Question1: What is the EOQ and what is the lowest total cost?

The term EOQ stands for Economic Order Quantity. It is the optimal order quantity that a
company should hold in its inventory given a set of production, demand rate, and other variables.
Thus, it is a model commonly used to establish optimum inventory levels in order to manage
inventory. This measurement is generally used in the field of operations, supply management,
and logistics to define the volume and frequency of orders to minimize the cost per order.
Therefore, it can be an important tool for small business owners in deciding about the quantity of
holding inventory, numbers of items to order in each period, and also the frequency to reorder to
incur the lowest possible costs.

The EOQ model assumes constant demand and the inventory reduced at a fixed rate until it
reaches zero. Inventory is the stock of resources that used in an organization e.g. Raw materials,
work in process, finished goods that a company accumulated. Due to purchasing in economy of
scale the cost of ordering inventory (e.g. delivery charges) falls with the rise in ordering quantity
of a product. However, the cost of holding inventory (e.g. storage costs) increases with the
growing size of the inventory. So, there is a tradeoff between holding costs and order costs of
inventory. To illustrate, if a small business firm gets large order at a single time that accelerates
holding costs but reduces order costs, while frequent orders with fewer items successively
increase order costs but decrease holding costs. So, the EOQ model helps to find the quantity that
minimizes both of these inversely related costs.

The Basic EOQ relationship can be shown as below.

𝐷 𝑄
𝑇𝐶 = 𝐷𝑃+𝑄 𝑆 + 2 𝐻

Here, TC is the annual total cost to be calculated

D=total numbers of unit purchased in a year

P= price per unit

H= annual holding and storage cost per unit

S=fixed cost of each year

Q=order quantity each time an order is made

To find the optimal quantity that minimizes cost we need to differentiate the annual TC with
respect to Q and set it equal to zero. It is shown as follows.

dTC 2𝑆𝐷
So, EOQ = =√
dQ 𝐻
Graphically, the equation can be represented as follows. Here, we can see that when the cost of
holding goes up the ordering costs goes down, and the EOQ lies in the intersection.

Costs

Total cost cost of holding

cost of ordering

EOQ Order qty

Certainly, the lowest total cost is lying at the intersection point of two curves. In other words,
when both of the costs are equal we can get the lowest or minimum total cost. In short, using the
above mentioned formula a small business owner can compute the EOQ by calculating the total
cost of inventory and then go for the optimal quantity that gives him minimum cost.

Question 2: What is the annual cost of holding inventory at the EOQ and the annual cost of
ordering inventory at the EOQ?

Inventory is the items or resources used in an organization which is a kind of current asset found
in the balance sheet. It consists of raw materials, finished goods, work in progress, component
parts that a company has accumulated. The inventory cost includes two types of costs – carrying
costs or costs of holding inventory and costs to order.

The holding cost is based on the average inventory associated with the expenses related to
storing and holding of unsold goods. In other words, carrying costs or any other costs that are
associated with holding inventory is holding costs. When a company buys inventory it has to do
something with it until it sells its actual inventory. So, we called them holding. Therefore, it is
the opportunity cost of holding inventory rather than investing elsewhere. There is a number of
different costs associated with holding inventory. For example, the most obvious is storage costs.
Since a company has to rent out a warehouse or some kind of storage facility in order to hold its
inventory. And, the cost associated with the rent which is a kind of cost of holding inventory. So,
rent would be a holding cost. Once a company has inventory then the company will purchase
insurance in case inventory could have been damaged due to natural disasters or expired or
destroyed. Because the inventory has value, so the firm wants to insure it. So, the cost of
insurance can also be the cost of holding inventory.
Hence, the holding cost per unit can be expressed as the multiplication of purchase price per unit
and interest rate. H = iC. Thus the annual holding cost is the sum product of holding inventory
and per unit holding cost.
𝑄
Annual holding cost = ×𝐻
2

However, ordering cost is a kind of expenditure that a company needs to bear while processing
an order to a supplier. These expenses basically include the wages of procurement department,
payroll taxes and benefits. So, this kind of costs has to incur with the purchase of inventory from
a company suppliers. For example, if a restaurant receiving some vegetables and before unloaded
the manager wants to make sure that this is high quality vegetables not spoiled. So, manager will
spent time in inspecting the inventory while receiving it. So, here ordering cost is not real cost
but anything that can consume somebody’s time, as the manger can have done something else in
that time. Moreover, process the payment to the supplier there might be paper work involved
with that. So, lot of the costs involved over time. But ordering costs can be come down as lots of
process can be done online in an automated process. This cost is even a significant cost of
inventory despite it goes down over time. And, the annual ordering cost can be computed by
multiplying the number of orders with the fixed cost.
𝐷
Annual ordering cost = 𝑄 × 𝑆

