The EOQ model is based on a mathematical derivation (with which you would not be

Question

The EOQ model is based on a mathematical derivation (with which you would not be expected to be familiar) that achieves a cost minimization between two different types of costs. With this context, answer the following questions:

What two types of costs are being minimized by the EOQ formula?

Why does the POQ model differ from the EOQ model (in other words, what circumstances are different in two environments that would use these different models)?

If a supplier has a "batch size" or "lot size" restriction, how will that impact the organization's ability to place orders of the size suggested by the EOQ formula?

What will be the effect on costs if an organization fails to order the EOQ in each time period (discuss both the possibility of ordering too much each time an order is placed and the possibility of ordering too little each time an order is placed)?

Give an example of an organization that uses the EOQ to determine how much they order each time an order is placed. Cite the source of your example.

Explanation / Answer

1. EOQ minimizes the total inventory costs. Total inventory costs = ordering costs+holding or carrying costs. These are the two costs being minimized. Ordering costs are the costs of ordering extra inventories. Carrying costs or holding costs are the costs of holding inventory (eg. storage costs, costs of working capital being tied up etc.)

2. POQ is the production order quantity model. It differs from the EOQ model in the sense that the POQ model is used to determine the optimal production volume. The circumstances that are different in POQ and EOQ is that the EOQ model assumes that  goods are shipped in bulk at one time. POQ, on the other hand, assumes a continuous and regular flow of inventory.

3. When there is lot size or batch size restriction, then EOQ formula will change. In lot for lot ordering, fixed ordering costs are negligible. The probability of stockouts are high and the focus is on maintaining safety stocks. The lot size is different from EOQ. The formula for EOQ = (2*annual demand*ordering cost/holding cost)^1/2.

Now average lot size = EOQ+((variance+mean^2)/2*mean)

The impact of batch size and lot size is that metrics like lead time and backordering are introduced. Secondly, batch size may not be independent of lead time and this factor is also taken into consideration. To correct this anomaly, the EOQ formula is multiplied by a correcting factor which is greater than 1.

4. If too much is ordered at a time then the total ordering cost will decrease but the holding cost will increase as there will be more inventory on hand and the organization will have to spend greater amount towards its storage and for working capital. If too less is ordered, then the total ordering costs will increase as the frequency of placing orders will increase. However the holding cost will decline. In both the cases, total costs will not be optimal.

5. An organization that uses EOQ is Procter and Gamble (P&G). The company has reduced its investment in inventory using the EOQ model and reduced the amount of funds being tied as working capital.

Reference: https://faculty.psau.edu.sa/.../doc-11-pdf-dacc1d0620cc02d0f1a4e141b1883ef4

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