Material Costing – How much to order – Theory of EOQ

ECONOMIC ORDER QUANTITY

INTRODUCTION

Whenever we think of cost for making a product the first thing that comes to our mind is Material Cost and undoubtedly it’s the heaviest cost incurred by any manufacturing company due to which we try to minimise it. Inventory is nothing but assets of organisation which requires investment. Every investment has a cost attached to it and if we invest huge in inventory we will have to loose an opportunity of investing these funds elsewhere and earn something but if we are low on investment in inventory we tend to loose on sales. Think of being a trader of any commodity you will definitely feel the above words. So now we not only have to think on how much to invest in inventory (HOW MUCH TO ORDER) but when to invest (WHEN TO ORDER). We hereby only discuss how many units should one order i.e. HOW MUCH TO ORDER.

BASIC UNDERSTANDING

Being a consumer we consume food grains, pulses, nuts, fruits, vegetables, milk & milk products etc. on a daily basis. For consuming them we purchase it by placing orders and once we receive them we tend to stock it up and use whenever required and this is our routine exercise.

Now if someday you are given a task to manage the food stock of your house and you were to order the required necessities, how much quantity will you order and when will place the order?

Let’s take an e.g. suppose you have to purchase sugar. How many kgs of sugar would you purchase? Well, your answer can be 1 kg or 10 kgs or 100 kgs or even 10 grams. Whatever you answer is based on your requirements, availability of the required products and the frequency with which you are going to use/consume it up, so there is nothing right or wrong. But do remember whenever we order, we can incur costs such as storage and transportation. Now, let’s take extreme cases to develop our understanding, suppose if we buy all 100 kgs which is our yearly requirement (assumed – you can take any number which you want to) at one time what would happen? Frankly we would end up facing storage issues or you may think we will suffer losses due to spoilage (generally in case of perishable products) but save heavily on transport cost since all units are purchased at one time. If I say there are no space issues and the product will not get spoiled will you still buy all 100 kgs at one time? No. Why? Reason being why to invest so much money in the form of stock and loose opportunity by investing it elsewhere and rather earn something. Let’s think other way round; if we purchase only 100 grams which is our daily requirement (assumed) will it suffice? No, because than we rush to the market again & again for purchasing which will lead to more of transport cost & lower of storage costs. Thus we need to decide carefully in relation to number of units to be purchased at one time otherwise it will impact our pockets adversely. This problem in above e.g. looks kid dish but if we talk about manufacturing companies than the volume would multiply but facts remains the same.

ORDERING COST

It simply means the cost incurred on every single purchase which includes travelling allowance & daily allowance purchase managers, salary of purchase department personnel, transportation cost, Inspection cost, loading unloading & handling cost. All these costs are pertaining in respect of every order and are not absorption of any overheads. Now this cost increases as number of orders increase and vice versa. The following Graph depicts its nature.

CARRYING COST

Carrying cost means cost incurred for holding inventory. It includes storage cost & interest cost in respect of money locked in stocks. Carrying cost further includes deterioration, insurance, pilferage, obsolescence and shrinkage cost. Higher the stock of raw materials higher will be the carrying cost and vice versa & in order to understand this cost in more detail we have represented the following graph:

ECONOMIC ORDER QUANTITY (EOQ) MODEL

Based on above we can conclude that both the costs are inversely related to each other. Lowering one increases another and vice versa & thus it is practically impossible to minimise both at the same time and therefore we need to minimise total inventory associated cost Thus EOQ is determine by the intersection of ordering cost curve and carrying cost line. At this point total ordering cost is equal to total carrying cost, and the total of the two costs is the least

Annual Requirement (A) – It represents demand for Raw material or Input for a year.

Cost per Order (O) – It represents cost of placing an order for purchase.

Carrying Cost (C) – It represents cost of carrying average inventory on annual basis.

DERIVATION OF FORMULA

This formula is derived from the following cost function:

At EOQ, Total Carrying Cost = Total ordering Cost

Carrying cost per unit = C

Average inventory = EOQ / 2

Carrying cost of average inventory = (EOQ /2)×C

Cost incurred to place a single order = O

Order size = EOQ

Annual demand in units = A

Total number of order for the period = A / EOQ

Total ordering cost for the period = (A / EOQ) × O

At EOQ, Total Carrying Cost = Total ordering Cost

(EOQ /2) × C = (A / EOQ) × O

EOQ × EOQ = (2 × A × O) / C

EOQ = √ (2×A×O)/C

We can say, Total ordering cost + Total carrying cost = √(2×A×O×C)

ASSUMPTIONS OF THE THEORY

The formula is based on the following assumptions. Without these assumptions, the EOQ model cannot work to its optimal potential.

  1. A, O, C are constant throughout the year.
  2. There is no lead time i.e.no time gap between ordering and receiving goods.
  3. Raw materials are evenly consumed.

LIMITATIONS OF THEORY

The EOQ model assumes steady demand of a business product and immediate availability of items to be re-stocked. It does not account for seasonal or economic fluctuations. It assumes fixed costs of inventory units, ordering charges and holding charges.

CONCLUSION

The EOQ is very useful tool of inventory control for top organisations as well as small traders. It may be applied to finished goods inventories, work-in-progress inventories and raw material inventories. It regulates purchase and storage of inventory in such a way so as to maintain an even flow of production & at the same time, avoiding excessive investment in inventories.

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