Example: To illustrate the question lets go through an example. Suppose, Duncraft is a

manufacturer of metal safe bird feeders. Their annual sales amount to 500,000 units. The
purchasing price is $3 per feeder. It faces a carrying cost of inventory 20% of a unit cost. The
ordering cost is $100 per order. What is the EOQ?

dTC 2SD 2×100×500,000

EOQ = =√ =√ = 12, 909.95 or 12, 910 bird feeders
dQ H 20%×3

So, at EOQ level the annual cost of holding inventory:

Q 12910
H= × 0.6 = 3873
2 2

And, at EOQ level the annual cost of ordering inventory:

𝐷 500,000
𝑆= × 100 = 3873
𝑄 12910
 D Q
So, the annual total cost = TC = DP+Q S + 2 H

=500,000 × 3 + 3873 + 3873

=15, 07,746

With the result that, we can surely say that at EOQ level both of the costs are equal. And this is
the point of intersection where the company can derive their minimum annual Total cost.

Question 3: How much does the total cost increase if the store manager orders twice as many
bird feeders as the EOQ? How much the total cost increase if the store manager orders half as
many bird feeders as the EOQ?

Considering the previous example, if the order became twice as bird feeders as the EOQ

So, now New order= 2× EOQ = 2 × 12, 910=25,820 feeders

So, at new order level the annual cost of holding inventory:

Q 25,820
H= × 0.6 = 7746
2 2
And, at new order level the annual cost of ordering inventory:
D 500,000
S= × 100 = 1937
Q 25,820

D Q
Therefore, the new annual total cost = TC1 = DP+Q S + 2 H

=500,000 × 3 + 7746 + 1937

=15, 09,683

The increase in Total cost is = TC1 − TC

=15, 09,683−15, 07,746

=1937

Thus, TC1 = TC + new annual ordering cost.

So, it can be said that more volume of order less annual order cost and more annual holding cost.
And due to increasing order twice as EOQ level, the new annual total cost is increased exactly by
the same amount of new annual order cost.

Now again, considering the previous example, if order became half as bird feeders as the EOQ

1 1
So, New order= 2 × EOQ = 2 × 12, 910 = 6455 feeders

So, at new order level the annual cost of holding inventory:

Q 6455
H= × 0.6 = 1937
2 2
And, at new order level the annual cost of ordering inventory:
D 500,000
S= × 100 = 7746
Q 6455

D Q
Therefore, the new annual total cost = TC2 = DP+ S + H
Q 2

=500,000 × 3 + 1937 + 7746

=15,09,683

The increase in Total cost is =TC2 − TC

=15,09, 683−15,07,746

=1937

Thus, TC2 = TC + new annual holding cost.

So, it can be said that fewer order results in less annual holding cost and more annual order cost.
And due to reducing order by half as EOQ level, the new annual total cost is increased exactly by
the same amount of new annual holding cost. Though orders became double or half as the EOQ,
it has been found that the total cost remains same for both cases.
Question 4: What happens to the EOQ and the total cost when the demand is doubled? What
happens to the EOQ and the total cost when unit price is doubled?

Considering the example of question no (2), if demand is doubled then D1 =500,000 × 2

= 10,00,000

dTC 2SD 2×100×1000000

EOQ1 = =√ =√ = 18,257.42 or 18,257 bird feeders
dQ H 20%×3

So, at EOQ1 level the annual cost of holding inventory:

Q 18257
H= × 0.6 = 5477
2 2

And, at EOQ1 level the annual cost of ordering inventory:

D 10,00,000
S= × 100 = 5477
Q 18257
D Q
Therefore, the new annual total cost = TC3 = DP+Q S + 2 H

=10,00,000 × 3 + 5477 + 5477

=30,10,954

So, (TC3 − TC)

= (30,10,954 −15, 07,746)

= 15,07,746

Thus we can write,

TC3 − TC = TC

or, TC3 = 2TC

Hence, if demand doubled then the annual total cost also becomes doubled accordingly.
Lets considering the previous example of question no (2), if unit price is doubled then

P1 =3 × 2

=6

dTC 2SD 2×100×500,000

EOQ 2 = =√ =√ = 9128.71 or 9129 bird feeders
dQ H 20%×6

So, at EOQ 2 level the annual cost of holding inventory:

𝑄 9129
𝐻= × 1.2 = 5477
2 2

And, at EOQ 2 level the annual cost of ordering inventory:

𝐷 500,000
𝑆= × 100 = 5477
𝑄 9129
D Q
Therefore, the new annual total cost = TC4 = DP+Q S + 2 H

=500,000 × 6 + 5477 + 5477

=30,10,954

So, (TC4 − TC)

= (30,10,954 −15, 07,746)

= 15,07,746

Thus we can write,

TC4 − TC = TC

or, TC4 = 2TC

Hence, if unit price is doubled then the annual total cost also becomes doubled accordingly.