Economic order quantity

Economic order quantity (EOQ) is the order quantity 1.2 The Total Cost function and derivation
that minimizes the total inventory holding costs and or- of EOQ formula
dering costs. It is one of the oldest classical production
scheduling models. The framework used to determine
this order quantity is also known as Wilson EOQ Model,
Wilson Formula or Andler Formula. The model was
developed by Ford W. Harris in 1913,[1] but R. H. Wil-
son, a consultant who applied it extensively, and K. An-
dler are given credit for their in-depth analysis.[2]

1 Overview
EOQ applies only when demand for a product is constant
over the year and each new order is delivered in full when
Classic EOQ model: trade-o between ordering cost (blue) and
inventory reaches zero. There is a xed cost for each or- holding cost (red). Total cost (green) admits a global optimum.
der placed, regardless of the number of units ordered. Purchase cost is not a relevant cost for determining the optimal
There is also a cost for each unit held in storage, com- order quantity.
monly known as holding cost, sometimes expressed as a
percentage of the purchase cost of the item. The single-item EOQ formula nds the minimum point
We want to determine the optimal number of units to or- of the following cost function:
der so that we minimize the total cost associated with the Total Cost = purchase cost or production cost + ordering
purchase, delivery and storage of the product. cost + holding cost
The required parameters to the solution are the total de- Where:
mand for the year, the purchase cost for each item, the
xed cost to place the order and the storage cost for each
item per year. Note that the number of times an order is Purchase cost: This is the variable cost of goods:
placed will also aect the total cost, though this number purchase unit price annual demand quantity. This
can be determined from the other parameters. is P D

Ordering cost: This is the cost of placing orders:

1.1 Variables each order has a xed cost K, and we need to order
D/Q times per year. This is K D/Q
P = purchase unit price, unit production cost
Holding cost: the average quantity in stock (between
Q = order quantity fully replenished and empty) is Q/2, so this cost is h
Q/2
Q = optimal order quantity
DK hQ
D = annual demand quantity TC = PD + Q + 2 .
To determine the minimum point of the total cost curve,
K = xed cost per order, setup cost (not per unit, partially dierentiate the total cost with respect to Q (as-
typically cost of ordering and shipping and handling. sume all other variables are constant) and set to 0:
This is not the cost of goods)
0 = DK
Q2 + 2
h

h = annual holding cost per unit, also known as car- Solving for Q gives Q* (the optimal order quantity):
rying cost or storage cost (capital cost, warehouse 2 2DK
space, refrigeration, insurance, etc. usually not re- Q = h
lated to the unit production cost) Therefore:

1
2 5 REFERENCES

All units discount: an order of 1-1000 units costs

$50 each; an order of 1001-5000 units costs $45
Q* is independent of P; it is a function of only K, D, h. each; an order of more than 5000 units costs $40
each. So when 1500 units are ordered, the total cost
The optimal value Q* may also be found by recognising
is $45*1500.
that[3]

T C = DK + hQ + P D = 2Qh
(Q 2DK/h)2 +
Q 2
2.1 Design of Optimal Quantity Discount
2hDK + P D, where the non-negative quadratic term
disappears for Q = 2DK/h, which provides the cost Schedules
minimum T Cmin = 2hDK + P D.
In presence of a strategic customer, who responds opti-
mally to discount schedule, the design of optimal quantity
1.3 Example discount scheme by the supplier is complex and has to be
done carefully. This is particularly so when the demand
Suppose annual requirement quantity (D) = 10000 at the customer is itself uncertain. An interesting eect
units called the reverse bullwhip takes place where an in-
crease in consumer demand uncertainty actually reduces
Cost per order (K) = $2
order quantity uncertainty at the supplier.[6]
Cost per unit (P)= $8
Carrying cost percentage (h/P)(percentage of P) =
0.02
3 Other Extensions
Annual carrying cost per unit (h) = $0.16 Several extensions can be made to the EOQ model devel-
oped by Mr. Pankaj Mane, including backordering costs
Economic order quantity = 2DK = 2100002
= and multiple items. Additionally, the economic order in-
h 80.02
500 units terval can be determined from the EOQ and the economic
production quantity model (which determines the optimal
Number of orders per year (based on EOQ) = 10000 500 = production quantity) can be determined in a similar fash-
20 ion.
Total cost = P D + K(D/EOQ) + h(EOQ/2) A version of the model, the Baumol-Tobin model, has
Total cost = 810000+2(10000/500)+0.16(500/2) = also been used to determine the money demand function,
$80080 where a persons holdings of money balances can be seen
in a way parallel to a rms holdings of inventory.[7]
If we check the total cost for any order quantity other
[8]
than 500(=EOQ), we will see that the cost is higher. For Malakooti (2013) has introduced the multi-criteria
instance, supposing 600 units per order, then EOQ models where the criteria could be minimizing the
total cost, Order quantity (inventory), and Shortages.
Total cost = 810000+2(10000/600)+0.16(600/2) =
$80081
Similarly, if we choose 300 for the order quantity then 4 See also
Total cost = 810000+2(10000/300)+0.16(300/2) =
$80091 Constant ll rate for the part being produced:
Economic Production Quantity
This illustrates that the Economic Order Quantity is al-
ways in the best interests of the rm. Demand is random: classical Newsvendor model
Demand varies over time: Dynamic lot size model

