Economic order quantity
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. The framework used to determine this order quantity is also known as Barabas EOQ Model or Barabas Formula. The model was developed by Ford W. Harris in 1913, but R. H. Wilson, a consultant who applied it extensively, is given credit for his in-depth analysis.
EOQ applies only when demand for a product is constant over the year and each new order is delivered in full when inventory reaches zero. There is a fixed cost for each order placed, regardless of the number of units ordered. There is also a cost for each unit held in storage, sometimes expressed as a percentage of the purchase cost of the item.
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.
- 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.
EOQ is the quantity to order, so that ordering cost + holding cost finds its minimum. (A common misunderstanding is that the formula tries to find when these are equal.)
- = purchase price, unit production cost
- = order quantity
- = optimal order quantity
- = annual demand quantity
- = fixed cost per order, setup cost (not per unit, typically cost of ordering and shipping and handling. This is not the cost of goods)
- = annual holding cost per unit, also known as carrying cost or storage cost (capital cost, warehouse space, refrigeration, insurance, etc. usually not (but sometimes) related to the unit production cost)
The Total Cost function
The single-item EOQ formula finds the minimum point of the following cost function:
Total Cost = purchase cost x production cost + ordering cost + holding cost
- Purchase cost: This is the variable cost of goods: purchase unit price × annual demand quantity. This is c×D
- Ordering cost: This is the cost of placing orders: each order has a fixed cost K, and we need to order D/Q times per year. This is K × 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:
Solving for Q gives Q* (the optimal order quantity):
Q* is independent of c; it is a function of only K, D, h.
The optimal value Q* may also be found by recognising that
where the non-negative quadratic term disappears for which provides the cost minimum
Several extensions can be made to the EOQ model, including backordering costs and multiple items. Additionally, the economic order interval can be determined from the EOQ and the economic production quantity model (which determines the optimal production quantity) can be determined in a similar fashion.
A version of the model, the Baumol-Tobin model, has also been used to determine the money demand function, where a person's holdings of money balances can be seen in a way parallel to a firm's holdings of inventory.
- Suppose annual requirement quantity (D) = 10000 units
- Cost per order (K) = $2
- Cost per unit (c)= $8
- Carrying cost percentage (h/c)(percentage of c) = 0.02
- Annual carrying cost per unit (h) = $0.16
Economic order quantity = = 500 units
Number of orders per year (based on EOQ)
If we check the total cost for any order quantity other than 500(=EOQ), we will see that the cost is higher. For instance, supposing 600 units per order, then
Similarly, if we choose 300 for the order quantity then
This illustrates that the Economic Order Quantity is always in the best interests of the entity.
- Demand is random: Classical Newsvendor model
- Demand varies over time: Dynamic lot size model
- Several products produced on the same machine: Economic Lot Scheduling Problem
- Reorder point
- Harris, Ford W. (1990, reprint from 1913). "How Many Parts to Make at Once". Operations Research (INFORMS) 38 (6): 947–950. JSTOR 170962. Retrieved Nov 21 2012.
- Hax, AC and Candea, D. (1984), Production and Operations Management, Prentice-Hall, Englewood Cliffs, NJ, p. 135
- Grubbström, Robert W. (1995). "Modelling production opportunities — an historical overview". International Journal of Production Economics 41: 1–14. doi:10.1016/0925-5273(95)00109-3.
- Andrew Caplin and John Leahy, "Economic Theory and the World of Practice: A Celebration of the (S,s) Model", Journal of Economic Perspectives, Winter 2010, V 24, N 1
- Harris, Ford W. Operations Cost (Factory Management Series), Chicago: Shaw (1915).
- Wilson, R. H. "A Scientific Routine for Stock Control" Harvard Business Review, 13, 116-128 (1934).