Economic Order Quantity (EOQ)

with Quantity Discounts

Prepared by:

Robbie Harmon
Brigham Young University
November 28, 2005

Outline

What is EOQ?
When do I use it?
Definition of EOQ components
How does it work?
Introducing Quantity Discounts
Are there any limitations?
Real World Example
Practice
Summary
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What is EOQ?
EOQ = mathematical device for arriving at
the purchase quantity of an item that will
minimize the cost equation below
total cost = holding costs + ordering costs

SoWhat does that mean?

Basically, EOQ helps you identify the most
economical way to replenish your inventory
by showing you the best order quantity.

When do I use it?

Suppose you are responsible for ordering
inventory. You have the following information.
It costs $5 to hold one widget in inventory for a year
It costs $100 to place an order for widgets, regardless of size
Customers demand 2,500 widgets every year
(Sales are distributed evenly throughout the year)
How large should your orders be to minimize total cost?

How large should your orders

be?

If your orders are too large, youll have excess inventory and high holding
costs

If your orders are too small, you will have to place more orders to meet
demand, leading to high ordering costs

Order Size

Holding Costs

Ordering Costs

Too LARGE

High

Low

Too SMALL

Low

High

EOQ helps you find the balance!!!

EOQ is the quantity where Holding cost = Ordering cost

Definition of EOQ Components

H = annual holding cost for one unit of inventory
S = cost of placing an order, regardless of size
P = price per unit
d = demand per period
D = annual demand
L = lead time
Q = Order quantity (this is what we are solving for)

How does it work?

Total annual holding cost = (Q/2)H
Total annual ordering cost = (D/Q)S
EOQ:
Set (Q/2)H = (D/Q)S and solve for Q
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Solve for Q algebraically

(Q/2)H = (D/Q)S
Q2 = 2DS/H
Q = square root of (2DS/H) = EOQ

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When should we place an order for

Q units?
SS = safety stock
Reorder point = ROP = d L + SS

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Introducing Quantity Discounts

What are quantity discounts?
Example:

Order Size

1 - 100

101 - 200

201 - 300

Price per unit

$20

$18

$16

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EOQ with Quantity Discounts

Minimize the following equation:
Total cost = holding costs + ordering costs + item costs
(Total cost = (Q/2)H + (D/Q)S + DP)

This is done in 2 steps

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2 Steps
1.

Calculate EOQ. If this amount can be purchased at the

lowest price, you have found the quantity that minimizes
the equation. If not, proceed to step 2.

2.

Compare total cost at the EOQ quantity with total costs

at each price break above the EOQ.

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Limitations of this basic model

1. H and S are often estimated imprecisely
2. Ordering costs and demand rates vary
throughout the year

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Real World example

1974 Report to Congress by the
Comptroller General of the U.S.
Proper Use of the Economic Order Quantity
Principle Can Lead to More Savings

16

Practice
Suppose you are responsible for ordering inventory. You
have the following information.
It costs $5 to hold one widget in inventory for a year
It costs $100 to place an order for widgets, regardless of size
Customers demand 2,500 widgets every year
(Sales are distributed evenly throughout the year)

What is EOQ?
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EOQ = 316

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Practice continued
Now suppose the following quantity discounts are
available.
Order Size

1 - 200

201 - 350

351 - 500

Price per unit

$20

$18

$16

What amount should be purchased?

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Summary
Understanding EOQ and quantity discounts
can result in substantial savings!
Review

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Review
What is EOQ?
What 2 steps should be taken when
considering quantity discounts?

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Reading List
Bogner, Michael. Quantity Discounts / Economic Order Quantity.
http://www.dau.mil/pubs/pm/pmpdf02/Sept_Oct/BOGSE-0C2.pdf
Bozarth, Cecil C., & Handfield, Robert B. Introduction to Operations and Supply
Chain Management. Upper Saddle River, NJ: Pearson Prentice Hall, 2005
Bragg, Steven M. Inventory Best Practices. Hoboken, NJ: John Wiley & Sons,
Inc., 2004
Ozcan, Yasar A. Quantitative Methods in Health Care Management. San
Francisco, CA: Jossey-Bass, 2005 (pp. 259 -267)
Report to the Congress by the Comptroller General of the United States. Proper
Use of the Economic Order Quantity Principle Can Lead to More Savings:
United States General Accounting Office, 1974 (pp. 1-10)

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Reading List
Schreibfeder, Jon. Effective Replenishment Parameters. Microsoft. Microsoft
Business Solutions.
http://download.microsoft.com/download/d/6/9/d69de816-aecb-4869-a920-2b
5afccd7589/eimwp4_replenish.pdf
Toomey, John W. Inventory Management: Principles, Concepts, and Techniques.
Norwell, MA: Kluwer Academic Publishers, 2000 (pp. 61-72)

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