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ECONOMIC ORDER QUANTITY

Its Cost Components

Home | What is Economic Order Quantity? | Its Cost Components | EOQ Model with Purchases | Assumptions of the Model | Optimizing Economic Order Quantity | Graphical Solutions | Sample Problems | Answers

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Cost Components

Annual Usage/Demand: Expressed in units this is generally the easiest part of the equation. You simply input your forecasted annual usage


Order Cost: Also known as purchase cost or set up cost, this is the sum of the fixed costs that are incurred each time an item is ordered. These costs are not associated with the quantity ordered but primarily with physical activities required to process the order. 

     For purchased items these would include the cost to enter the Purchase Order and/or Requisition, any approval steps, the cost to process the receipt, incoming inspection, invoice processing and vendor payment, and in some cases a portion of the inbound freight may also be included in order cost. It is important to understand that these are costs associated with the frequency of the orders and not the quantities ordered. For example in your receiving department the time spent checking in the receipt, entering the receipt and doing any other related paperwork would be included while the time spent repacking materials, unloading trucks, and delivery to other departments would likely not be included. If you have inbound quality inspection where you inspect a percentage of the quantity received you would include the time to get the specs and process the paperwork and not include time spent actually inspecting, however if you inspect a fixed quantity per receipt you would then include the entire time including inspecting, repacking, etc. In the purchasing department you would include all time associated with creating the purchase order, approval steps, contacting the vendor, expediting, and reviewing order reports, you would not include time spent reviewing forecasts, sourcing, getting quotes (unless you get quotes each time you order), and setting up new items. All time spent dealing with vendor invoices would be included in order cost. 

     Associating actual costs to the activities associated with order cost is where many an EOQ formula runs afoul. Do not make a list of all of the activities and then ask the people performing the activities "how long does it take you to do this?" The results of this type of measurement are rarely even close to accurate. I have found it to be more accurate to determine what percentage of time within the department is consumed performing the specific activities and multiplying this by the total labor costs for a certain time period (usually a month) and then dividing by the line items processed during that same period.

     It is extremely difficult to associate inbound freight costs with order costs in an automated EOQ program and I suggest it only if the inbound freight cost has a significant effect on unit cost and its effect on unit cost varies significantly based upon the order quantity.

     In manufacturing the Order cost would include the time to initiate the work order, time associated with picking and issuing components excluding time associated with counting and handling specific quantities, all production scheduling time, machine set up time, and inspection time. Production scrap directly associated with the machine setup should also be included in order cost as would be any tooling that is discarded after each production run. There may be times when you want to artificially inflate or deflate set up costs. If you lack the capacity to meet the production schedule using the EOQ you may want to artificially increase set up costs to increase lot sizes and reduce overall set up time. If you have excess capacity you may want to artificially decrease set up costs, this will increase overall set up time and reduce inventory investment. The idea being that if you are paying for the labor and machine overhead anyway it would make sense to take advantage of the savings in reduced inventories.

     For the most part Order cost is primarily the labor associated with processing the order however you can include the other costs such as the costs of phone calls, faxes, postage, envelopes, etc. 

Carrying cost (Inventory Holding Costs): Also called Holding cost, carrying cost is the cost associated with having inventory on hand. It is primarily made up of the costs associated with the inventory investment and storage cost. For the purpose of the EOQ calculation, if the cost does not change based upon the quantity of inventory on hand it should not be included in carrying cost. In the EOQ formula, carrying cost is represented as the annual cost per average on hand inventory unit. Below are the primary components of carrying cost.

Interest. If you had to borrow money to pay for your inventory, the interest rate would be part of the carrying cost. If you did not borrow on the inventory however have loans on other capital items, you can use the interest rate on those loans since a reduction in inventory would free up money that could be used to pay these loans. If by some miracle you are debt free you would need to determine how much you could make if the money was invested.

Insurance. Since insurance costs are directly related to the total value of the inventory, you would include this as part of carrying cost.

Taxes. If you are required to pay any taxes on the value of your inventory they would also be included.

Storage Costs. Mistakes in calculating storage costs are common in EOQ implementations. Generally companies take all costs associated with the warehouse and divide it by the average inventory to determine a storage cost percentage for the EOQ calculation. This tends to include costs that are not directly affected by the inventory levels and does not compensate for storage characteristics. Carrying costs for the purpose of the EOQ calculation should only include costs that are variable based upon inventory levels. 

     If you are running a pick/pack operation where you have fixed picking locations assigned to each item where the locations are sized for picking efficiency and are not designed to hold the entire inventory, this portion of the warehouse should not be included in carrying cost since changes to inventory levels do not effect costs here. Your overflow storage areas would be included in carrying cost. Operations that use purely random storage for their product would include the entire storage area in the calculation. Areas such as shipping/receiving and staging areas are usually not included in the storage calculations, however if you have to add an additional warehouse just for overflow inventory then you would include all areas of the second warehouse as well as freight and labor costs associated with moving the material between the warehouses.

