## Executive Summary

• We cover the Economic Order Quantity formula and the applicability of the Economic Order Quantity and EOQ and perishability and quantity discounts.
• EOQ can be calculated for both production and procured products.

## Introduction: The Origins of the Economic Order Quantity

Economic order quantity (EOQ) is one of the oldest formulas in inventory management. It was first developed by Ford W. Harris in 1913. Since its introduction, EOQ has been one of the most important and most durable formulas in inventory management. You will learn about the calculation of EOQ, reorder points and the other factors which are included into the calcuation of EOQ.

## What is the Reorder Point?

The reorder point tells the system when to reorder, while the economic order quantity tells the system how much to order; as such they are necessarily highly integrated values. EOQ is one method for performing what is generally known as lot sizing. The lot size is the quantity in which the item is produced or procured and therefore it is set at the production location combination in the product master.

## Common Methods of Lot Sizing

Common methods of calculating the lot size are the following:

• Lot for Lot: This is confusingly named because lot for lot is simply a lot size based upon the net requirements in a particular period. Therefore it is essentially no lot size. Using lot for lot sizing would be considered Lean as the company is only producing or procuring what it absolutely knows that it needs.
• Economic Order Quantity: This bases the lot size on a financial calculation.
• Periodic Order Quantity: This is simply the economic order quantity, but stated in terms of a reorder frequency.

## The Applicability of the Economic Order Quantity

Some have proposed that because EOQ does not automatically adjust with the variability of its inputs, it cannot be used for more product location combinations (PLC’s) with more variable demand history, and this is true – if the data provided to the EOQ is not periodically changed. Therefore, it must be periodically recomputed for the entire product location database. It would be relatively easy to make the EOQ formula continuously altered based upon changes on its inputs, but I have yet to see this functionality in any supply planning application.

## Validity and Applicability of EOQ

EOQ was originally developed for a production lot sizing. However, the book Factory Physics states the following with respect to EOQ:

“For example, in 1913, Harris published his original EOQ paper and established a precise mathematical standard for efficiency research with his famous “square root formula” for the lot size problem. While elegant, this formula relied on assumptions that – for many real world production systems – were highly questionable.”

1. A fixed, known setup cost
2. Constant deterministic demand
3. Instantaneous delivery (infinite capacity)
4. A single product or no product interactions

“Because of these assumptions, EOQ makes much more sense applied to purchasing environments than to the production environment for which Harris intended it. In a purchasing environment, setups (i.e. purchase orders) may adequately be characterized with constant costs. However in manufacturing systems, setup costs cause all kinds of other problems (e.g., product mix implications, capacity effects, variability effects). The assumptions of EOQ completely gloss over these important issues.”

This is the very well-known sawtooth pattern, which is a feature of the stocking level rising to its highest point when a new procurement order is received or a new production order is completed, and with the stocking level declining to its lowest point right before the procurement order is received or right before a new production order is scheduled. The minimum stock level should be the safety stock, which the inventory level may consume due to variability in demand or supply.

EOQ actually has a number of slight adjustments to the formula used to account for different requirements, like the calculator included at this article which calculates an EOQ in the case where the company wants to build inventory.

## EOQ and Perishability

There can be scenarios where the shelf life of the product does not allow for the full EOQ to be ordered. In this case, the EOQ formula should not be used, and the shelf life time converted into units, should be used instead (Silver and Peterson).

The same issue applies to products that go through frequent revisions, where ordering the EOQ would or could result in significant obsolescence. EOQ must also be managed versus storage capacity. In general, storage capacity is less expensive than accepting increased costs through shorter production runs. However, this does not seem to have much influence with companies because they cannot quantify how their production costs change from changing the length of production runs.

Therefore, philosophy rather than facts tends to rule the day with a much greater focus being placed in inventory and storage costs rather than production costs. Although, this greatly depends upon the company. Some companies work exactly the opposite, focusing very little on reducing inventory and being primarily focused on minimizing procurement costs through buying in very large and uneconomic quantities. The question becomes quite a bit more grey for procured items where the costs to be traded off are quantity discounts and order costs.

