EconomicOrderQuantityModels

Inacontinuous,orfixedorderquantity,systemwheninventoryreachesaspecificlevel,referredtoasthereorderpoint,afixedamountisordered.Themost
widelyusedandtraditionalmeansfordetermininghowmuchtoorderinacontinuoussystemistheeconomicorderquantity(EOQ)model,alsoreferredtoas
theeconomiclotsizemodel.TheearliestpublishedderivationofthebasicEOQmodelformulain1915iscreditedtoFordHarris,anemployeeatWestinghouse.

ThefunctionoftheEOQmodelistodeterminetheoptimalordersizethatminimizestotalinventorycosts.ThereareseveralvariationsoftheEOQmodel,
dependingontheassumptionsmadeabouttheinventorysystem.Wewilldescribetwomodelversions,includingthebasicEOQmodelandtheEOQmodelwith
noninstantaneousreceipt.

TheBasicEOQModel
ThebasicEOQmodelisaformulafordeterminingtheoptimalordersizethatminimizesthesumofcarryingcostsandorderingcosts.Themodelformulais
derivedunderasetofsimplifyingandrestrictiveassumptions,asfollows:

Demandisknownwithcertaintyandisconstantovertime.
Noshortagesareallowed.
Leadtimeforthereceiptofordersisconstant.
Theorderquantityisreceivedallatonce.

ThesebasicmodelassumptionsarereflectedinFigure12.1,whichdescribesthecontinuousinventoryordercyclesysteminherentintheEOQmodel.Anorder
quantity,Q,isreceivedandisusedupovertimeataconstantrate.Whentheinventoryleveldecreasestotherecorderpoint,R,aneworderisplacedaperiodof
time,referredtoastheleadtime,isrequiredfordelivery.Theorderisreceivedallatoncejustatthemomentwhendemanddepletestheentirestockof
inventorytheinventorylevelreaches0sotherewillbenoshortages.Thiscycleisrepeatedcontinuouslyforthesameorderquantity,reorderpoint,andlead
time.

Aswementioned,theeconomicorderquantityistheordersizethatminimizesthesumofcarryingcostsandorderingcosts.Thesetwocostsreactinverselyto
eachother.Astheordersizeincreases,fewerordersarerequired,causingtheorderingcosttodecline,whereastheaverageamountofinventoryonhandwill
increase,resultinginanincreaseincarryingcosts.Thus,ineffect,theoptimalorderquantityrepresentsacompromisebetweenthesetwoinverselyrelatedcosts.

Thetotalannualorderingcostiscomputedbymultiplyingthecostperorder,designatedasCo,timesthenumberofordersperyear.Sinceannualdemand,D,is
assumedtobeknownandtobeconstant,thenumberoforderswillbeD/Q,whereQistheordersizeand
TheonlyvariableinthisequationisQbothCoandDareconstantparameters.Thus,therelativemagnitudeoftheorderingcostisdependentupontheorder
size.

Totalannualcarryingcostiscomputedbymultiplyingtheannualperunitcarryingcost,designatedasCc,timestheaverageinventorylevel,determinedby
dividingtheordersize,Q,by2:Q/2

Thetotalannualinventorycostisthesumoftheorderingandcarryingcosts:

ThegraphinFigure12.2showstheinverserelationshipbetweenorderingcostandcarryingcost,resultinginaconvextotalcostcurve.

