HBS Toolkit

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Copyright 1999 President and Fellows of Harvard College

Economic Order Quantity Calculator

INTRODUCTION

Contents Introduction Analysis Chart

This sheet Economic Order Quantity Calculator Static graphs of typical EOQ outputs with basic descriptions

Overview Economic Order Quantity (EOQ) is a tool for helping managers decide how much of a given item to produce or order. It takes into account the main costs associated with acquiring and holding inventory and finds the optimum trade-off between them. EOQ can be applied to a wide variety of situations: A machine in a plant produces two different widgets. How many of each widget should be produced before the machine is stopped and reset in order to produce the other? An office manager wants to decide how to order stationery supplies. A restaurant needs to decide how frequently to have rice delivered. The components of EOQ are: 1. Cost of setup. This can refer to the downtime a machine has when it is retooled in order to produce a different product, the direct and indirect costs of ordering supplies, or whatever is appropriate to the specific decision. It is the additional cost, incurred regardless of volume, that must be paid each time you order or produce a run of the product. The larger the amount of product you order or produce each time, the fewer setups and therefore the lower setup cost. Therefore, high setup costs will tend to lead to larger quantities. 2. Inventory carrying cost rate. This is the estimated annual percentage cost of holding inventory. It reflects not only the cost of capital, but also storage and movement costs, risk of obsolescence or damage, etc. 3. Value of inventory per unit. The more expensive the inventory is to produce or order, the more expensive it will be to hold on to it. 4. Annual Demand and Number of Units produced per batch. These are simply part of the mathematical formula so that the optimum number of batches can be determined.

Directions You may want to print these directions as a reference guide for this tool. To understand the tradeoff, let us look at the two extremes. Let us assume that annual demand is 100 units, setup costs are $1, value of inventory per unit is $1, carrying cost rate is 40% and batch size is 1. One option would be to produce or order all 100 units on day one, then gradually sell or consume them over the period of a year. That would minimize setup costs at $1, but we would have an average of fifty units in storage during the year, implying a carrying cost of $50 * 40% = $20. Total cost $21. At the other extreme, we could produce just one unit at a time, as needed. Then we would never have inventory on hand (other than for a brief moment while waiting delivery), but we would have 100 setups at $1 each. Total cost $100. Now lets try something in the middlewell produce four batches. That means four setups, or $4. It also means that our average inventory level will be 12.5 units, implying a carrying cost of $12.5 * 40% = $5. Total cost $9. Clearly the middle ground offers us an improvement over either extreme, and the EOQ formula allows us to calculate the optimum number of units/batches to produce or order each time. The formula is: Square root of: 2 * [cost of setup] * [annual demand] [inventory carrying cost rate] * [value of inventory per unit]

Economic Order Quantity Calculator

Other things to bear in mind when using EOQ

INTRODUCTION

As with any formula, your answer can only be as accurate as your assumptions. EOQ is most likely to be useful with respect to stable products where demand can reliably be forecast and where the risk of obsolescence is low. Remember that as a manager you are not always bound by the constraints in your environment. Setup costs can be reduced if your operations strategy calls for smaller, faster production runs. To start using the tool, remove the sample data from the tool using the Show/Hide Sample Data option under the HBS Menu Note About Using Internet Explorer The default setting in Internet Explorer is to open these tools in the Explorer application instead of Excel. We recommend against this and provide directions in the Help section of the HBS Toolkit web site to change this default behavior.

HBS Menu Show/Hide Sample Data: Show Calculator: Show/Hide Celltips: Print Sheet with Celltips: Set Zoom: Visit Web Links: About HBS Toolkit:

Displays or removes sample entries Launches Windows calculator Toggles in/out red Celltips in documented cells Prints Celltip documentation on current sheet Provides quick access to 80%, 100%, and 125% zoom levels Links to HBS Toolkit website, Toolkit Glossary, and Toolkit Feedback, as well as HBS and HBS Publishing web sites Launches the about box for the HBS Toolkit

Jon B. DeFriese MBA `00 and Chad Ellis, MBA `98 developed this software under the supervision of Professor Steven Wheelwright as the basis for class discussion rather than to illustrate either the effective or ineffective handling of an administrative situation.
Copyright 1999 President and Fellows of Harvard College

Economic Order Quantity Calculator

Cost per Setup Annual Demand Value of Inventory per Unit Inventory Carrying Cost Rate Number of Units Produced per Batch $ $ 400 1,500.00 800.00 40% 61.00

ANALYSIS

Cost of Carrying Inventory Cost of Setups Total Cost of Inventory Carrying and Setups Economic Order Quantity

$ $

9,760.00 9,836.07 $19,596.07 61

Copyright 1999 President and Fellows of Harvard College

Economic Order Quantity Calculator

CHART

Inventory Level

25 20 15 10 5 0 Time

Here's another way to think about the EOQ problem. This chart displays a typical inventory scenario. Initially, 20 units of an item are placed into inventory (purchased, manufactured, etc.). As the units are removed from inventory (sold, shipped, etc.), inventory drops to 0, at which point 20 more units are placed into inventory. The Problem 20 units may not be the optimal order level. There is a cost to keep each item in inventory (inventory holding cost), and there is a set-up cost to add new items into inventory. If acquiring inventory (set-up) carries a low cost, you may be better off ordering more frequently and keeping fewer items on hand. On the other hand, if it is very expensive to get items into inventory, but very inexpensive to keep them there, you would be better off ordering more units at a time, and ordering less frequently. The analysis sheet of this tool answers the question, "What inventory order level (q) best balances set-up costs against inventory holding costs?"

Economic Order Quantity Calculator

CHART

250 Cost ($) per annum 200 150 100 50 0 10 60 Order Size (units)
As you can see from this chart, the two fundamental variables (inventory holding cost and set-up cost) typically have an inverse relationship relative to order size. The total cost line is simply the sum of these two variables. The lowest point on the total cost curve corresponds to the optimal order size. The equations on the analysis sheet of this tool are simply calculating that low point, and presenting the corresponding order size. Some other issues to think about include "How frequently should I place orders?" and "At what inventory level should I replenish my inventory?" These questions are affected by issues including spoilage, product lifecycle, and your sales cycle. The HBS Toolkit also contains some other Inventory Planning Tools that take some of these other factors into account. For more information on these tools, visit the HBS Toolkit Website.
Copyright 1999 President and Fellows of Harvard College
inventory holding cost

set-up cost total cost