## Using Economic Order Quantity Formula in Live Systems

After EOQ’s calculation, it is most often placed into the minimum order quantity field which all supply planning systems have. This sets the minimum order level. However, sometimes other factors that are larger than this – such as when products must be purchased in rail carloads, set the actual minimum order level. In that case, no EOQ calculation is necessary. The minimum order quantity is the carload.

While the formula is one of the easiest in supply chain to calculate, many companies do not determine their unconstrained products (that is unconstrained by minimum order sizes such as with the example of the carload, or minimum package quantities) on the basis of EOQ. However, there really is no reason aside from work effort to not do so – and in fact, the work effort is quite low.

## Economic Order Quantity and Forecast Error

The higher the forecast error, the less use the EOQ value is. This is because as the forecast error increases, the likelihood that the quantity will be consumed declines. However, this is no different from any other supply planning parameter; supply planning parameters have the highest value when the forecast is most accurate.

## EOQ and Quantity Discounts

If there are quantity discounts, the calculation below will not be accurate. For instance, the formula below may propose an EOQ of 184 units. If the price per each at this level is \$50, then this is a total cost of (184 * \$50) + 45 or \$9,245. However, if the quantity discount kicks in at 200 units and this discount is 15%, then 16 more units could be obtained for \$8,538. This would be a missed opportunity. This can be easily calculated for an individual item, but this cannot really be systematized because supply planning applications do not have EOQ functionality or even step function min lot sizes. Typically this is handled by procurement as they are up to date on the volume discounts and will increase the orders to meet the discount.

## How Often is EOQ Actually Calculated?

For whatever reason, most companies don’t get around to calculating EOQ or, if they do calculate it, they do so very infrequently. Students at university are often told that EOQ is frequently used in industry, when in fact it isn’t (this is just one of the misrepresentations of supply chain management on the part of college courses and supply chain textbooks). But this does not mean that it should not be used. EOQ certainly adds value and quantifies and then trades off the most important costs for making an ordering decision. That is the truth of how understaffed supply chain management departments are. They often do not have the staffing to apply elementary inventory management techniques that are over 80 years old.

## Deriving EOQ Order Cost or Cost Per Order

If the item in question is procured than the standard term order cost or cost per order which is often used with the EOQ formula is correct.

## EOQ For Procured Items

EOQ is often first introduced to people as the order cost or cost per order from a supplier. If you discuss this topic with companies, you will often hear order costs around \$12 discussed. In fact, there are many web pages that estimate the ordering cost in the low teens. This is inaccurate and does not show appreciation for what the EOQ formula represents.

The order cost or cost per order for EOQ is supposed to moderate the number of orders that companies place, which means that the order cost or cost per order includes all the costs of placing the order. This includes not only the cost of placing the order in the system (which is the lowest cost portion of the order) but also the cost of receiving the order. The cost of moving the order into stock. The cost of tracking the order and following up if the order is not delivered, etc.. For this reason, once all the total ordering cost is considered, that is the cost of the initial order.

That is all the way to put away, an order cost of between \$60 to \$75 seems reasonable for many items. However, certain items can be much higher than this. Larger, more difficult items to manage should receive greater economies of scale in receipt and put away than smaller items. Once you move to ordering extremely large units, such as industrial equipment, the order cost or cost per order rises again. But on the other hand, as a percentage of the cost of the item, the order cost or cost per order cost may decline.

## EOQ Internally Produced Items

If the EOQ is being calculated for an internally produced item, then the order cost or cost per order becomes the “ordering and setup/changeover cost.” This is the cost of changing the line over to a new product. Unfortunately, few companies have costings for their changeovers. Therefore, this usually takes some time to develop these costs.

## EOQ and Production Planning

If the item in question is procured, then the standard term “ordering cost,” which is often used with the EOQ formula, is correct. However, if the EOQ is being calculated for an internally produced item, then the order cost becomes the “ordering and setup/changeover cost.” This is the cost of changing the line over to a new product. This is because what is called the ordering cost is really just the total costs for initiating the replenishment. Unfortunately, few companies have realistic costings for their changeovers. Therefore, it usually takes some time to develop these costs.

