Economic Order Quantity Model in Stock Management

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How realistic are the assumptions of the Economic Order Quantity (EOQ) model?

Economic order quantity is an accounting operational method that assists the company to order an order size or quantity that minimizes costs. The method works on several assumptions. It assumes that the demand, lead time, purchase price, holding cost, and order costs are constant and known with certainty. Secondly, no shortages are allowed in the system. The goods are replaced instantaneously or at once when ordered by the company.

The assumptions are unrealistic since orders do not always arrive instantly and at once. Secondly, demand is not perfectly steady as it is affected by different factors such as the price of goods, substitutes, compliments, and consumer tastes. The assumption that demand is constant becomes realistic.

Safety stocks determine when to order and by how much therefore it affects the lead time. It provides a buffer in times of emergency when the regular stock is not available. The safety stock acts as a buffer. It helps the company deal with fluctuations in demand and supply. Safety stock is the stock kept by the company above the normal level of stock. Lead time refers to the point at which a company makes an order to the time the quantity is available for use.

Re-order point on the other hand refers to the point where minimum inventory level is attained and the company has to replenish the stock. It is the summation of lead time demand and the optimal safety stock. In random demand, the inventories for safety stock are usually from 60- 90% of the average inventory while the order quantities are between 10- 40%. This means that safety stocks have twice the influence of order quantities.

How can the issues of safety stock be incorporated in EOQ and re-order point (RP) while ordering inventory?

It is important to incorporate safety stock in EOQ because you can change them easily without affecting the procurement costs and they are the most effective in decision making (Hax and Candea, 1984, p 135) The optimal safety stock is whereby the total cost is minimized.

The formula is Total cost = PD + D/Q*Co + (1/2Q + S)*Ch whereby Q is the economic order quantity, D is the annual demand, Co is the ordering cost that is the cost incurred each time an order is made, Ch is the holding cost that is the cost of having inventory at hand P is the purchase cost per unit and S is the safety stock. The minimum point of the total cost is whereby the ordering cost is equal to the holding costs that is, D/Q*Co = Q/2*Ch. The formula is important as it assists the company to analyze the transport costs, lead times, and order quantities of different suppliers. The economic order quantity formula is useful in the calculation of input stock which leads to accurate output with cost-effective order quantity depending on the current operational costs, hence useful in management decision making.

Is the model still used in practice? If not, what model is mostly used while ordering inventory?

The EOQ model is not widely used in practice today. Managers are now using the Just in Time model to order inventory.

Just in Time is a production model whereby items are made to meet the demand. There is no surplus production since the company produces only what is needed. The purpose of JIT is to avoid wastes such as overproduction; defective items and waiting by ensuring operations are smooth and continuous.

Just in Time features has a production line that is run on a demand-pull basis. This ensures that the activity of each work station can only be authorized on demand. Therefore there is a smooth and continuous flow of parts based on end unit demand to maintain a constant flow of parts. It ensures total quality whereby emphasis is doing the job right the first time. This eliminates wastes as the production is stopped if defective work is found. Set up time and lead times are minimized. Production depending on demand requires the manufacture of small quantities which is economical if set up time are small.

The advantages of Just in Time are several. It leads to substantial savings in stockholding costs because work in progress enables control of inventory through observation. Work in progress constitutes a lower percentage of total costs. There is an elimination of wastes and savings in factory and warehouse space, which can be used for other profitable activities. Furthermore, there is a reduction in obsolete stock because of the lack of large amounts of materials. There is also a considerable reduction in paperwork arising from a reduction in purchasing stock and accounting transactions. This is because a cost accounting system is not required.

The disadvantages are that there will need to be additional investment costs in new machinery, changes in plant layout, and goods inwards facilities. It is difficult to predict daily or weekly demand.

There is also increased risk due to the greater probability of stockout costs arising from strikes or other unforeseen circumstances that restrict production.

In conclusion, due to the presence of JIT, EOQ has lost its relevance because most organizations focus on the reduction of the total cost. JIT provides for that as it reduces the cost of delayed delivery, cost of early delivery, and ordering costs. Organizations using JIT are reporting significant cost savings.

References

Hax, A. and Candea, D. (1984). Production and Operations Management. NJ, Prentice-Hall.

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Economic Order Quantity Model in Stock Management

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