Last Updated 18 Jun 2020

Economic Order Quantity and Its Implementation on Business

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ECONOMIC ORDER QUANTITY AND IT’S IMPLMENTATION IN BUSINESS Any business man, executive, and entrepreneur should know the basic tools for a company to develop in the market, regardless how big the business is, there are many factors involve. It is very important in every business to handle well developed financial and logistics processes. In order for a company to handle a correct logistic, without matter if it is a goods or services company, it is necessary to identify many factors.

Some of the factors to be taken into account are many strategic and financial matters, such as the supply chain management, warehouses, distribution centers, inventory management, packaging and material handling, transportation, among others. A commonly faced problem in companies is that managers of manufacturing or distribution organizations, doesn’t know which will be the adequate quantity of inventory to have in stock. Many people would think that the more stock a company has is the best.

It is true that having a large amount of inventory will help customers to make faster and immediate purchases, shipments will be done quicker, and will prevent the company of being out of stock of certain product and causing some opportunity cost with the customers; it is important to notice that the stocking of products is very expensive. Some companies, such as Wal-Mart or Dell Computers, handle an efficient managing of inventory that has developed their competitive advantage. Wal-Mart helps it suppliers by having the right quantity of their products in the shelves, so that will minimize the inventory accumulation of the merchandise.

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In the case of Dell, instead of having lots of computers stored in warehouses, waiting to be sold, the company minimizes this cost by building a computer right after an order is placed. [1] They keep at hand many computer components to make this possible, as they have a policy of five-day delivery. In order for every business to succeed as Wal-Mart and Dell Computers have done, it is important first to understand the decision – making techniques that many companies used to have and effective and efficient inventory management and production control.

The three main techniques are: Just – in – time system (JIT), Economic Order Quantity method, and a comparison between LIFO and FIFO. In this occasion I will focus precisely in a method for a well handling of the inventory, called Economic Order Quantity (EOQ) which has been used since the rise of the modern manufacturing processes in the early 20th century. The Economic Order Quantity is a calculating method used in small and large businesses in order to determine which will be the best level of inventory for production or purchasing while being the most cost effective.

EOQ is a tool mainly used in Operations Management that helps to minimize the purchasing costs as well as the inventory handling costs. The first model of this method was designed by F. W. Harris back in 1913. [2] The Economic Order Quantity is use to know how much inventory should be order by a company at a particular time. The EOQ method is used as a part of a periodically review inventory system that helps monitor the level of inventory that a company has at the moment and a fixed quantity of product can be order at any time that the inventory has reached a specific reorder point.

There is a model, or equation, that helps calculate the appropriate reorder point (ROP) and which will be the optimal reorder quantity for a successful replenishment cycle and inventory that will avoid a shortage, which may provoke the company to face some stockout costs. It helps determine the best point where the company can have the lowest inventory, holding, and ordering costs, by a mathematical formula that will show the number of units that the company should order. 3] It is very important to notice that not every business, company or industry uses the Economic Order Quantity method. It is a very useful tool in small businesses where the owners have to make the decisions regarding the amount of inventory they should be having on stock, which will be the quantity of a certain product that they will purchase or manufacture each time, and when will be the appropriate time to do it without having high costs.

Mainly because when we refer to small business, most of the time are new business that have to learn slowly how the market is developing and how to handle it, that’s why the economic order quantity method is an important tool to know the correct logistic for inventory to have, as long as the business grow. Also it is very common to be used in manufacturing facilities, where they have a constant and repetitive ordering of stock and production, they should know what will be the most cost effective quantity to manufacture in order to not face a shortage or have more inventories that needed.

Another example of types of business which find very useful the Economic Order Quantity method are the ones that handle several inventory activities such as maintenance, repair, and operation. Finally, another example will be all the companies that handle a large amount of stock and it is mainly used when goods and materials are purchased periodically. As we have already defined what the Economic Order Quantity method is, and which types of business used it, we have to determine which the main components of this model are.

The EOQ is mathematical equation, as I said before, that will throw the appropriate number that a company or small business should purchase, in order to minimize as best as possible all the cost involved in the process. But for make it possible for this method to work, we need to know the main variables - such as demand, purchasing costs, production, etc - to be taken into account at the moment of calculating this EOQ. When a company will take a purchasing decision, it is important and very necessary take into consideration the costs involved in the purchase or placing of the order, as well as the inventory holding or carrying costs.

In a mathematical way, the economic order quantity can be determined in two different ways. The first option is to present the answer in units. But before talking about every variable that is required for this method to be useful, we will define which is the equation used in this model. The Economic Order Quantity is the square root of [two times the annual usage, or demand of product, in units times the cost per order] divided by the annual carrying cost per unit. It is expressed as follows:

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