Economic Order Quantity

The economic order quantity (EOQ) is

the fixed order quantity (Q) that
minimizes the total annual costs of
placing orders and holding inventory
(TC).
Economic Order Quantity
Assumptions
Demand (D) is known and constant
H is known and constant
Order costs (S) are constant
The order quantity arrives in a single
shipment
No quantity discounts are available
All demand will be met (no shortages)

We want to minimize TC
D, S, and H are constant. TC is a function of Q.
1
2 2
D Q H
TC S H DS Q
Q Q
= + = +
Economic Order Quantity (3)
*
2DS
Q
H
=
*
*
2
D Q
TC S H
Q
= +
Let Q
*
be the economic order quantity. Then
For Q
*
, annual order cost = annual inventory cost
*
*
2
D Q
S H
Q
=
Simple Reorder Point
Use this method when daily demand is
constant.
R = reorder point
d = daily demand (may have to compute
this)
L = lead time (Caution: if lead time is given
in weeks, convert this to days).
R = dL
Reorder Point with Safety Stock (2)
How much safety stock (SS) ?

Reorder point with safety stock:
Service level is the probability of having enough
inventory to meet demand during lead time
The probability of a stockout is (1 - service level)
Demand during lead time is normally distributed
with mean and standard deviation o
dL

SS L d R + =
demand daily average = d
L d
Reorder Point with Safety Stock (2)
How much safety stock (SS) ?
z is the number of standard deviations required to
meet the desired service level
SS = zo
dL

Reorder point with safety stock: R = + zo
dL


L d
Reorder Point with Safety Stock
Example
Given
D = annual demand = 10,000
N = number of business days per year = 250
The company operates 5 days per week
= average daily demand
o
dL
= standard deviation of demand during lead time = 20
L = lead time = 1 week
Service level = 96%
Find: reorder point with safety stock: R = + zo
dL

L d
d
Computing Reorder Point
with Safety Stock
1. If average daily demand ( ) is not given,
compute it.
Note: = D/N and D =
= 10,000/250 = 40
2. If the lead time is given in weeks or
months, compute lead time in days.
L = 1 week = 1(5) = 5 days
Note: 1 week is the number of days per week that
the company operates. This may be 5, 6, or 7.

d
d
d d N
Computing Reorder Point
with Safety Stock (2)
3. Find the z value for the service level
(96%)
Probability of
a stockout =
1 service
level = 4%
z
50% 46%
L d
Appendix B gives
this area.
Computing Reorder Point
with Safety Stock (3)
3. Find the z value for the service level (96%) (cont.)
(a) Write the service level as a decimal
96% = 0.9600
(b) Subtract 0.5000 from the service level
0.9600 0.5000 = 0.4600
(c) Use the table in Appendix B, page 652, to find
the area that is closest to 0.4600
The closest area in the table is 0.4599, which
occurs when z = 1.75
Use z = 1.75
Computing Reorder Point
with Safety Stock (4)
4. Compute R
R = L+ zo
dL

= 40(5) + 1.75(20) = 200 + 35
= 235
Note: If the computation gives a fractional
value, round up to nearest integer.
Example: Computed R = 210.2 R = 211

d
Economic Production Quantity
Key question: How many units of a part or
product should be made at one time?
The economic production quantity (EPQ) is
the production quantity (lot size) that
minimizes the total annual cost of setups
and holding inventory.


Economic Production Quantity (2)
Notation
Q = Amount to make (lot size)
D = annual demand for the item
d = daily demand for the item
p = daily production rate
S = cost of one setup
H = inventory holding cost per unit per year
(commonly called holding cost)
TC = annual cost of setups
+ annual cost of holding inventory
The EPQ is the quantity that minimizes TC
Economic Production Quantity (3)
Assumption: Daily demand < daily production.
When the item is being made, some is sold or used to
make a product. The remainder goes into inventory.
When production stops, the inventory is used until
there is no inventory left. Then production resumes.
Ending inventory
= beginning
inventory
+ production
- sales or usage
Economic Production Quantity (4)
Length of production run = Q/p
During production, d units are sold or used each day. (p d)
units go into inventory.
|
|
.
|

\
|
= =
p
d
Q d p 1 ) (
p
Q
I
MAX
Maximum inventory:
Total cost: |
.
|

\
|
+ |
.
|

\
|
= H
2
I
S
Q
D
TC
MAX
EPQ
Economic production
quantity (EPQ):
|
|
.
|

\
|

=
p
d
1 H
2DS
EPQ
EOQ vs. EPQ
When to use economic order quantity (EOQ):
Demand is independent
Compute how much to order (order quantity)
When to use economic production quantity
(EPQ):
Parts or products will be produced: demand is
dependent
Compute how much to make at one time
(production lot size)