Economic Order Quantity

October 16, 2005 2:26 PM

What are the advantages and disadvantages of the Economic Order Quantity (EOQ) formula?

Thank you.
http://en.wikipedia.org/wiki/Economic_order_quantity

posted by strangelove to work & money (9 comments total)

Well, it seems like the downside of this formula is that the underlying assumptions are perposterous.

Though it seems that it could be a useful way to pinpoint which variable requires the most attention.
posted by mullacc at 2:37 PM on October 16, 2005

I've got a degree in Logistics, and we studied EOQ pretty thoroughly.

The advantage of the EOQ formula is that it provides a baseline for getting the best deal. It helps you purchase what you're going to use and keeps you from overpurchasing to get 'deals' from vendors.

The disadvantages are very obvious if you've got a high periodicity or seasonality to your consumption, or your usage is very minimal. EOQ should only be applied to higher volume items that are worth inventorying; it's much safer to use VMI (Vendor Managed Inventory) for items like bolts and screws that have a high volume and aren't worth inventorying. For instance, I would never use EOQ to order screws or bolts unless they were particularily expensive and individually inventoried. I wouldn't use EOQ to order memory chips for a retail computer store, because demand can vary greatly and the risk that they'll become obsolete is high. However, I would use EOQ to order steel L-brackets for an industrial production facility where production is consistent and/or forecast.

To use EOQ reliably, you must not have seasonality, you must know and understand both historical and future demand, and you must maintain a sane safety stock.
posted by SpecialK at 2:42 PM on October 16, 2005

mullacc: What parts are preposterous?

1. the demand for the item is known

In industrial applications, yeah, you generally know what your production forecasts are going to be.

2. the lead time is known and fixed

Again, in industrial applications, you usually know how long it takes to get things.

3. the receipt of the order occurs in a single instant

This means that you're not doing continuous receipts; i.e. you're not ordering 1,000 and having ten delivered per week... this is because holding cost is factored in here.

4. quantity discounts are not calculated as part of the model

That's to keep you from trying for them. Holding cost (or in a retail buy-stock-sale (as opposed to job lot sale-buy-ship) environment, marketing liqudiation cost due to overstock) usually cancels out any possible quantity discounts you can get.

5. stockouts or shortage do not occur

Hence the safety stock. You MUST have a safety stock, and it should not be factored into the equation.

BTW, do note that we're looking at traditional cost accounting structures here (i.e. holding cost). If you're using the shift in internal accounting advocated by Goldblatt's Theory of Constraints, EOQ is not a good tool to use.
posted by SpecialK at 2:47 PM on October 16, 2005

This is a great response so far! Thank you everyone.
posted by strangelove at 2:57 PM on October 16, 2005

Sorry, I was talking out of my ass. I was thinking of posting a "please ignore me" comment after your first comment and I wish I would've since you took the time to refute my nonsense.

I've spent the last few years doing M&A in the technology sector, so whenever I see something like "demand is known" and "lead time is known" it seems totally ridiculous.
posted by mullacc at 3:01 PM on October 16, 2005

Mullacc: Not a problem, it's OK. It's just that talking out of your ass isn't usually that helpful on AxMe, so I tend to discourage it whenever I see it. ;)

BTW, I meant GoldRatt instead of Goldblatt. Strangelove, you might go to the library and check out "The Goal" ... it's a very good read, and it's a story told in novel form as opposed to a textbook.

EOQ sounds like it's a good match for your organization in some cases, but you're going to need to be careful with it due to the project-oriented nature of companies these days. Make sure you factor demand from different projects into your considerations; i.e. if a project is using 40 #2 widgets a month for the next six months and then demand will drop back to 2 per month, you fall into a seasonality trap.
posted by SpecialK at 3:14 PM on October 16, 2005

I should also say that EOQ was developed back when your father's father's factory opened and planned to make bolts for the next 300 years, and needed to know how much bar stock to buy per month. Keep that in mind when you're using it in today's shorter-product-lifecycle environment. No equation or theory or principle can or shold overrule good ol' common sense in purchasing.
posted by SpecialK at 3:17 PM on October 16, 2005

No equation or theory or principle can or shold overrule good ol' common sense in purchasing.

Eh :) Try explaining that to managers by magazine. 2005 is the year of FIFO I tell you, all the experts concur !
posted by elpapacito at 4:57 PM on October 16, 2005

We use it in almost every solicitation (DoD, buying things like hardware and spare parts). What will happen is that our customers will want to buy one widget and we'll issue a solicitation for one widget. In the solicitation will be a clause (EOQ) where vendors can tell us, look, it just doesn't pay for me to tool up and build just one of these widgets. The EOQ = >1.
posted by fixedgear at 5:49 PM on October 16, 2005