TheoptimalorderquantityoccursatthepointinFigure12.2wherethetotalcostcurveisataminimum,whichcoincidesexactlywiththepointwherethe
carryingcostcurveintersectstheorderingcostcurve.ThisenablesustodeterminetheoptimalvalueofQbyequatingthetwocostfunctionsandsolvingforQ:

Alternatively,theoptimalvalueofQcanbedeterminedbydifferentiatingthetotalcostcurvewithrespecttoQ,settingtheresultingfunctionequaltozero(the
slopeattheminimumpointonthetotalcostcurve),andsolvingforQ:
Thetotalminimumcostisdeterminedbysubstitutingthevaluefortheoptimalordersize,Qopt,intothetotalcostequation:

EXAMPLE
TheEconomicOrderQuantity
12.2

TheI75CarpetDiscountStoreinNorthGeorgiastockscarpetinitswarehouseandsellsitthroughanadjoiningshowroom.Thestorekeeps
severalbrandsandstylesofcarpetinstockhowever,itsbiggestsellerisSuperShagcarpet.Thestorewantstodeterminetheoptimalorder
sizeandtotalinventorycostforthisbrandofcarpetgivenanestimatedannualdemandof10,000yardsofcarpet,anannualcarryingcostof
$0.75peryard,andanorderingcostof$150.Thestorewouldalsoliketoknowthenumberofordersthatwillbemadeannuallyandthetime
betweenorders(i.e.,theordercycle)giventhatthestoreisopeneverydayexceptSunday,ThanksgivingDay,andChristmasDay(whichis
notonaSunday).

SOLUTION:

Cc=$0.75peryard

Co=$150

D=10,000yards

Theoptimalordersizeis
ThetotalannualinventorycostisdeterminedbysubstitutingQoptintothetotalcostformula:

Thenumberofordersperyeariscomputedasfollows:

Giventhatthestoreisopen311daysannually(365daysminus52Sundays,Thanksgiving,andChristmas),theordercycleis
Theoptimalorderquantity,determinedinthisexample,andingeneral,isanapproximatevalue,sinceitisbasedonestimatesofcarryingandorderingcostsas
wellasuncertaindemand(althoughalloftheseparametersaretreatedasknown,certainvaluesintheEOQmodel).InpracticeitisacceptabletoroundtheQ
valuesofftothenearestwholenumber.Theprecisionofadecimalplaceisgenerallynotnecessary.Inaddition,becausetheoptimalorderquantityiscomputed
fromasquareroot,errorsorvariationsinthecostparametersanddemandtendtobedampened.Forinstance,inExample12.2,iftheordercosthadactually
been30percenthigher,or$200,theresultingoptimalordersizewouldhavevariedonlybyalittleunder10percent(i.e.,2,190yardsinsteadof2,000yards).
Variationsinbothinventorycostswilltendtooffseteachother,sincetheyhaveaninverserelationship.Asaresult,theEOQmodelisrelativelyresilientto
errorsinthecostestimatesanddemand,orisrobust,whichhastendedtoenhanceitspopularity.

TheEOQModelwithNoninstantaneousReceipt
AvariationofthebasicEOQmodelisthenoninstantaneousreceiptmodel,alsoreferredtoasthegradualusageandproductionlotsizemodel.InthisEOQ
modeltheassumptionthatordersarereceivedallatonceisrelaxed.Theorderquantityisreceivedgraduallyovertime,andtheinventorylevelisdepletedatthe
sametimeitisbeingreplenished.Thissituationismostcommonlyfoundwhentheinventoryuserisalsotheproducer,asinamanufacturingoperationwherea
partisproducedtouseinalargerassembly.Thissituationalsocanoccurwhenordersaredeliveredgraduallyovertimeorwhentheretailerisalsotheproducer.

ThenoninstantaneousreceiptmodelisshowngraphicallyinFigure12.3.Theinventorylevelisgraduallyreplenishedasanorderisreceived.InthebasicEOQ
model,averageinventorywashalfthemaximuminventorylevel,orQ/2,butinthismodelvariation,themaximuminventorylevelisnotsimplyQitisan
amountsomewhatlowerthanQ,adjustedforthefacttheorderquantityisdepletedduringtheorderreceiptperiod.

