Spreadsheet Models for Managers
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Spreadsheet Models for Managers
This reading is especially relevant for Session 11Economic Order Quantity
To understand why the Economic Order Quantity is given by the formula in the session notes, we must understand why the minimum value of Ct, total cost, occurs when the two contributing terms are equal. Remember that the total cost per unit has two components — the cost of ordering and the cost of carrying inventory.
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This total cost per unit, of course, isn’t really the total cost, despite our use of the word “total.” This total cost ignores the cost of the unit itself. But since we’re assuming that this element of cost is independent of Q, the task of finding the optimal value of Q reduces to the task of minimizing the sum of the two terms above.
- where
- D is annual demand (units)
Q is quantity per order
C0 is cost per order
Cc is carrying Cost of inventory (dollars per unit per year)
To learn why this strange coincidence occurs, you usually need to use Calculus, but we can give a pretty good argument without it. Let’s work a simpler problem first. We will find the value of Q that minimizes the expression
<snip>…
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…<end snip>
So
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Last Modified: Wednesday, 27-Apr-2016 04:15:26 EDT
Although the assumption of constant demand is critical to justifying the derivation of the formula for Economic Order Quantity, most problems don’t satisfy that requirement in the strict sense. But EOQ is nevertheless a valuable concept in two kinds of circumstances. The first case is when the time scale of the inventory management decisions is much shorter than the time scale of the variations in demand. And the second is when the fluctuations in demand occur much more rapidly than the inventory management decisions.
These two approximations occur repeatedly in modeling problems. Watch for opportunities to apply them elsewhere.