The Economic Order Quantity (EOQ): You do not have to develop graphs to determine the EOQ for every stocked product. The “best buy” quantity can be derived from a formula. In fact, Microsoft distribution software products utilize one of two versions of the EOQ equation:
One version is based on forecasted demand per business day:
2 x [Number of work days in the past 12 months] x [Reordering cost] x [Demand/day] divided by: [Annual carrying cost percentage] x [Replacement cost per unit]
The other version is based on forecasted demand per month:
24 x Reordering cost x Monthly demand divided by: Annual carrying cost percentage x Replacement unit cost
If accurate parameters are entered into the EOQ formula, it will suggest the quantity that produces the lowest “total cost” of inventory per piece; this will maximize your profitability. However in today’s economy we see many companies emphasizing “cash flow management” over profitability. That is, they are willing to sacrifice some profit dollars in order to invest smaller amounts in inventory.
If you find yourself in this situation, closely examine the EOQ quantities calculated by your computer system in terms of the day’s supply of inventory. Compare the results to the value of the product sold or used during the order cycle for each supplier. For example, you may receive shipments from the primary vendor for this line every 10 days. If you include this item on each order, you can order a ten-day supply (10 days × 1.5/Day = 15 pieces). Compare the value of the EOQ and order cycle replenishment quantities for our first example (the monthly forecast of 25 pieces is divided by 30 days to result in the demand per day):
EOQ value = 39 pieces × $10 per piece = $390
Order cycle qty value = 10 days × (25 ÷ 30 days) × $10 = $83.33
This lower 10-day reorder quantity of this product results in buying $306.67 ($390 – $83.33) less inventory. Note that the order cycle reorder quantity does not affect either anticipated lead time usage or safety stock quantity. These are elements of the minimum or “order point” quantity, which will ensure that you reorder the product at the “right” time in order to avoid a stockout. Replacing the EOQ with the order cycle quantity for many items can substantially reduce the amount of money you have to invest in inventory.
Though you will not be buying to achieve the lowest total cost for each piece of the product and maximize your profitability, buying just enough to last during the order cycle will reduce necessary cash outlays and increase your inventory turnover (that is, your opportunities to earn a profit from every dollar of your average inventory investment). This may be just the remedy for a company having cash flow challenges. And because the elements of the minimum or “order point” are not affected, “order cycle” replenishment should not have a detrimental effect on customer service!
Time is a precious commodity. If the parameters in an advanced distribution system are set correctly, a good distribution system can automatically perform routine replenishment decisions and bring unusual situations to the attention of buyers, management, and salespeople. But this ideal situation requires that your employees have the knowledge to exploit your system’s capabilities. A necessary step in this process is to understand how reordering parameters are calculated, so that they can be fine-tuned to meet the exact requirements of every replenishment situation.
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