Inordertodeterminetheaverageinventorylevel,wedefinethefollowingparametersuniquetothismodel:

p=dailyrateatwhichtheorderisreceivedovertime,alsoknownastheproductionrate

d=thedailyrateatwhichinventoryisdemanded

Thedemandratecannotexceedtheproductionrate,sincewearestillassumingthatnoshortagesarepossible,and,ifd=p,thereisnoordersize,sinceitemsare
usedasfastastheyareproduced.Forthismodeltheproductionratemustexceedthedemandrate,orp>d.

ObservingFigure12.3,thetimerequiredtoreceiveanorderistheorderquantitydividedbytherateatwhichtheorderisreceived,orQ/p.Forexample,ifthe
ordersizeis100unitsandtheproductionrate,p,is20unitsperday,theorderwillbereceivedin5days.Theamountofinventorythatwillbedepletedorused
upduringthistimeperiodisdeterminedbymultiplyingbythedemandrate:(Q/p)d.Forexample,ifittakes5daystoreceivetheorderandduringthistime
inventoryisdepletedattherateof2unitsperday,then10unitsareused.Asaresult,themaximumamountofinventoryonhandistheordersizeminusthe
amountdepletedduringthereceiptperiod,computedas
Sincethisisthemaximuminventorylevel,theaverageinventorylevelisdeterminedbydividingthisamountby2:

Thetotalcarryingcostusingthisfunctionforaverageinventoryis

Thusthetotalannualinventorycostisdeterminedaccordingtothefollowingformula:

SolvingthisfunctionfortheoptimalvalueQ,

EXAMPLE
TheEOQModelwithNoninstantaneousReceipt
12.3
AssumethattheI75OutletStorehasitsownmanufacturingfacilityinwhichitproducesSuperShagcarpet.Theorderingcost,Co,isthe
costofsettinguptheproductionprocesstomakeSuperShagcarpet.RecallCc=$0.75peryardandD=10,000yardsperyear.The
manufacturingfacilityoperatesthesamedaysthestoreisopen(i.e.,311days)andproduces150yardsofthecarpetperday.Determinethe
optimalordersize,totalinventorycost,thelengthoftimetoreceiveanorder,thenumberofordersperyear,andthemaximuminventory
level.

SOLUTION:

Theoptimalordersizeisdeterminedasfollows:

Thisvalueissubstitutedintothefollowingformulatodeterminetotalminimumannualinventorycost:
 Thelengthoftimetoreceiveanorderforthistypeofmanufacturingoperationiscommonlycalledthelengthoftheproductionrun.

Thenumberofordersperyearisactuallythenumberofproductionrunsthatwillbemade:

Finally,themaximuminventorylevelis

ComputerSolutionofEOQModelswithExcelandExcelOM
EOQanalysiscanbedonewithExcelandExcelOM(aswellaswithPOMforWindows).TheExcelscreenforthenoninstantaneousreceiptmodelofExample
12.3isshowninFigure12.2.TheformulafortheoptimalvalueofQiscontainedincellD10asshownontheformulabaratthetopofthescreen.

ExcelOMalsoincludesasetofspreadsheetmacrosforinventorythatincludesEOQanalysis.AftertheExcelOMmenuisaccessedbyclickingon"OM"onthe
menubaratthetopofthespreadsheet,clickon"Inventory."Figure12.3showstheExcelOMspreadsheetforthenoninstantaneousreceiptmodelinExample
12.3.
128.ExplainhowtheorderquantityisdeterminedusingthebasicEOQmodel.

129.WhataretheassumptionsofthebasicEOQmodelandtowhatextentdotheylimittheusefulnessofthemodel?

1210.Howarethereorderpointandleadtimerelatedininventoryanalysis?

1211.DescribehowthenoninstantaneousreceiptmodeldiffersfromthebasicEOQmodel.

1212.InthenoninstantaneousreceiptEOQmodel,whatwouldbetheeffectoftheproductionratebecomingincreasinglylargeasthedemandratebecame
increasinglysmall,untiltheratiod/pwasnegligible?