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Economic Order Quantity (EOQ)

Economic order quantity (EOQ) is the order quantity of inventory that minimizes the total cost of inventory management.

Two most important categories of inventory costs are ordering costs and carrying costs. Ordering costs are costs that are incurred on obtaining additional inventories. They include costs incurred on communicating the order, transportation cost, etc. Carrying costs represent the costs incurred on holding inventory in hand. They include the opportunity cost of money held up in inventories, storage costs, spoilage costs, etc.

Ordering costs and carrying costs are quite opposite to each other. If we need to minimize carrying costs we have to ...view middle of the document...

632.5 × $10).

SAFETY STOCK ANALYSIS

EOQ tells us HOW MUCH to order…but WHEN should we order?

Safety Stock

What Happens when either Demand or Lead Time Varies?

What is the Chance of a Stockout?

EXAMPLE

Finding Z

Safety Stock

When both lead time & demand are constant, you know exactly what the reorder point is …

* Under these assumptions:

Reorder point = demand during lead time

* Where

= demand per time period

= lead time

What Happens when either Demand or Lead Time Varies?

* Variances are caused by changes in demand rates and lead times.

* Additional inventory beyond amount needed to meet “average” demand during lead time

* Protect against uncertainties in demand or lead time

* Balance the costs of stocking out against the cost of holding extra inventory

* When holding safety stock (SS), the average inventory level is:

* Shown graphically:

What is the Chance of a Stockout?

Recalculating the reorder point to include safety stock

GRAPHIC

EXAMPLE

Calculating averages and variances of demand and lead time using historical data

Historical data for 10 weeks of demand, as well as 8 previous orders

Finding Z

* Z = number of standard deviations above average demand during lead time

* The higher z is:

* >> The lower the risk of stocking out

* >> The higher the average inventory level

* Typical choices for Z:

* Z = 1.29 >> 90% cycle service level

* Z = 1.65 >> 95% cycle service level

* Z = 2.33 >> 99% cycle service level

* Cycle service level:

* Once the reorder is placed, the probability that stocks will be depleted before the new order arrives

REORDER POINT FORMULA

The reorder point formula allows us to determine the safety stock (SS) needed to achieve a certain cycle service level. In general, the longer the lead times are, and the greater the variability of demand and lead times, the more SS we will need.

Revisiting the Reorder Point Formula

Fill Rate vs. Cycle Service Level

Revisiting the Reorder Point Formula

Where the formula came from is not important, but notice the implications for safety stock:

* What happens if lead time is constant?

* What happens if the demand rate is constant?

* What happens if both are constant?

* If you wanted to reduce the amount of safety stock you hold, what is your best option?

Fill Rate vs. Cycle Service Level

* Cycle service level is concerned with our ability to meet demand during the reorder cycle, when we are most in danger of running out

* In contrast, fill rate refers to the percent of demand that we are able to meet from stock across all time periods

* Rule of Thumb:

* The resulting fill rate for a product will be higher than the cycle service level.

* The “right” cycle service level for a given fill rate can be found through experience.

How to Optimize Your Inventory System with the Reorder Point...

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