13.1 Inventory Costs and Economic Order Quantity

Inventory management involves balancing ordering, holding, and shortage costs. Companies must carefully consider these factors to optimize their inventory levels and minimize overall expenses. The Economic Order Quantity (EOQ) formula helps find the sweet spot between ordering too much or too little.

Determining the optimal order quantity requires calculating the EOQ, reorder point, and total inventory costs. Factors like demand changes, lead time variations, and cost fluctuations can impact these calculations. Companies must adapt their inventory strategies to account for real-world complexities beyond the basic EOQ model.

Inventory Cost Components and Economic Order Quantity

Costs of inventory management

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• Ordering costs involve administrative expenses for placing orders, shipping and handling fees, receiving and inspection costs (paperwork processing, quality control)

• Holding costs encompass storage space expenses, insurance premiums for inventory, opportunity cost of capital tied up in inventory, depreciation or obsolescence of stored items (warehousing, security)

• Shortage costs include lost sales due to stockouts, expedited shipping costs for rush orders, customer dissatisfaction and potential loss of goodwill, production downtime due to lack of materials (backorder costs, overtime labor)

Economic Order Quantity calculation

• EOQ formula $EOQ = \sqrt{\frac{2DS}{H}}$ balances ordering and holding costs where D represents Annual demand, S denotes Setup or ordering cost per order, H signifies Holding cost per unit per year

• EOQ significance minimizes total inventory costs, provides optimal order quantity for each replenishment (cost efficiency, inventory optimization)

• EOQ model assumes constant and known demand, fixed ordering and holding costs, instantaneous replenishment, no quantity discounts (simplified inventory management)

Optimal order quantity determination

• Calculate optimal order quantity using EOQ formula while considering constraints or practical limitations (storage capacity, shelf life)

• Reorder point calculation: $Reorder Point = (Average Daily Demand × Lead Time) + Safety Stock$ accounts for lead time between placing and receiving an order, safety stock handles uncertainties (stockout prevention)

• Total inventory cost components include annual ordering cost $(D/Q) × S$, annual holding cost $(Q/2) × H$, total cost $TC = (D/Q) × S + (Q/2) × H$ (cost analysis, decision-making)

• Cost trade-offs: larger order quantities reduce ordering costs but increase holding costs, smaller order quantities increase ordering costs but reduce holding costs (inventory strategy)

Factors affecting inventory costs

• Demand changes impact EOQ and total costs: increased demand raises both, decreased demand lowers both (market fluctuations)

• Lead time variations affect reorder point and safety stock: longer lead times increase both, shorter lead times decrease both (supply chain efficiency)

• Ordering cost changes influence EOQ: higher ordering costs increase EOQ, lower ordering costs decrease EOQ (process improvements)

• Holding cost changes affect EOQ: higher holding costs decrease EOQ, lower holding costs increase EOQ (storage efficiency)

• Quantity discounts may justify ordering larger quantities than EOQ, requires comparison of total costs at different order sizes (bulk purchasing)

• Seasonal demand necessitates adjustments to EOQ and reorder points for different seasons, consideration of peak periods and off-seasons (holiday shopping, agricultural cycles)