Couple of decades ago, close friends Suresh and Mahesh got placed in the same company after their engineering. They decided to share a rented accommodation. Knowing their respective weaknesses in household chores (read kitchen), Suresh took charge of kitchen and Mahesh would do the utensils and market purchasing. Of course, quick delivery and ready-to-eat food were not popular at that time, and definitely not affordable for these young boys. Within a month of the arrangement, Suresh was heard complaining of the shortage of space in kitchen and food items going stale. The blame was squarely placed on Mahesh on buying too high quantities (he simply minimized his cumbersome visits to the grocer). The two had a bitter verbal duel accusing each other of dereliction of respective duties. They could not arrive at a consensus for many months until they learnt about EOQ (Economic Order Quantity).
For all the businesses that practise make-to-stock and then sell from accumulated inventory, EOQ links the supply chain costs effectively between the nodes – within the organization and with suppliers.
In the current inflationary times, when raw-material, freight and services costs have seen a double-digit increase, it is critical to minimize the inventory levels and definitely avoid waste. However, one must ensure that the inventory reduction should not lead to customer service loss (OTIF).
Devised in 1913, the EOQ model is a fundamental model that can be used first. This model helps optimize the cost of both inventory purchasing (ordering) cost and holding cost. Ordering cost is determined by the number of purchase orders. Holding cost is determined by the average inventory. Total cost = holding cost + ordering cost.
Ordering cost includes order preparation, processing, inspection costs, and transportation costs. The economies of scale suggest that higher order quantity will help reduce ordering cost. And the more frequently we place order, the quantity per order reduces, working up the ordering cost.
The cost of carrying inventory has more than what meets the eye, it includes:
- Warehouse expenses (2-4%)
- Handling costs (2-5%)
- Insurance costs (1-3%)
- Inventory control/management costs (3-5%)
- Obsolescence (6-12%)
- Shrinkage/pilferage (3-6%)
- Opportunity cost of the capital (6-12%)
Higher the inventory in our warehouse, higher is the carrying cost. There is a negative co-relation between the ordering and carrying costs.
EOQ is the sweet spot where ordering and carrying costs meet on the graph. This is the point where ‘Total cost’ is minimum.
Order quantity has a big impact on the transportation, inventory carrying, warehouse operations, and order processing costs. When put to application, it would not be possible to order in exactly the mathematically arrived EOQ number. Carton/pallet load size, truck capacity on the lane would be some basic factors that help define the range of EOQ. Further, it is advised to do a sensitivity analysis to identify the operationally viable range of EOQ. Here, one varies the input factors by small percentages to see the impact on EOQ. This also helps to identify the input costs to which EOQ is most sensitive to.
So far, so good!
Now, let’s constructively challenge the assumptions built in the above model and make it furthermore user-friendly. There are quantity discounts that suppliers and transporters give when you buy more. The discounts are generally at a slab level. The graph given aptly represents the effect on total cost with the ordering discounts. As you can see, the total cost is reducing to 580 when we order 10,000 units.
Note: This has an impact on the warehousing space and costs, which has been assumed linear (flat) for all quantity levels.
So, how do we adapt EOQ concept in our far complex, volatile, uncertain business environment? Let’s first identify the key business factors that must be carefully built into the model and/or considered while ascertaining the EOQ.
Key factors to be considered are:
- 1. Demand volatility: EOQ model assumes uniform demand across the year. You would definitely want to include the demand variability. At this stage it is important to introduce “Safety Stock”. (EOQ concept did not have safety stock)
- 2. Irregular demand: In addition to base EOQ calculation, we now add re-order point (ROP) concept to procurement scheduling.
- 3. Demand seasonality: EOQ concept considered annual demand. The year could be broken into buckets, demarcating the seasonal peak periods for which separate EOQ level would be applicable.
- 4. Promotions: This is planned inventory buildup and will supersede EOQ when placing the order.
- 5. Product shelf life: While EOQ may suggest particular quantity inventory order, we must ensure minimal obsolescence. This may require to order more frequently and smaller quantity.
- 6. Clustering opportunity: Same supplier and transporter could be supplying many different items. Ordering costs should be clubbed for these items together when calculating EOQ.
- 7. Product life cycle: For a product that is nearing the end of its lifecycle, you would want to hold lesser quantity, even if it means a higher ordering cost.
Market demand and supply conditions are constantly changing. All considerable changes should be captured as an input for regular review and revision in procurement scheduling. More significant external (and internal) changes would call for an amendment in mid to long-term sourcing strategy itself.
This article by Shammi Dua, Vice-President, Kearney originally appeared in the SCM Spotlight segment for the May 2022 issue of Logistics Insider magazine. All views expressed in the article are his own and do not represent those of any entity he was, is or will be associated with.