## Conclusion

Order cost or cost per order estimation is tricky, and no one can say exactly what an ordering cost is for a particular item. Companies can use variable order cost or cost per order to change depending on the product.

One thing for certain is that the order cost or cost per order that is often presented on websites on the topic does not represent what the EOQ is meant to represent regarding the total order cost or cost per order.

To calculate the EOQ formula online, see our EOQ Calculator at this article.

Also, learn about the limitations of EOQ at this article.

• ## Want Help with Supply Planning?

It is difficult for most companies to make improvements in supply planning without outside advice. And it is close to impossible to get knowledgeable supply planning advice from large consulting companies. We offer remote unbiased multi-dimension supply planning support.

## Improving Your Supply Planning, MRP & S&OP Software

Brightwork Research & Analysis offers the following supply planning tuning software, which is free to use in the beginning. See by clicking the image below:

## Lean and Reorder Point Planning: Implementing the Approach the Right Way in Software

### A Lost Art of Reorder Point Setting?

Setting reorder points is a bit of a lost art as company after company over-rely upon advanced supply planning methods to create the supply plan. Proponents of Lean are often in companies trying to get a movement to Lean. However, how does one implement Lean in software?

### Implementing Lean in Software

All supply planning applications have “Lean” controls built within them. And there are in fact some situations where reorder points will provide a superior output. With supply planning, even within a single company, it is not one size fits all. The trick is understanding when to deploy each of the approaches available in software that companies already own.

### Are Reorder Points Too Simple?

Reorder points are often considered to be simplistic, but under the exact circumstances, they work quite well.

There are simply a great number of misunderstandings regarding reorder points – misunderstandings that this book helps clear up.

Rather than “picking a side,” this book shows the advantages and disadvantages of each.

• Understand the Lean Versus the MRP debate.
• How Lean relates to reordering points.
• Understand when to use reorder points.
• When to use reorder points versus MRP.
• The relationship between forecastability and reorder points.
• How to mix Lean/re-order points and MRP to more efficiently perform supply planning.

### Chapters

• Chapter 1: Introduction
• Chapter 2: The Lean versus MRP Debate.
• Chapter 3: Where Supply Planning Fits Within The Supply Plan
• Chapter 4: Reorder Point Planning
• Chapter 5: Lean Planning.
• Chapter 6: Where Lean and Reorder Points are Applicable
• Chapter 7: Determining When to use Lean Versus MRP
• Chapter 8: Mixing Lean and Reorder Points with MRP-Type Planning

EOQ is calculated in supply planning systems.

## Software Ratings

Brightwork Research & Analysis offers the following free supply planning software analysis and ratings. See by clicking the image below:

## Executive Summary

• This is an introduction to the economic order quantity formula.
• We analyze Ford W. Harris’ original economic order quantity paper.
• We cover using the economic order quantity in production planning systems.

## Introduction

Economic order quantity (EOQ) is one of the oldest formulas in inventory management. It was first developed by Ford W. Harris in 1913. Since its introduction, EOQ has been one of the most important and most durable formulas in inventory management.

## Who Developed the Economic Order Quantity Formula?

Companies and universities tend to claim the invention of most everything.

As with the development of MRP, the originator of the Economic Order Quantity Formula was not an academic, and unassociated with any company. He was simply looking for a way to make rational ordering decisions with some quantitative support. This shows two important developments in supply chain planning were developed outside of the traditional system.

• MRP Development: Orlicky, Plossl & Wight were employed at JI Case and Stanley Tools in the 1960s. They were trying to solve inventory problems at these companies. But JI Case and Stanley Tools did not contribute to the work.
• EOQ Development: Ford W. Harris had no affiliation and was not an academic. While he later became an attorney, at the time he developed the EOQ formula, he had only a high school education.

This is not exclusive to supply chain innovations. For instance, Einstein had no university affiliation when he wrote his papers while employed as a patent clerk. He later gained university affiliation with top schools after he did his most important work. Not only did Einstein have no university affiliation when he wrote is four breakthrough papers, but he had also applied for, and been rejected as a high schools science teacher in the years before his discoveries.

