Calculation of Economic Order Quantity and Its Weaknesses

A strategic factor in inventory control is computing the optimum size of a normal purchase order. It is the quantity of inventory which can be reasonable ordered at a time and purchased economically. It is also known as Standard Order Quantity, optimum quantity or Economic Lot Size. By definition, Economic order quantity is that size of order for which the total cost is minimum.

Calculation of Economic Order Quantity

In determining the economic order quantity the problem is one to set a balance between two opposing costs, namely ordering costs and carrying costs. The ordering costs are basically the costs of getting an item into the firm’s inventory. They are also known as acquisition costs or procurement costs. Carrying costs, sometimes also known as holding costs or cost or possessing the materials. These costs are known as ‘Associated Costs’ in aggregate .

The management is tempted on one hand to order huge quantity but, holding costs are also to be considered. Either of these two courses will have an adverse effect on the profits of the firm. Hence the management tries to reconcile them and this reconciliation point is economic order quantity. The nature of cost of carrying (holding cost) and cost of not carrying enough is quite opposite as follows:
The costs of carrying or holding costs can be estimated by the management on the basis of sales of past years but costs of not carrying enough are only estimated.

Formula to calculate Economic Order Quantity (EOQ)

The widely used formula of E.O.Q. to calculate the economic lot- size is as follows :

EOQ=√{(2RCp/CH)}

Here, R =Annual quantity to be used in units; Cp = Cost of Placing an order; CH = Cost of holding one unit for one year.

The following example will illustrate the method.

Example : Calculate the Economic Order Quantity if the annual demand for the product is 5,000 units, the ordering cost is US$30 per order and the holding cost is US$6/- per unit per annum.

Given :

R=5,000 units; Cp =US$30 ; CH= US$6

EOQ=√{(2RCp/CH)}

= √{(2x5000x30)/6}

=√50000 = 224 or 225 units.

The Limitations or weaknesses of the EOQ Model:

This EOQ model has certain weakness that are directly attributable to the assumptions on which it is based. The assumptions of a constant usage rate and the instantaneous replenishment of stocks are quite suspect. Most firms maintain safety stocks as a buffer against an unusual increase in demand or slow deliveries. The assumption of a known annual demand for items is also quite questionable. Actually a demand forecast is used to make the order quantity decision. If the forecast differs greatly from the actual outcome the wrong EOQ may be used.

Another weakness may become apparent when the model is used. Substituting the appropriate values into the EOQ equation may well produce some number such as 325.76 units. Ordering a portion of a unit would be quite difficult, however, this problem is easily solved by rounding the units. A more difficult situation, occurs when the number of orders to be placed turns to be a fraction 7.5 orders may be quite difficult to place in a given period. Since the total cost function is not actually symmetrical around the EOQ, some sensitivity analysis would be required to find the number of orders that should be placed.

Although, even the simple EOQ model has some weakness, it certainly provides the decision maker with better ground for a decision than subjective observations only.