Basic Economic Order Quantity (EOQ) Model
Basic Economic Order Quantity (EOQ) Model Figure 4.2.3: EOQ Model
The basic EOQ model is used to identify a fixed order size that will minimise the total annual costs of holding inventory and ordering. Since the unit cost is not affected by the order size unless quantity discounts are there, unit purchase price is not included in the total cost. If carrying costs (holding costs) are specified as a percentage of unit cost, then unit cost is included indirectly in the total cost.
The basic EOQ model involves the following assumptions: This model is applicable when only one product is involved Annual demand is known Demand rate is reasonably constant as the demand is spread evenly throughout the year Constant lead time Each order is received
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As already mentioned. If the order size varies, one type of costs will increase while the other decreases. Therefore, an order size should be selected in sicu a way that it causes neither a few very large orders nor many small orders, but one that lies somewhere between.
Annual carrying cost is a product of average amount of inventory on hand and cost of carrying per unit per year. It is computed as follows:
Annual carrying cost = Q/2 H
Where Q is the order quantity in units and H is the carrying cost per unit. From the above equation, it is clear that carrying cost is a linear function of Q; that is, carrying costs increase or decrease in direct proportion to changes in the order quantity Q.
Annual ordering cost is a function of number of orders per year. It is computed as follows:
Annual Ordering cost = D/Q S
Where D: the annual demand in units
S: ordering cost.
Annual ordering cost is inversely related to the order
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Similar to EOQ model, there is a cost trade-off in this model too. If the batch size is large, the average level of inventory of the product is also large and therefore the inventory carrying costs are high. Since a few of such large batches would suffice for the annual requirements, the number of set- ups would be small and the corresponding set up costs would be low. Conversely, when the batch size is small, the number of set-ups required for production purpose is high. Subsequently the order cost or the set up cost would be high. But at the same time, the average inventory levels are small which make the carrying costs as
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