2 Quantity Discounts Several products produced on the same machine:

Economic Lot Scheduling Problem
An important extension to the EOQ model of Wilson Reorder point
is to accommodate quantity discounts. There are two
main types of quantity discounts: (1) all-units and (2)
incremental.[4][5] Here is a numerical example: 5 References
Incremental unit discount: Units 1-100 cost $30 [1] Harris, Ford W. (1990) [Reprint from 1913]. How Many
each; Units 101-199 cost $28 each; Units 200 and Parts to Make at Once (PDF). Operations Research (IN-
up cost $26 each. So when 150 units are ordered, FORMS) 38 (6): 947950. doi:10.1287/opre.38.6.947.
the total cost is $30*100 + $28*50. JSTOR 170962. Retrieved Nov 21, 2012.
 3

[2] Hax, AC and Candea, D. (1984), Production and Opera- 7 External links
tions Management, Prentice-Hall, Englewood Clis, NJ,
p. 135 The EOQ Model
[3] Grubbstrm, Robert W. (1995). Modelling produc- http://www.inventoryops.com/economic_order_
tion opportunities an historical overview. Inter- quantity.htm
national Journal of Production Economics 41: 114.
doi:10.1016/0925-5273(95)00109-3. http://www.scmfocus.com/supplyplanning/2014/
04/10/economic-order-quantity-calculator/
[4] Nahmias, Steven (2005). Production and operations anal-
ysis. McGraw Hill Higher Education.

[5] Zipkin, Paul H, Foundations of Inventory Management,

McGraw Hill 2000

[6] Altintas, N.; Erhun, F.; Tayur, S. (2008). Quantity Dis-

counts Under Demand Uncertainty. Management Science
54 (4): 777792. doi:10.1287/mnsc.1070.0829.

[7] Andrew Caplin and John Leahy, Economic Theory and

the World of Practice: A Celebration of the (S,s) Model,
Journal of Economic Perspectives, Winter 2010, V 24, N
1

[8] Malakooti, B (2013). Operations and Production Systems

with Multiple Objectives. John Wiley & Sons. ISBN 978-
1-118-58537-5.

6 Further reading

Harris, Ford W. Operations Cost (Factory Manage-

ment Series), Chicago: Shaw (1915)

Camp, W. E. Determining the production order

quantity, Management Engineering, 1922

Wilson, R. H. A Scientic Routine for Stock Con-

trol, Harvard Business Review, 13, 116-128 (1934)

Plossel, George. Orlickys Material Requirements

Planning. Second Edition. McGraw Hill. 1984.
(rst edition 1975)

Alessandro Andrioloa, Daria Battinia, Robert W.

Grubbstrmb, Alessandro Personaa, Fabio Sgar-
bossaa, A century of evolution from Harriss basic
lot size model: Survey and research agenda, Inter-
national Journal of Production Economics 2014

Donald Erlenkotter. Ford Whitman Harriss eco-

nomical lot size model, International Journal of Pro-
duction Economics 2014

Tsan-Ming Choi (Ed.) Handbook of EOQ Inven-

tory Problems: Stochastic and Deterministic Mod-
els and Applications, Springers International Series
in Operations Research and Management Science,
2014.
4 8 TEXT AND IMAGE SOURCES, CONTRIBUTORS, AND LICENSES

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