Operations Manager: EOQ

Economic Order Quantity (EOQ)

The purpose of the EOQ model is simple, to find that particular quantity to order which minimizes the total variable costs of inventory. Total variable costs are usually computed on an annual basis and include two components, the costs of ordering and holding inventory. Annual ordering cost is the number of orders placed times the marginal or incremental cost incurred per order. This incremental cost includes several components: the costs of preparing the purchase order, paying the vendor’s invoice, and inspecting and handling the material when it arrives. It is difficult to estimate these components precisely but a ball-park figure is good enough. The EOQ is not especially sensitive to errors in inputs.

Why don’t we include the purchase cost of the inventory in this calculation? It is not a variable cost. We have to purchase the inventory in any event. The goal is to minimize those costs that vary with the quantity purchased at one time.