ECONOMIC ORDER QUANTITY

 

Purchase department in manufacturing concerns is usually faced with the problem of deciding the 'quantity of various items' which they should purchase. If purchases of material are made in bulk then inventory carrying cost will be high. On the other hand if order size is small, then the ordering cost will be high. In order to minimize ordering and carrying costs it is necessary to determine the order quantity which minimizes these two costs. The size of the order for which both ordering and carrying cost are minimum is known as economic order quantity.

Assumptions underlyinq E.O.Q: The calculation is s    to the following assumptions:

a)    Ordering cost per order and carrying cost per u   nnum are known and they do not change.

b)    Anticipated usage of material in units is kno       vance.

0

c)    Cost per unit of the material is constant   own in advance.

d)    The quantity of material ordered is rec    Immediately i.e. the lead time is zero.

How to calculate? : An e.g.: Orderin per annum. Annual usage of R.M. - 3,

er order: Rs. 150. Carrying cost per unit: Rs.1.50 per unit units. No discounts are offered. Find EOQ.

Tabular Or Trial & Error Method:

If the entire raw material required is purchased at a time, number of orders to be placed - 1 •

Ordering cost P.A. - 1 order x 150 Carrying cost - 3,200 x 1/2 x 1.50

150 = 2 400

                        

  Total cost                     2 550

If two purchase orders are placed:

Ordering cost P.A. - 2 orders x 150	300
Carrying cost - 1,600 x 1/2 x 1.50	= 1 200 (3,200	1.50)
Total cost	1 500

If 3 purchase orders are placed: Total cost - 1 ,250 (450 + 800)

If 4 purchase orders are placed: Total cost - 1 ,200 (600 + 600) If 5 purchase orders are placed: Total cost - 1 ,230 (750 + 480)

Let us tabulate:

No. of Orders (1)	Qty./order (2)	Avg. Inv.	Ordering cost (4) = (1) X 150	Carrying cost (5) = (3) x 1.50	Total cost
1	3,200	1 ,600	150	2,400	2,550
2	1 ,600	800	300	1 ,200	1 ,500
3	1066	533	450	800	1 ,250
4	800	400	600	600	1,200
5		320	750	750	1 ,230

* Since the total cost is least here, EOQ is 800 units (i.e. 4 orders per annum) Some Observations:

a)  At EOQ, OC = CC.

b)  Upto EOQ, total cost is decreasing and thereafter it is increasing. Formula/Equation Method (Wilson's Formula):

2AS

EOQ = c

Where,

A = Annual usage

per order

S = Ordering cost Both must be for the same time period C = Carrying cost per unit per annum

Costs associated with EOQ:

1.    Buying or Ordering Costs: These are costs associated with every purchase order and are incurred every time a purchase order is made out. So examples are:

a)    Cost of paperwork - Purchase Requisition, Pu           rder.

b)    Cost of placing advertisements in newspa     iting quotations from suppliers.

c)    Cost of administration - negotiation a            n with suppliers.

d)    Cost of inspection, sample testing

2.    Carrying or Stockholding Cost e are costs associated with carrying one unit of the raw material in stock. It includes:

a)    Interest on working capital.

b)    Insurance & Warehousing Charges.

c)    Loss due to deterioration of materials during storage & obsolescence etc.

As the number of purchase orders decreases, quantity ordered every time increases. Hence carrying cost also increases based on average inventory held.

Total ordering cost = no. of orders X cost per order

Total carrying cost = EOQ / order size X — X carrying cost p.u/ p.a