Calculate Economic Order Quantity Principles of Cost Analysis and Management © Dale R Geiger 2011 What you think? Corporal O’Reilly, the supply clerk, knows that it costs the Army money to generate a purchase order To save money he proposes ordering the five years’ worth of ammunition at once © Dale R Geiger 2011 Terminal Learning Objective • Action: Calculate Economic Order Quantity For Various Situations • Condition: You are a cost advisor technician with access to all regulations/course handouts, and awareness of Operational Environment (OE)/Contemporary Operational Environment (COE) variables and actors • Standard: With at least 80% accuracy: Describe the concept of economic order quantity Identify the key variables in the EOQ calculation © Dale R Geiger 2011 Batch Quantity Concepts • Certain costs are fixed on a per-batch basis • Setting up machinery to run a particular product • Purchasing cost • Training cost • We call these “Batch Costs” • More units in a batch means lower batch cost per unit Batch cost per unit = © Dale R Geiger 2011 Batch Cost Assumptions • Annual demand for units produced in batches is known • Every batch is the same size i.e same quantity of units produced â Dale R Geiger 2011 Batch Costs • Batch Cost = Batch Cost per Unit * # Units Demanded -or- * #Units Demanded © Dale R Geiger 2011 Batch Costs • Another way of thinking of Batch costs is: # of Batches * Cost per Batch -or* Batch $Cost © Dale R Geiger 2011 Batch Costs • The full equation is: • First divide # units demanded by # units in batch to get # of batches, then multiply by Batch $ Cost © Dale R Geiger 2011 Batch Costs • The full equation is: • First divide # units demanded by # units in batch to get # of batches, then multiply by Batch $ Cost © Dale R Geiger 2011 Batch Costs • The full equation is: • Or, first divide Batch $ Cost by # Units in batch to get Batch cost per unit, then multiply by # units demanded © Dale R Geiger 2011 10 Holding Cost Example • Annual holding cost for supplies is $50 per unit • What is holding cost if each unit of supplies is purchased on its own purchase order? Average inventory = unit/2 or ẵ unit ẵ unit * $50/unit = $25 What is holding cost if all 200 units of supplies are purchased on one purchase order? • Average inventory = 200 units/ or 100 units • 100 units * $50/unit = $5,000 © Dale R Geiger 2011 30 Holding Cost Example • Annual holding cost for supplies is $50 per unit • What is holding cost if each unit of supplies is purchased on its own purchase order? • Average inventory = unit/2 or ẵ unit ẵ unit * $50/unit = $25 • What is holding cost if all 200 units of supplies are purchased on one purchase order? • Average inventory = 200 units/ or 100 units 100 units * $50/unit = $5,000 â Dale R Geiger 2011 31 Graph of Holding Cost Holding Cost $ 5000 4500 4000 3500 3000 2500 2000 1500 1000 500 When quantity per purchase order is 10 Average Inventory = and holding cost is $250 When quantity per purchase order is 100 Average Inventory = 50 and purchasing cost is $2,500 50 100 150 X-Axis = Number of units per purchase order As number of units per purchase order increases, holding cost increases © Dale R Geiger 2011 200 32 Check on Learning • How does holding cost change as batch quantity changes? • How is holding cost represented on the graph? © Dale R Geiger 2011 33 Optimizing Order Quantity • Total Costs Related to Order Quantity = Purchasing Cost + Holding Cost • What is Total Cost when Quantity per order is 10 units? 5000 + 250 = 5250 • What is Total Cost when Quantity per order is 100 units? 500 + 2500 = 3000 © Dale R Geiger 2011 34 Optimizing Order Quantity • Total Costs Related to Order Quantity = Purchasing Cost + Holding Cost • What is Total Cost when Quantity per order is 10 units? 5000 + 250 = 5250 • What is Total Cost when Quantity per order is 100 units? 500 + 2500 = 3000 © Dale R Geiger 2011 35 Optimizing Order Quantity • Total Costs Related to Order Quantity = Purchasing Cost + Holding Cost • What is Total Cost when Quantity per order is 10 units? 5000 + 250 = 5250 • What is Total Cost when Quantity per order is 100 units? 500 + 2500 = 3000 © Dale R Geiger 2011 36 Graph of Total Costs 5000 4500 Total Cost is minimized where Purchasing Cost = Holding Cost 4000 3500 3000 Purchasing Cost Holding Costs Total Cost 2500 2000 1500 1000 500 0 20 40 60 ≈45 80 100 120 140 160 180 200 X-Axis = Order quantity in units © Dale R Geiger 2011 37 Optimizing Order Quantity • Total Cost is minimized at the order quantity where Holding Cost = Purchasing Cost • Computation of this “Indifference Point” requires calculus beyond the scope of this course © Dale R Geiger 2011 38 Optimizing Order Quantity • The relationship is well-documented and is captured in the “Economic Order Quantity” (EOQ) Formula: EOQ = d = Demand in units p = cost per Purchase Order h = Holding cost per unit â Dale R Geiger 2011 39 Calculating EOQ Demand is 200 units • Purchasing Cost is $250 per Order • Holding Cost is $50 per Unit EOQ = EOQ = = approx 45 units © Dale R Geiger 2011 40 Check on Learning • What are the three variables used in the Economic Order Quantity formula? • How will EOQ change if holding cost per unit increases while all other variables remain the same? © Dale R Geiger 2011 41 Practical Exercise © Dale R Geiger 2011 42 Batch Quantity Spreadsheet Enter batch cost, holding cost, and demand into the spreadsheet to generate the graph of total cost © Dale R Geiger 2011 43 Practical Exercise © Dale R Geiger 2011 44 ... a purchase order To save money he proposes ordering the five years’ worth of ammunition at once © Dale R Geiger 2011 Terminal Learning Objective • Action: Calculate Economic Order Quantity For... 1000 500 5000 When quantity per purchase order is 10, twenty purchase orders are issued and purchasing cost is $5000 When quantity per purchase order is 100, two purchase orders are issued and... purchase order is issued for each unit of supplies? 200 purchase orders * $250/ purchase order = $50,000 • How much is purchasing cost if all 200 units are purchased using a single purchase order?