Economic Order

Quantity
 Five categories of costs
associated with goods for sale.
Costs Associated with
Goods for Sale

1. Purchasing costs include transportation costs.

2. Ordering costs include receiving and

inspecting the items in the orders.
3. Carrying costs include the opportunity cost
of the investment tied up in inventory and
the costs associated with storage.
Costs Associated with
Goods for Sale

4. Stockout costs occur when an organization

runs out of a particular item for which
there is a customer demand.
5. Quality costs of a product or service is its lack
of conformance with a prespecified standard.
Economic-Order-Quantity

Balance ordering costs with

carrying costs using the
economic-order-quantity
(EOQ) decision model.
Economic-Order-Quantity
Decision Model Assumptions

The EOQ minimizes the relevant ordering

costs and carrying costs.
Economic-Order-Quantity
Decision Model Assumptions
1. The same quantity is ordered at each
reorder point.
2. Demand, ordering costs, carrying costs,
and purchase-order lead time are
known with certainty.
3. Purchasing costs per unit are unaffected
by the quantity ordered.
Economic-Order-Quantity
Decision Model Assumptions

4. No stockouts occur.
5. Quality costs are considered only to the
extent that these costs affect ordering
costs or carrying costs.
Economic-Order-Quantity Decision
Model Example
2 DP
EOQ =
C
D = Demand in units for a specified time period

P = Relevant ordering costs per purchase order

C = Relevant carrying costs of one unit in

stock for the time period used for D
Ordering Cost
 Total ordering costs include those spent in placing an order,
waiting for an order, inspection and receiving costs, setup costs
and quantity discounts lost.

 Cost per order = Total ordering costs / Number of orders

 Total ordering costs = Cost per order x No. of orders

 No. of orders = Annual demand / Order size

Sample problem

Big City Corporation expects to use 10,000 units of

material XPO per month in 2019. Last year, the total
ordering costs amounted to P200,000 for a total of 40
orders. It is expected that prices in 2019 would be 10%
higher than that of last year. Determine the expected
ordering costs in 2019 if the company orders in a batch of
12,000 units or 24,000 units.
Order size 12,000 units 24,000 units
Annual demand (AD) 120,000 units 120,000 units
No. of orders
(120,000/12,000) 10
(120,000/24,000) 5
Cost per order (CPO) P5,500 P5,500
Total Ordering costs (AD x CPO) P55,000 P27,500
 Carrying Cost
 Carrying costs are those spent in holding, maintaining or
warehousing inventories such as warehousing and storage
costs, handling and clerical costs, property taxes and
insurance, deterioration and shrinkage of stocks,
obsolescence of stocks, interest and return on investment
(e.g., lost return on investment tied up in inventory).
Carrying Costs
 Carrying cost per unit = Total carrying costs / Average inventory

 Total carrying costs = Carrying cost per unit x Average inventory

 Average inventory = Order size / 2

 Carrying costs per unit = Unit cost x Carrying costs ratio

 Carrying costs ratio = Carrying costs per unit / Unit cost

Sample problem

In 2018, UCU Company incurred a total of P800,000 for

inventory carrying costs with an average inventory of 200,000
units. What would be the total carrying costs in 2019 if the order
size is 500,000 units or 900,000 units, assuming the company
does not maintain safety stock quantity.
 500,000 units 900,000 units
Carrying cost per unit (P800,000 / 200,000 units) P4 P4
Average inventory (500,000 / 2) 250,000 units
(900,000 / 2) 450,000 units
Total carrying costs (CCPU x Ave. inventory) P1,000,000 P1,800,000
 Average inventory
Average inventory is calculated by dividing the order size by 2.
The average inventory is computed using the simple average
method, that is, beginning balance plus ending balance divided
by 2. The beginning balance is the order size and the ending
balance is zero, because all of the units ordered and received
have been used. Hence, average inventory is (order size + 0/2) or
simply (order size/ 2). One important assumption iş that the units
received will be used evenly throughout the production period.
Economic Order Quantity

Economic order quantity is the point where the

total ordering cost equals the total carrying cost.
Also, at this point the total inventory cost is at its
minimum.
If, at EOQ … Computing for the EOQ (order size), we have:

