Monday, June 30, 2008

Beware of EOQ

Reverse Supply Chain – Aditya Kavi Raaj Chennuru

Economic Order Quantity (EOQ) is the scientifically drawn formula to balance the ordering cost and inventory holding cost to arrive at the optimal quantity for which reordering must be done.

Q* = Economic Order Quantity
C = Fixed Cost of Ordering
D = Annual Demand of the product
H = Holding cost of inventory

EOQ is believed to be so sacrosanct that more often than not B-School grads tend to swear by EOQ in the long run. But end of the day, what has to be observed is that things in real world are not as hunky dory as shown in the text books and the assumptions behind the derivation of EOQ must not be forgotten while applying EOQ in real life.

The derivation of the above formula is based on some frequently overlooked presumptions. Based on my learning/ experience in last one year at RIL, I would like to attack some of these presumptions in this article.

Demand or consumption pattern must be steady
EOQ model assumes a steady or uniform consumption pattern, where there is a variance; we need to pad up the EOQ with some safety stock. Wherever the coefficient of variance (standard deviation / mean) of demand is very high, there is very little benefit drawn out of EOQ. This is due to the reason that EOQ would be very much negligible compared to the safety stock.

Note: Further read up on the topic of “long tails” would help which talks about categories of products where coefficients of variability are very high

Vendor does not always sell a single product
EOQ assumes a ‘single vendor – single product’ scenario. In real life a vendor doesn’t supply one single item to a customer. In such a situation, you always find ways to order for quantity well below your EOQ, as the ordering cost is offset by combining orders for more than one item together.

Vendor is not necessarily a friend
Some Original Equipment Manufacturers who enjoy a monopoly or a technology advantage have the upper hand and do not supply to orders which are valued below a certain value. If your EOQ happens to be valued below the limit imposed by the vendor, you are in trouble. There are a number of consolidation strategies to resort to in such conditions which require thrashing of EOQ.

Logistical implications on procurement lot size
Sometimes it is logistics that recommends a larger lot size of procurement for simple reasons of convenience. This lot size again could be larger than the EOQ.

Consumption does not always happen in factors or multiples of EOQ
Some materials always get consumed in lots. For instance, the activity of replacing tires of a car requires replacing all 4. Here the consumption lot size is 4. In such cases it is not right to procure in numbers that are not multiples of four. In such cases the right approach is to revise the EOQ to the immediate next multiple of the lot size.

Vendor might be happy to stagger the deliveries
Some vendors would be more than willing to deliver the order quantity in small lots in a periodic basis rather than in a single delivery. This is very advantageous as it reduces inventory at vendors place as well. The implication being that, since our average inventory has gone down, we can order for more than EOQ.

Some products come with an expiry date
Some items have a shelf life (expiry date in other words). In such cases if EOQ results in inventory to satisfy demand for longer than the shelf life, we would always face a loss due to expiry of the product. In such cases, the order quantity must be lower than EOQ to avoid such loss.

Volume discounts may encourage larger order quantities
By going a little above EOQ if we become eligible for volume discounts that give us more benefits compared to the loss due to inventory holding, then it is logically better to go for the same.

Product Life Cycle shouldn’t be forgotten
A strategic implication comes into picture when dealing with products that have a life-cycle. Again here, the demand has a variation of rapid increase in the beginning, followed by a plateau of demand and ending with a drastic decline and obsolescence of the product. In such cases, application of EOQ gets complicated and may endanger us into having a stock of obsolete products at the end.

Therefore, the assumptions behind EOQ should not be forgotten before applying it. Based on the nature of material, its consumption pattern, vendor association and product life cycle, EOQ may not be applicable or it might require adjustment.

Aditya Kavi Raaj Chennuru, Batch of ’07 is working as a Manager – Special Projects, Reliance Industries Ltd. And can be reached at

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