Economic Order Quantity
Chapter 8
The Economic Order-Quantity (EOQ) Model
Leroy B. Schwarz Purdue University
The economic order-quantity model considers the tradeoff between ordering cost and storage cost in choosing the quantity to use in replenishing item inventories. A larger order-quantity reduces ordering frequency, and, hence ordering cost/ month, but requires holding a larger average inventory, which increases storage (holding) cost/month. On the other hand, a smaller order-quantity reduces average inventory but requires more frequent ordering and higher ordering cost/month. The cost-minimizing order-quantity is called the Economic Order Quantity (EOQ). This chapter builds intuition about the robustness of EOQ, which makes the model useful for management decision-making even if its inputs (parameters) are only known to be within a range of possible values. This chapter also provides intuition about choosing an inventory-management system, not just an EOQ.
Introduction
Lauren Worth is excited about her new job at Cardinal Hospital. Lauren had worked at Cardinal, first as a candy-striper, and then, after college, as a registered nurse. After several years “working the wards,” Lauren left Cardinal to get an MBA. Now, having recently graduated, Lauren had returned to Cardinal as its first “Inventory Manager.” Lauren’s boss, Lee Atwood, is Purchasing Manager at Cardinal Hospital. Lauren has known Lee since her days as a candy-striper, and regards him as a friend. Lee describes himself as being from the “old school” of inventory management. “Lauren, I know that there are sophisticated methods for managing inventories, and, in particular for determining ‘optimal order-quantities.’ And, I know that Cardinal is paying a ‘management-cost penalty’ for using other than optimal orderquantities. In other words, that Cardinal is incurring higher than the minimum possible inventory-management costs in managing its inventories. But, frankly, I’m skeptical about what it will cost Cardinal
The Economic Order-Quantity (EOQ) Model
Leroy B. Schwarz Purdue University
The economic order-quantity model considers the tradeoff between ordering cost and storage cost in choosing the quantity to use in replenishing item inventories. A larger order-quantity reduces ordering frequency, and, hence ordering cost/ month, but requires holding a larger average inventory, which increases storage (holding) cost/month. On the other hand, a smaller order-quantity reduces average inventory but requires more frequent ordering and higher ordering cost/month. The cost-minimizing order-quantity is called the Economic Order Quantity (EOQ). This chapter builds intuition about the robustness of EOQ, which makes the model useful for management decision-making even if its inputs (parameters) are only known to be within a range of possible values. This chapter also provides intuition about choosing an inventory-management system, not just an EOQ.
Introduction
Lauren Worth is excited about her new job at Cardinal Hospital. Lauren had worked at Cardinal, first as a candy-striper, and then, after college, as a registered nurse. After several years “working the wards,” Lauren left Cardinal to get an MBA. Now, having recently graduated, Lauren had returned to Cardinal as its first “Inventory Manager.” Lauren’s boss, Lee Atwood, is Purchasing Manager at Cardinal Hospital. Lauren has known Lee since her days as a candy-striper, and regards him as a friend. Lee describes himself as being from the “old school” of inventory management. “Lauren, I know that there are sophisticated methods for managing inventories, and, in particular for determining ‘optimal order-quantities.’ And, I know that Cardinal is paying a ‘management-cost penalty’ for using other than optimal orderquantities. In other words, that Cardinal is incurring higher than the minimum possible inventory-management costs in managing its inventories. But, frankly, I’m skeptical about what it will cost Cardinal
References: Erlenkotter, D. (1989) “An Early Classic Misplaced: Ford W. Harris’s Economic Order Quantity Model of 1915,” Management Science 35:7, pp. 898–900. Federgruen, A. and Y. S. Zheng. (1992) “An Efficient Algorithm for Computing an Optimal (r,Q) Policy in Continuous Review Stochastic Inventory Systems,” Operations Research 40:4, pp. 808–813. Gallego, G. (1998) “New Bounds and Heuristics for (Q,r) Policies,” Management Science 44:2, 219–233. Harris, F. M. (1913) “How Many Parts to Make at Once,” Factory, The Magazine of Management 10:2, 135–136, 152. Reprinted in Operations Research 38:6 (1990), 947–950. Lowe, T. J. and L. B. Schwarz. (1983) “Parameter Estimation for the EOQ Lot-Size Model: Minimax and Expected-Value Choices,” Naval Research Logistics Quarterly, 30, 367–376. Schwarz, L. B. (1972) “Economic Order Quantities for Products with Finite Demand Horizons,” AIIE Transactions 4:3, 234–237. Zheng, Y. S. (1992) “On Properties of Stochastic Inventory Systems,” Management Science 38:1, 87–103. Zipkin, P. (2000) Foundations of Inventory Management, McGraw-Hill Higher Education, New York, New York.