4.3.1 Basic inventory decisions and EOQ
At the very basic level any firm faces two main decisions concerning the management of inventory: When should new stock be ordered and in what quantities? With regard to the order quantity, which minimises inventory related costs, we are familiar with the classical EOQ (economic order quantity) model. This remains the basic inventory model even when it is not applicable in real life business situations in most cases.
In inventory related literature, the answer to the question of when to order is given with reference to the ROP (reorder point), the point at which the replenishment order should be initiated so that the facility receives the inventory in time to maintain its target level of service. The ROP can be defined in terms of units of days or in units of inventory. In the static and deterministic model, the ROP is the simple multiplication of the number of lead days and the daily demand. It means that every time the inventory falls to the ROP level, an order must be initiated. And the order quantity is given by the EOQ model which is based on cost minimisation.
Figure 4.1 A simple deterministic inventory model based on fixed demand and fixed lead time
You are aware that the EOQ quantity is the balance between order and holding costs attached with the inventory. The order cost is made up of fixed and variable costs, whereas the holding cost consist of costs of insurance, taxes, maintenance and handling, opportunity costs and costs of obsolescence.
In your text
See Section 3.2.1 for a good discussion on the EOQ model.
The formula for EOQ or economic order quantity is well known:
Q is the order quantity per order.
K is the fixed set up cost which the warehouse incurs every time it places an order.
D is the demand per day.
h is the inventory carrying or holding cost per unit per day.
You will notice that your text highlights two important insights regarding the EOQ model. These are:
- Optimum order size is a good balance between the holding cost and the fixed order cost.
- Total inventory cost is related with order size, but the relationship is not very significant.
A discussion of the EOQ model would remain incomplete if the inherent assumptions on which the model is based are ignored. Bowersox (2001) explains that these major assumptions are:
- All demand is satisfied.
- The rate of demand is continuous, constant and known.
- Replenishment lead time is constant and known.
- There is a constant price of product that is independent of order quantity or time.
- There is an infinite planning horizon.
- There is no interaction between multiple items of inventory.
- There is no inventory in transit.
- There are no limits on capital availability.
Back Page