Example
The material DX is used uniformly throughout the year. The data about annual requirement,
ordering cost and holding cost of this material is given below:
Annual requirement: 2,400 units
Ordering cost: $10 per order
Holding cost: $0.30 per unit
Required: Determine the economic order quantity (EOQ) of material DX using above data.
Solution
The economic order quantity for material DX is 400 units. Now, we can compute the number
of orders to be placed per year, annual ordering cost, annual holding cost and combined
annual ordering and holding cost as follows:
Number of orders per year
= Annual demand/EOQ
= 2,400 units/400 units
= 6 orders per year
Ordering cost
= Number or orders per year × Cost per order
= 6 orders × $10
= $60
Holding cost
= Average units × Holding cost per unit
= (400/2) × 0.3
= $60
Combined ordering and holding cost at economic order quantity (EOQ):
= Ordering cost + Holding cost
= $60 + $60
= $120
Notice that both ordering cost and holding cost are $60 at economic order
quantity. The holding cost and ordering cost at EOQ tend to be the same.
Tabular determination of economic order quantity (EOQ)
Under tabular approach of determining economic order quantity, the combined ordering and
holding cost is computed at different number of orders and their respective order quantities.
This approach is also known as trial and error approach of determining economic order
quantity.
This approach is illustrated below using the same data as used in the above example:
*Average units × Holding cost per unit: 1,200 units × 0.30 = $360
Notice that the quantity of 400 units with 6 annual orders and a combined ordering and
holding cost of $120 is the most economical quantity to order. Other order quantities that
result in more or less than six orders per year are not so economical. For example, if only
one order for the whole annual requirement of 2,400 units is placed, the combined ordering
and holding cost comes to $370 which is far higher than the cost at economic order quantity
of 400 units.
The application of tabular approach is not common as it is more time consuming as
compared to formula approach. Moreover, in some situations, it provides only an estimate
of economic order quantity and is therefore not as accurate as the formula approach. If a
question regarding economic order quantity is asked in the examination, the students
should avoid using tabular (trial and error) approach; rather they should use the formula
approach which is comparatively less time consuming and which also provides the most
accurate answer.
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Example 2
The John Sports Inc. purchases tennis balls at $20 per dozen from its suppliers. The John
Sports will sell 34,300 dozens of tennis balls evenly throughout the year. The total cost to
handle a purchase order is $10. The insurance, property tax and rent for each dozen tennis
balls in the average inventory is $1.40. The company wants a 5% return on average
inventory investment.
Required:
1. Compute the economic order quantity.
2. Compute the total annual inventory expenses to sell 34,300 dozens of tennis balls if
orders are placed according to economic order quantity computed in part 1.
Solution
1. Economic order quantity:
*$0.40 + ($20 × 5/100) = $1.4
2. Total annual inventory expenses to sell 34,300 dozens of tennis balls:
= Annual ordering cost + Annual holding cost
= (Number of orders × Cost per order) + (Average units × Holding cost per unit)
= (*49 orders × $10) + [(700/2) × 1.4]
= $490 + $490
= $980
*Number of orders to be placed: 34,300/700 = 49 orders
Underlying assumptions of economic order
quantity (EOQ)
The computation of economic order quantity (EOQ) is based on the following assumptions:
1. The total number of units to be consumed during the period is known with certainty.
2. The total ordering cost remains constant throughout the period.
3. The inventory cost remains constant throughout the period.
4. There are no cash or quantity discounts available.
5. The whole quantity of ordered inventory is delivered in one batch.
6. The optimal quantity for each invariable or stock item is computed separately.
7. The lead time does not fluctuate and the order is received on time with the total
order quantity.
The assumptions described above are also known as the limitations of economic order
quantity (EOQ).
