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Unit 7: Inventory Management
one-half the order quantity. Therefore, the larger the order quantity, the larger the average Notes
inventory and consequently, the greater the maintenance cost per year. However, the larger the
order quantity, the fewer orders required per planning period and, consequently, the lower the
total ordering cost. Lot quantity formulations identify the precise quantities at which the annual
combined total cost of ordering and maintenance is lowest for a given sales volume.
Economic Order Quantity
The Economic Order Quantity (EOQ) is the replenishment order quantity that minimizes the
combined cost of inventory maintenance and ordering. Identification of such a quantity assumes
that demand and costs are relatively stable throughout the year.
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Caution Since an EOQ is calculated on an individual product basis, the basic formulation
does not consider the impact of joint ordering of products.
The most efficient method for calculating economic order quantity is mathematical. To make
the appropriate calculations, the standard formulation for EOQ is
EOQ = 2CoD/CiU
Where EOQ = economic order quantity (EOQ)
Co = cost per order
Ci = annual inventory carrying cost
D = annual sales volume, units
U = cost per unit
While the EOQ model determines the optimal replenishment quantity, it does require some
rather stringent assumptions that constrain its direct application. The major assumptions of the
simple EOQ model are:
1. Satisfaction of all demand
2. Continuous, constant, and known rate of demand
3. Constant and known replenishment performance-cycle time
4. Constant price of product that is independent of order quantity or time (i.e., no purchase
quantity or transportation price discounts are available)
5. Infinite planning horizon
6. No interaction between multiple items of inventory
7. No inventory in transit
8. No limit on capital availability. The constraints imposed by some of these assumptions
can be overcome through computational extensions. However, the EOQ concept illustrates
the importance of the trade-offs associated with holding and acquisition cost.
EOQ Extensions
While the EOQ formulation is relatively straightforward, there are some other factors that must
be considered in actual application. The most persistent problems are those related to various
adjustments necessary to take advantage of special purchase situations and unitization
characteristics.
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