EOQ and inventory management techniques in plant operations


Economic order quantity (EOQ) is the technique which solves the problem of the materials manager. EOQ or Opt Q (Optimum Quantity) is the order size at which the total cost, comprising ordering cost plus carrying cost, is the least. The materials manager determines these optimum quantities while ordering through the techniques which he must be aware of.

Weakness of EOQ Formula

1. Erratic Usages: The formulae used assume that the usage of materials is both predictable and evenly distributed. When this is not the case, the formulae are useless. Different and far more complex formulae can be developed for wide swings in usage, so long as these swings can be predicted. But if usage varies unpredictably, as it often does, no formula will work well.

2. Faulty Basic Information: EOQ calculations are only as accurate as the order cost and carrying cost information in which they are based. It is no easy job to calculate order cost. In practice, order cost varies from commodity to commodity. Carrying cost can vary with the company’s opportunity cost of capital.

3. Costly calculations: It is not an easy job to estimate the cost of acquisition and cost of possession accurately. This requires hours of work by skilled cost accountants. Actual calculation of EOQ can be time-consuming even when the simple formulae for steady usage are used. More elaborate formulas are even more expensive. In many cases, cost of estimation, cost of possession and acquisition and calculation of EOQ exceeds the savings made by buying that quantity.

4. No Formula is a Substitute for Commonsense: It is therefore desirable to include a number of modifiers. The formula may suggest that, we order six years supply, based on the assumption that we will continue to require the item at the same rate for the next six years. The modifier is a ‘maximum’, not more than certain period of supply. It may suggest that we order every week, and for these volumes a different ordering method is required to be followed. It may suggest that we order very small quantities, unacceptable to the supplier or penalized by small quantity extras.

The modifier here would be ‘minimum’ limit. Some items are best ordered from an outside source and at the same time from the works (in house) jointly in case the item is manufactured in house to save on set-up time or for some other reason. ‘Order with’ would be the modifier.

5. EOQ ordering must be tempered with judgment:

Certain corporate operating goals must be followed in managing an inventory. Sometimes, the guidelines provide a conflict in ordering. Where an order strategy conflicts with an operating goal, order strategy restrictions should be developed to permit honoring the goal. EOQ restrictions might include the following:

§ Items purchased to order, and items subject to rapid product improvement will be restricted from EOQ use.

§ Shelf life items (those goods only for a specific length of time) should be restricted to a quantity, not greater than one fourth of their age limitation.

§ Items with unusual sales will be identified, with annual sales reduced by appropriate quantities, prior to calculating EOQ.

§ Critical supply items (those having most effect on customer’s service), will be ordered in greater than normal quantities. The time of supply of quantities selected will over-ride EOQ.

Minimum-Maximum technique:

The minimum-maximum system is often used in connection with manual inventory control systems. The minimum quantity is established in the same way as any re-order point. The maximum is the minimum quantity plus the optimum lot-size. In practice, a requisition is initiated when a withdrawal reduces the inventory below the minimum level. The order quantity is the maximum minus the inventory status after the withdrawal. If the final withdrawal reduces the stock level substantially below the minimum level, the order quantity will be higher than the calculated EOQ.

Two-Bin Technique:

One of the oldest systems of inventory control is the two-bin system which is mainly adopted to control ‘C’ group inventories (lowest value in terms of annual consumption). In the two-bin system, stock of each item is separated into two bins. One bin contains stock, just enough to last from the date a new order is placed until it is received in inventory. The other bin contains a quantity of stock, enough to satisfy probable demand during the period of replenishment. To start with, the stock is issued from the first bin. When the first bin is empty, an order for replenishment is placed, and the stock in the second bin is utilized until the ordered material is received.

Such a method is appropriate to ideal conditions in which the rate of consumption is fairly constant and for items, the lead time of which is fairly established and regular.