     Since storage costs are generally applied as a percentage of the inventory value you may need to classify your inventory based upon a ratio of storage space requirements to value in order to assess storage costs accurately. For example let's say you have just opened a new E-business called "BobsWeSellEverything.com". You calculated that overall your annual storage costs were 5% of your average inventory value, and applied this to your entire inventory in the EOQ calculation. Your average inventory on a particular piece of software and on 80 lb. bags of concrete mix both came to $10,000. The EOQ formula applied a $500 storage cost to the average quantity of each of these items even though the software actually took up only 1 pallet position while the concrete mix consumed 75 pallet positions. Categorizing these items would place the software in a category with minimal storage costs (1% or less) and the concrete in a category with extreme storage costs (50%) that would then allow the EOQ formula to work correctly.

    There are situations where you may not want to include any storage costs in your EOQ calculation. If your operation has excess storage space of which it has no other uses you may decide not to include storage costs since reducing your inventory does not provide any actual savings in storage costs. As your operation grows near a point at which you would need to expand your physical operations you may then start including storage in the calculation.

     A portion of the time spent on cycle counting should also be included in carrying cost, remember to apply costs which change based upon changes to the average inventory level. So in cycle counting you would include the time spent physically counting and not the time spent filling out paperwork, data entry, and travel time between locations.

     Other costs that can be included in carrying cost are risk factors associated with obsolescence, damage, and theft. Do not factor in these costs unless they are a direct result of the inventory levels and are significant enough to change the results of the EOQ equation.

 

Variations

There are many variations on the basic EOQ model. I have listed the most useful ones below.

        Quantity discount logic can be programmed to work in conjunction with the EOQ formula to determine optimum order quantities.  Most systems will require this additional programming.

        Additional logic can be programmed to determine max quantities for items subject to spoilage or to prevent obsolescence on items reaching the end of their product life cycle.

        When used in manufacturing to determine lot sizes where production runs are very long (weeks or months) and finished product is being released to stock and consumed/sold throughout the production run you may need to take into account the ratio of production to consumption to more accurately represent the average inventory level.

        Your safety stock calculation may take into account the order cycle time that is driven by the EOQ.  If so, you may need to tie the cost of the change in safety stock levels into the formula.

 

Implementing EOQ

 

     There are primarily two ways to implement EOQ. Both methods obviously require that you have already determined the associated costs.  The simplest method is to set up your calculation in a spreadsheet program, manually calculate EOQ one item at a time, and then manually enter the order quantity into your inventory system.  If your inventory has fairly steady demand and costs and you have less than one or two thousand SKUs you can probably get by using this method once per year.  If you have more than a couple thousand SKUs and/or higher variability in demand and costs you will need to program the EOQ formula into your existing inventory system.  This allows you to quickly re-calculate EOQ automatically as often as needed.  You can also use a hybrid of the two systems by downloading your data to a spreadsheet or database program, perform the calculations and then update your inventory system either manually or through a batch program.  Whichever method you use you should make sure to follow the following steps:

        Test the formula.  Prior to final implementation you must test the programming and setup.  Run the EOQ program and then manually check the results using sample items that are representative of the variations of your inventory base.

        Project results.  You'll need to run a simulation or use a representative sampling of items to determine the overall short-term and long-term effects the EOQ calculation will have on warehouse space, cash flow, and operations.  Dramatic increases in inventory levels may not be immediately feasible, if this is the case you may temporarily adjust the formula until arrangements can be made to handle the additional storage requirements and compensate for the effects on cash flow.  If the projection shows inventory levels dropping and order frequency increasing, you may need to evaluate staffing, equipment, and process changes to handle the increased activity.

        Maintain EOQ.  The values for Order cost and Carrying cost should be evaluated at least once per year taking into account any changes in interest rates, storage costs, and operational costs.

      A related calculation is the Total Annual Cost calculation.  This calculation can be used to prove the EOQ calculation.  Total Annual Cost = [(annual usage in units)/(order quantity)(order cost)]+{[.5(order quantity)+(safety stock)]*(annual carrying cost per unit)}.  This formula is also very useful when comparing quotes where vendors offer different minimum order quantities, price breaks, lead times, transportation costs.

      Use it!  The EOQ calculation is "Hard Science", if you have accurate inputs the output is the most cost-effective quantity to order based upon your current operational costs.  To further increase inventory turns you will need to reduce the order costs.  E-procurement, vendor-managed inventories, bar coding, and vendor certification programs can reduce the costs associated with processing an order.  Equipment enhancements and process changes can reduce costs associated with manufacturing set up.  Increasing forecast accuracy and reducing lead times which result in the ability to operate with reduced safety stock can also reduce inventory levels.

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