EOQ – End of …?
EOQ is the acronym of Economic Order Quantity, which is the optimal order quantity calculated based on some assumptions. The EOQ calculation, which was studied and proposed in 1915 by Mr. Ford. W. Ham is considered as the most important analysis of inventory control and one of the most important inventions derived in any area of operations management. This is done to minimize inventory holding and order-related costs.
The sudden appearance of JIT and Lean concepts, however, have been shaking the critical basement of EOQ. While JIT and Lean removes all wastes in inventory, every order only comes at the right time in the right quantity. EOQ requires an economic quantity, the items purchased in lots or batches and not continuously. It means that EOQ consumes more companies’ storage space, but the trend now is to eliminate all the wastes as much as possible.
In addition, EOQ is only applicable in the condition of some unrealistic assumptions such as known and constant demands, no allowable shortages, known and variable cost and zero lead time. But in reality, no companies exist in this environment. Hence “the old school EOQ” sayings of many supply chain industry executives
So, is EOQ really the “End of …” ?
The answer is no, it is still valid as a basic analytic tool in many companies. The reason for EOQ being not applicable lies in the ways that they implement EOQ, but not EOQ itself.
Who is most suitable for using EOQ?
In reality, EOQ still plays an essential role in operation management of many companies that deal with large volumes of stock as well as purchase-to-stock distributors and make-to-stock manufacturers. These are relevant in case materials only supplied by a limited number of suppliers or suppliers in a far distance.
For manufacturers, EOQ is particularly applicable if the product utilizing the raw materials has a simple process structure and is produced continuously over time at a fairly uniform rate.
By way of example, a chemical process manufacturer requires only a few major ingredients to yield a finished product because economic production run sizes are known and the production rate is relatively constant over a long time period. Therefore, many materials can be ordered in bulk on a quarterly or annual basis in container load, railcar load or truckload quantities.
Additionally, business candidates for EOQ applications are those that have a steady demand for stock such as maintenance, repair and operating inventory (MRO). Such suitable candidates can include manufacturers with a highly repetitive production process with long runs; while retailers and high technology providers are the least likely candidates.
Some mistakes when using EOQ
Thomas Tanel, the president and CEO of CATTAN services Group Inc, had alarmed that many companies have never determined their cost of placing and processing a single purchase order (e.g., the time and extra cost to send in an order for an item, receive it, handle the supplier’s invoice and pay for it). This cost of placing and processing a single paper-based purchase order (PO) is often substantial. The cost impact of placing and processing a single PO in many instances is further aggravated by the higher receipt handling processing and inbound freight charges that may incur for smaller and more frequently delivered orders. The issues in determining the purchase cost influenced directly the EOQ calculation.
In addition, many companies tend to ignore the change in demand during a period of manufacturing. In detail, EOQ is often calculated at the start of the year and companies have a tendency to stick to it without adjusting or even revision. This could lead to a period of stock out when demand is high or excess inventory building up in the warehouse. Because EOQ assumes that the entire order for an item is received into inventory at a given time.
Another terribly rarely- discovered mistake is that EOQ treats all inventory items in the same way, regardless of their value to the business. Whereas, most companies pay no attention to this issue. This means these companies are wasting valuable space on items which are unnecessary to have in stock.
What can be done to make EOQ become relevant again?
EOQ is great, but not in every case. Therefore, companies should consider when and how to implement EOQ to calculate the most relevant Economic Order Quantity.
Relating to this problem, Thomas Tanel developed some guidelines when implementing EOQ formula:
- The EOQ formula applies to products offered at a single price; therefore, if different prices or discounts are offered by your supplier based on quantity purchased, do not use EOQ.
- It works best with normal predictable demand items. If seasonality is involved, EOQ gives you the order quantity independent of the increased or decreased seasonal demand. For items with seasonal demand, you will have to make an adjustment in your demand.
- The EOQ formula assumes the price of goods acquired will not change during the time the order is in stock. If the item being ordered is subject to price volatility or the price is expected to increase or decrease, you should know how to stock ahead before a known upcoming price increase occurs and adjust the EOQ accordingly.
These guidelines after being introduced have gained a lot of support from business zones. However, in the modern world, it is advisable that companies should apply modern management systems with the support of Artificial Intelligence and IOT.
Huyen Tran
