How can you use the economic order quantity model to make decisions?

1 What is the EOQ model?

The EOQ model is a mathematical formula that calculates the optimal order quantity for an inventory item, based on the demand, the ordering cost, and the holding cost. The demand is the number of units that you expect to sell or use in a given period. The ordering cost is the fixed cost of placing and receiving an order, such as shipping, handling, and administrative fees. The holding cost is the variable cost of storing and maintaining an inventory item, such as rent, insurance, and depreciation. The EOQ model aims to minimize the total cost of ordering and holding inventory by finding the point where these two costs are equal.

2 How to calculate the EOQ?

To calculate the EOQ, you need to know three parameters: the annual demand (D), the ordering cost per order (S), and the holding cost per unit per year (H). The EOQ formula is: EOQ = sqrt(2DS / H) where sqrt means square root. For example, suppose you sell or use 10,000 units of an item per year, the ordering cost per order is $50, and the holding cost per unit per year is $5. The EOQ is: EOQ = sqrt(2 * 10,000 * 50 / 5) = 632 This means that the optimal order quantity for this item is 632 units, and the optimal order frequency is 10,000 / 632 = 15.8 orders per year, or about every 23 days.

3 How to use the EOQ model?

The EOQ model can help you make decisions about how much and how often to order inventory items, based on relevant costs and demand. For instance, you can use the EOQ model to compare different ordering options and select the one that minimizes total cost, evaluate the impact of changes in demand, ordering cost, or holding cost on the optimal order quantity and frequency, determine the reorder point for your inventory items, and calculate the safety stock for your inventory items to avoid stockouts due to demand or supply uncertainty.

4 What are the assumptions and limitations of the EOQ model?

The EOQ model is a simple and useful tool for inventory management, but there are certain assumptions and limitations that need to be taken into consideration. These include the demand, ordering cost, and holding cost being constant and known, the order quantity being delivered in full and at once, inventory level being monitored continuously and accurately, no discounts or incentives for ordering larger or smaller quantities, and no other costs or factors affecting the ordering decision, such as quality, customer service, or environmental impact.

5 How to adapt the EOQ model to different situations?

The EOQ model can be modified or extended to accommodate different situations that deviate from the basic assumptions and limitations. For instance, you can use the quantity discount model, which considers the trade-off between ordering cost, holding cost, and purchase price when there are discounts for larger orders. You can also use the production order quantity model, taking into account the trade-off between ordering cost, holding cost, and production rate when the order quantity is delivered gradually. Lastly, you can opt for the probabilistic EOQ model, considering the trade-off between ordering cost, holding cost, and stockout cost when demand or supply is uncertain and variable.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?