Explain the Economic Order Quantity (EOQ) from first principles.
EOQ, or Economic Order Quantity, was developed by F. W. Harris in1913, even if R. H. Wilson is recognized for his early deeply analysis of the model. Harris’s original pape was disseminated; it actually was ignored for many years before its rediscovery in 1988. During this period, a lot misunderstanding developed over the origin of the EOQ model.
The model is defined as the optimal quantity of orders that minimizes total variable costs required to order and hold inventory.
The first part of the essay will explain the principles of the EOQ and gives an idea about how it works.
Second part will sets out its advantages and disadvantages.
EOQ is not a simple solution but an instrument, which enable the firm to determine the order size that will reduce the total inventory costs, by calculating an economic order quantity. It refers to the most favourable order volume that will result in the lowest total of order and carrying costs for an article of inventory given its expected usage, carrying costs and ordering cost. Thus, by dint of its principles, the EOQ tool can be used to form the quantity of inventory that the firm should order each month.
Indeed, there are two categories of costs that need to be considered: ordering costs and carrying costs (also called holding costs) which must be defined.
Holding cost, carrying cost is the cost associated with having inventory on hand. It is made up of the costs linked with the inventory investment and storage cost. For the use of the EOQ calculation, the cost must change based upon the quantity of inventory on hand in order to be included in carrying cost. In the EOQ formula, carrying cost is represented as the annual cost per average on hand inventory unit.
The interest rate would be part of the carrying cost if a loan is required to pay for your inventory. If there are loans on other capital items, the use of the interest rate on those loans is possible since a reduction in inventory would free up money that could be used to pay these loans. If you are debt free you would need to determine how much you could make if the money was invested.
Insurance costs are also a part of carrying cost since they are directly related to the total value of the inventory.
If a payment of any taxes on the value of the inventory is necessary they would also be included.
Mistakes in calculating storage costs are frequent 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.
As to the ordering cost, it is associated with processing the order, by receipt and settlement of the suppliers bills. The marginal cost of the additional order can be appraised; its a fixed cost, independent of the size of the order.
When the order quantity (Q) increases, the total ordering costs decrease while the total carrying costs increase. The economic order quantity, denoted by Q, is that value at which the total cost of both ordering and carrying will be minimized.
The total cost curve reaches its minimum at the point of intersection between the ordering costs curve and the carrying costs line. The value of Q corresponding to it will be the economic order quantity Q.
The EOQ formula can be used in order to improve the management of supply, even if there is any information concerning the costs. It can reduce the value of the average inventory for the same order load and decrease the order load for the same average inventory.
The advantage of the EOQ formula is that it provides a baseline for getting the best deal. It helps you purchase what you are going to use and keeps you from over purchasing to get deals from vendors.
The disadvantages are obvious if you have a high periodicity or seasonality to your consumption, or your usage is minimal. EOQ should only be applied to higher volume items that are worth inventorying; for example, using EOQ to order memory chips for a retail computer store can be detrimental since the demand can vary greatly and the risk that they will become obsolete is high.
Knowing and understanding both historical and future demand, and maintaining a sane safety stock are the keys to use EOQ reliably. Furthermore, there should not have seasonality.
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