According to most sources, the concept of economic order quantity (EOQ) was developed in 1913 or 1914. That means we're observing its centennial. Happy birthday, EOQ!
In most cases, a 100th anniversary would call for a celebration. In this case, though, I believe we should mark the centennial of EOQ by putting it to rest once and for all.
Don't get me wrong: EOQ has served a purpose for manufacturers and distributors, giving them a formula that can help minimize the total cost of ordering and stocking inventory. Before the advent of computers, it was an effective approach.
EOQ works with a predefined reorder point (ROP), which has some problems of its own that I'll touch on below. With EOQ, you aim to order another shipment of supplies or inventory when you hit a predefined reorder point. The size of your order will be determined by the EOQ formula that's intended to balance the costs of ordering and holding merchandise to give you the lowest overall cost.
Theoretically, you can achieve the lowest total cost by ordering a quantity of merchandise that will lead to your order cost equaling your holding cost. It makes sense: placing any order comes with a cost in terms of fees and manpower invested. By ordering larger shipments less frequently, you can minimize your order costs, but you'll cause a spike in your holding costs. Conversely, by making frequent smaller orders, you'll incur more ordering costs but avoid driving up your expenses associated with warehousing, insurance, and obsolescence.
As you can see, EOQ can be a good way of analyzing your costs and taking proactive steps to contain them. But as you're also about to see, EOQ relies on several simplifying assumptions that can limit its effectiveness.
Five Reasons EOQ Doesn't Always Work
For EOQ to be useful, five things must be true about your business:
1. Your ordering cost and carrying cost must be known and constant.
2. Your rate of demand for an item must be known, and spread evenly throughout the year.
3. Your lead time must be fixed.
4. The purchase price of the item in question must be constant, with no discounts available.
5. You must be able to make replenishment instantaneously, with the whole batch delivered at once.
Now, tell me: can you guarantee that all five of these statements are true for the items you're ordering?
Take #1, for example. Most companies can calculate their carrying costs fairly easily. But what about your ordering costs-can you measure them accurately? Even small changes in these costs can have a major impact on how much you have to order and how often. The EOQ is very sensitive to changes in the order cost or carrying cost. If your business doesn't measure this accurately, how can you put EOQ into use?
And perhaps more importantly, if your business is like most, your demand is anything but flat and constant throughout the year. Most companies see demand fluctuate from one season to the next, often dramatically. It's not realistic to assume level demand.
There's one other problem I see with EOQ: it requires you to designate a reorder point at which you'll order a predetermined quantity of supplies or merchandise. But naturally, this reorder point also suffers from an assumption that demand is relatively constant-which it isn't for most companies.
All of the other key assumptions of the EOQ model have their own issues. One assumption I hope to discuss in more detail in another post is the notion that lead times are constant.
At the end of the day, an economic order quantity is a single, fixed value that doesn't change throughout the year when, in fact, most businesses will improve performance by varying order quantity to reflect the shifting needs of their customers and constraints of their supply chain.
A Better Approach for the Next 100 Years of Demand Planning
As I've explained, the concept of EOQ has probably outlived its usefulness. Fortunately for us all, there's a much better way to manage and plan inventory. It involves the use of a time phased requirements planning system, and it's often referred to as distribution requirements planning (DRP) or simply Requirements Planning.
The genius of Requirements Planning is that it takes into account everything we know or expect about the future. It starts with our best estimate of future demand from our forecast. It then layers on top of that any known customer orders and/or scheduled or planned receipts. It also accounts for variable lead times. Requirements Planning gives us visibility of the entire supply chain out into the future-information we can't see when we rely on EOQ-and provides a much more robust and accurate source of data for planning.
Requirements Planning lets us form a more accurate view of the future. With this view, we can make new orders of supplies or merchandise with full confidence that we're taking steps to contain our order costs and carrying costs based on reality-not just educated guesswork or overly simplistic assumptions.
Requirements Planning is a smarter way forward for any company that runs a supply chain. So let's say RIP to EOQ, and take a new approach for the next 100 years. To learn more about Requirements Planning and the Demand Solutions product that makes it possible, drop us a line.