Economic Order Quantity Model (EOQ)

Economic Order Quantity Model (EOQ)

As the name suggests, Economic order quantity (EOQ) model is the method that provides the company with an order quantity. This order quantity figure is where the record holding costs and ordering costs are minimized. By using this model, the companies can minimize the costs associated with the ordering and inventory holding. In 1913, Ford W. Harris developed this formula whereas R. H. Wilson is given credit for the application and in-depth analysis on this model.

Definition The economic order quantity (EOQ) is a model that is used to calculate the optimal quantity that can be purchased or produced to minimize the cost of both the carrying inventory and the processing of purchase orders or production set-ups.

Formula Following is the formula for the economic order quantity (EOQ) model:

Where Q = optimal order quantity

D = units of annual demand

S = cost incurred to place a single order or setup

H = carrying cost per unit

This formula is derived from the following cost function:

Total cost = purchase cost + ordering cost + holding cost

Re Order Point (ROP)

A reorder point is the inventory unit quantity on hand that triggers the purchase of a predetermined amount of replenishment inventory. If the purchasing process and supplier fulfillment work as planned, the reorder point should result in the replenishment inventory arriving just as the last of the on-hand inventory is used up.The reorder point can be different for every item of inventory, since every item may have a different usage rate, and may require differing amounts of time to receive a replenishment delivery from a supplier. For example, a company can elect to buy the same part from two different suppliers; if one supplier requires one day to deliver an order and the other supplier requires three days, then the company's reorder point for the first supplier would be when there is one day's supply left on hand, or three days' supply for the second supplier.

The basic formula for the reorder point is to multiply the average daily usage rate for an inventory item by the lead time in days to replenish it.

ROP=(Average daily usage rate x Lead time) + Safety stock

This formula alteration means that replenishment stock will be ordered sooner, which greatly reduces the risk that there will be a stockout condition. However, it also means that a company will have a larger investment in its on-hand inventory, so there is a trade-off between always having available inventory and funding a larger inventory asset.