TOC = TCC OS2 = 2 x AD X CPO

CCPU
Then, we could express that:

CPO x No. of orders = CCPU x Ave. inventory

OS =
√ 2 x AD X CPO
CCPU

CPO x (AD/OS) = CCPU x ( OS / 2 ) EOQ (units) =

√ 2 x AD X CPO
CCPU
Simplifying the equation, we have:

CPO x AD = CCPU x OS
EOQ (pesos) =
√ 2 x AD in pesos X CPO
CCRatio
OS 2

OS2 x CCPU = 2 x AD x CPO

where: TOC = total ordering cost CPO = cost pr order

TCC = total carrying cost OS = order size
CCPU = carrying costs per unit AD = annual demand
EOQ = Economic Order Quantity
Sample Problem
Assume an annual requirement of 24,000 units, a cost per
unit of P20, a cost per order of P750 and a carrying cost
percentage of 20%.
EOQ (units) =
√ 2 x 2,400 X 750
4
CCPU = UC x CCRatio = P20 x 20%
= P4

EOQ (pesos) =
√ 2 x 480,000 X 750
20%
We say, at EOQ, ordering cost = carrying costs.
To prove, we have:

TOC (8 times x P750) P 6,000

TCC (3,000 / 2 x P4) 6,000
Total relevant inventory costs P12, 000
Reorder point

 Reorder point ( ROP) refers to the inventory level

where a purchase order should be placed.
 Reorder point is the sum of lead time quantity
and safety stock quantity.
Reorder point
 Lead time refers to the waiting time from the date the order is placed
until the date the delivery is received.
 Lead time quantity represents the normal usage during the lead time
period.
 Normal usage means the average usage of inventory during a period
(i.e., annual demand/ working days in a year).
 Safety stock is set to serve as a margin in case of variations in normal
usage and normal lead time. Hence, there is a safety stock for
variation in usage and a safety stock for variations in time.
 The maximum inventory level is the sum of the safety stock quantity
and the order size.
 The minimum quantity is the safety stock quantity.
Reorder point
Reorder point = Lead time quantity + Safety stock quantity

where:
Lead time quantity = normal usage x normal lead time
Safety stock = safety stock (in usage) + safety stock (in time)
Safety stock (in usage) = (Maximum usage – Normal usage) x Normal lead time
Safety stock (in time) = (Maximum lead time – Normal lead time) x Normal usage

and
Maximum inventory level = Safety stock + Order size
Sample problem

Lina Corporation has the following production data:

Annual requirement 40,000 units
Number of working days 320 days
Normal lead time 10 days
Maximum lead time 16 days
Maximum usage 150 units
Economic order quantity 5,000 units
Stockout costs

The costs associated with the inadequate level of

inventory are substantial. Efforts are to be made to
reduce this cost. One of those that greatly
contribute to the costs of inadequate. Inventory is
the cost of stockouts. It includes the opportunity
cost of lost sales, lost customer goodwill,
disruptions of production schedules, overtime,
increase in set up costs, and higher price due to
small quantities.
Please answer Problems 1-3
Chapter 7 page 203
Problem 1 - Norman Company
________________
a) EOQ = \/ 2 x 64,000 x 40
2
= 1600 units

Ordering cost = No of orders x ordering cost

= 64,000 x 40
1,600
= 1,600

Carrying cost = Average inventory x 2

= 1600 x 2
2
= 1,600
Stockout costs

It normal lead time and normal usage are used in

determining the order point, a stockout can be
expected on every other order. Reducing
stockout occurrences have direct relations with
the level of safety stock. The higher the safety
stock quantity, the lower the possibility of stockout,
and vice-versa. Stockout has two costs, the
carrying costs of safety stock and the costs of
stockout occurrences.
Stockout costs
Total stockout costs = Cost of carrying SSQ + Cost of stockout occurences

Cost of carrying SSQ = SSQ x Carrying cost per unit

Cost of stockout occurences = [Stockout cost per occurrence x Probability

of occurrence] x No. of occurences