel
Determine your product management metrics to apply EOQ in the right supply chain
environments
T
he 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 dont 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 suppliers 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.
Logistics and Supply Chain World | July 2012
15
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.
EOQ adoptability
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 is computed at 316, meaning one will place 6.3
orders annually (Annual Usage 2000/EOQ 316). In
reality, you will place six or seven orders and will order
more or less than the EOQ of 316.
EOQ for order management
When using EOQ, its 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 :
1.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.
2.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.
3.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.
4.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.
5.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 know where 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
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Logistics and Supply Chain World | July 2012
line items to buy which cause the least or minimal extra
carrying costs.
6. 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
EOQ will increase as the annual demand and the cost
of ordering increase and it will decrease as the cost of
carrying inventory and the unit cost increase.
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 lets check that premise
by experientially comparing the inventory costs of
purchasing under EOQ with a quantity discount versus
those costs under JIT.
Experience shows us that at low levels of demand, JIT
is the preferred method, whereas EOQ has the cost
advantage for an item with a high demand. In a lean
environment, inventories are reduced (not allowed
to build up), thereby requiring less storage space and
manpower to receive, count, store, pick and deliver it.
For example, if you reduced your product costs your
EOQ will go up. If the bank interest rates are low, your
lot size will go up. In both of these situations, your
inventory levels will go up which is contradictory to the
expected benefit of a lean operation. On the other hand,
with a lower interest rate you would be able to borrow
at a good interest rate to add more storage space for the
entire excess inventory. Additionally, you would have to
ensure that your inventory carrying costs are reflective
of all the costs of storing that excess inventory.
The sum of its usability
The experienced supply chain practitioner will check
each application of EOQ to be sure that it is valid
for the practical situation at hand. With a thorough
understanding of EOQ, the technique can be used to
yield some of the following benefits by its modification
based on experience :
Establish minimum quantities to reflect a suppliers
minimum purchase of quantities or batches of items
made from one unit of raw material, e.g., steel bar or
sheet
Set a maximum ceiling stock figure for bulky, high
density or difficult-to-handle stock items where storage
space limitations exist
Base adjustments on multiples of packaged lots
(dozens, skids or unit packs), shipment loads (LTL, TL or
FCL), or units of material issue (drums, bundles, pails,
pallets and barrels)
Remember, EOQ balances supplier/vendor order size,
order frequency, the timing of orders and storage and
handling to minimize costs and improve efficiencies
as orders flow through the supply chain system.
Companies that have a steady demand for stock are the
most suitable for the application of EOQ. Consequently,
EOQ is not used (nor should it be used) in every type
of company and industry. It is commonly used in an
MRP manufacturing environment where the ordering of
stock is constant and repetitive. EOQ also has its use
for purchase-to-stock distributors and MRO storage
facilities that have to plan for forecasted demand and/or
have to generate multiple orders.
About the Author :
Thomas L. Tanel, C.P.M., CTL, CCA, CISCM, is
President and Chief Executive Officer of CATTAN
Services Group Inc., College Station, Texas. He
has an international reputation as a Subject Matter
Expert and Seminar Leader in Logistics and Supply
Chain Management.