EOQ View: Lesson for Inventory Management

A couple of decades ago, close friends Suresh and Mahesh got placed in the same company after their engineering course. They decided to share a rented accommodation. Knowing their respective weaknesses in household chores (read kitchen), Suresh took charge of kitchen and Mahesh would do the utensils and market purchasing. Of course, quick delivery and ready-to-eat food were not popular at that time. Within a month of the arrangement, Suresh was heard complaining of the shortage of space in kitchen and food items going stale. The blame was squarely placed on Mahesh on buying too high quantities (he simply minimized his cumbersome, boring visits to the grocer). That evening, the two had a bitter verbal duel accusing each other of dereliction of respective duties. They could not arrive at a consensus for many months until they learnt about EOQ (Economic Order Quantity).

For all the businesses that practice make-to-stock and then sell from accumulated inventory, EOQ links Supply Chain costs effectively between the nodes within the organization and with the suppliers.

In the current inflationary times, when raw-material, freight, services costs have seen a double-digit increase, it is critical to minimize the inventory levels and definitely avoid waste. However, one must ensure that the inventory reduction should not lead to customer service loss (OTIF).

Devised in 1913, the EOQ model is a fundamental model that can be used first. This model helps optimize both inventory purchasing (ordering) cost and holding cost. Ordering cost is determined by the number of purchase orders. Holding cost is determined by the average inventory. Total cost= holding cost + ordering cost.

Ordering cost includes order preparation, processing, inspection costs, transportation costs. The rule of ‘economies of scale’ suggests that higher order quantity will help reduce ordering cost. And the more frequently we place orders, the quantity per order reduces… thus working up the ordering cost per unit.

On the other hand, the cost of carrying inventory is far more than what meets the eye. It includes:

• Warehouse expenses (2 to 4%)
• Handling costs (2- 5%)
• Insurance costs (1 to 3%)
• Inventory control/ management (3-5%)
• Obsolescence (6 - 12%)
• Shrinkage/ pilferage (3- 6%)
• Opportunity cost of the capital (8 to 12%)

Higher the inventory in our warehouse, higher is the Carrying cost.

As we can see, there is a negative co-relation between the ordering cost and carrying costs.

Pic. Courtesy: International journal of economics, commerce and management.

EOQ is the sweet spot where ordering and carrying costs meet on the graph. This is the point where ‘Total cost’ is minimum.

When put to application, it would not be possible to order the exact mathematically arrived EOQ number.

Order quantity has a big impact on the transportation, inventory carrying, warehouse operations, and order processing costs. These costs/unit do not play in a linear fashion, but in slabs (range).

Carton/pallet load size, truck capacity on the lane would be some basic factors that help define the range of EOQ.

Further, it is advised to do a Sensitivity analysis to identify the operationally viable range of EOQ. Here, one varies the input factors by small percentages to see the impact on EOQ. This also helps identify the input cost components to which EOQ is most sensitive to.

So far, so good!

Now, let’s constructively challenge the assumptions built in the above model and make it furthermore user-friendly.

There are bulk-purchase discounts that suppliers and transporters give when you buy more. The discounts are generally at a slab level. Below graph aptly represents the effect on Total cost with the ordering discounts. As you can see, the total cost is reducing to 580 when we order 10000 units (10% bulk purchase discount). 

Pic courtesy: JE Beasley

Caution: Do check the impact on the warehousing space and costs, which have been assumed linear for all quantity levels.

So, how do we adapt EOQ concept in our far complex, volatile, uncertain business environment? Let’s identify the key business factors that must be carefully built into the model and/or considered while ascertaining the EOQ.

Key factors to be considered are:

1.     Demand volatility: EOQ model assumes uniform demand across the year. You would definitely want to include the demand variability. At this stage it is important to introduce “Safety Stock”. (EOQ concept did not have safety stock)

2.     Irregular demand: In addition to base EOQ calculation, we now add re-order point (ROP) concept to procurement scheduling.

3.     Demand seasonality: EOQ concept considered annual demand. The year could be broken into buckets demarcating the seasonal peak periods, for which separate EOQ level would be applicable.

4.     Promotions : Planned inventory build-up will supersede EOQ when placing the order.

5.     Product shelf life: while EOQ may suggest particular quantity inventory order, we must ensure minimal obsolescence. Short shelf-life products may require more frequent ordering, in lesser than EOQ.

6.     Clustering opportunity: Same supplier and transporter could be supplying many different items. Ordering costs should be clubbed for these items together when calculating Ordering costs.

7.     Product life cycle: For a product that is end of lifecycle, you would want to hold lesser quantity, even if it means a higher ordering cost.

Market demand and supply conditions are constantly changing. All considerable changes should be captured as an input for regular review and revision in procurement scheduling.

More significant external (and internal) changes would call for an amendment in mid to long-term sourcing strategy.

#EOQ #inventorymanagement #planning

All views expressed in this article are my own and do not represent the opinions of any entity whatsoever with which I have been, am now, or will be affiliated.