## Issac Newton, College Drop Out?

Another example is Issac Newton did have a university affiliation. He was not a professor when he developed his theories of calculus, optics, and gravitation. These were all established while he was away from Cambridge for two years. Newton’s papers could not be published for roughly 13 years because the head of the Royal Society was envious of Newton. He took credit for anything Newton published. Therefore, Newton stopped publishing during this time. Finally, this individual died, and Newton became the head of the Royal Society. Therefore what are widely considered to be the two most significant scientists in history had no university affiliation when they made their discoveries.

## An Analysis of Ford W. Harris’ Economic Order Quantity Formula Paper

Most people find out about EOQ second hand. The original paper How Many Parts to Make at Once is quite good. It is not only well laid out, but it is also well written. In fact, far more so than the vast majority of papers I have read by academics. That is people with much more education than Harris had at the time. It is also short compared to other academic papers in the field. Some interesting quotations from this paper follow:

“The writer has seen the practical workings of a first class stock system and does not wish to be understood as claiming that any mere mathematical formula should be depended upon entirely for determining the amount of stock that should be carried or put through on an order. This is a matter that calls, in each case, for trained judgement, for which there is no substitute. There are many factors of even more importance than those given in this discussion.”

This is quite an interesting quotation because subsequent authors to wrote on EOQ had a strong tendency to present the EOQ formula as much more final in nature.

“But in deciding on the best size of order, the man responsible should consider all the factors that are mentioned. While it is perfectly possible to estimated closely enough what effect these factors will have, the chances are many mistakes costing money will be made. Hence, using the formula as a check is at least warranted.”

This quotation envisions the EOQ as a check to compare against human judgment. This paper was written in 1913, and there were not computers in use in this or any other area. The EOQ formula that was being proposed by Harris would be calculated by hand. Supply planning software applications do not compute EOQ formulas.

## Changing the Cost of Computing the EOQ Formula

This changes the cost of computing the formula. It also changes the interpretation of how the EOQ formula can be used.

One would like to go back in time to ask Harris a question.  That question would be given the advantages that we have in computing power; he would still think the same thing he wrote back in 1913.

“In conclusion, it may be well to say that the method given is not rigorously accurate, for many minor factors have purposely been left out of the consideration. It may be objected that interest and depreciation should be figured, not only on original cost, but also on the setup cost, since that has to be incurred before the parts can be stocked. Such refinements, however, while interesting, are too fine spun to be practical. The general theory as developed here is reasonably correct to be found to give good results.”

Here Harris proposes that indeed other factors could be used, but he feels confident that the formula encompasses the most important factors for driving ordering. Of course, it is also an interesting statement, because his basic EOQ formula has been added to over the following years with many different additional costs and considerations.

## List of EOQ Formula Adjustments

Just a sample of these are listed below:

• EOQ Revisited with Sustainability Considerations
• Study of EOQ-based Inventory and Transportation
• EOQ and Inflation Uncertainty
• An EOQ Model for a Perishable product with Special Sale and Shortage
• Optimal Replenishment Cycle in an EOQ Model with Defective Items
• The Stochastic EOQ Model with Random Sales Price
• An EOQ Model for Deteriorating Items Under Credit Options
• EOQ Model with Stock-Dependent Demand

## Using Economic Order Quantity Formula in Production Systems

After calculating the Economic Order Quantity Formula, the output is most often placed into the minimum order quantity field. This sets the minimum order level. Sometimes other factors such as the larger than this level — such as when products must be purchased in rail carloads. In that case, the no EOQ calculation is necessary. The minimum order quantity is the carload.

The formula is one of the easiest in supply management chain to calculate. Many companies do not determine their unconstrained (that is unconstrained by minimum order sizes such as with the example of the carload or minimum package quantities) products by EOQ. However, there is no reason aside from work effort not to do so. The fact is, most companies don’t get around to calculating EOQ or if they do calculate it, they do so very infrequently. Students are often told that EOQ is used in industry very frequently — when in fact, it isn’t.

But this does not mean that it should not be — it certainly adds value and quantifies and then trades off the most relevant costs for making an ordering decision.

That is the truth of how lean the staffing is in supply chain management. They do not have the staffing the apply elementary inventory management techniques that are over 80 years old.

While it would be easy to place this into supply planning systems in the parameters of the product record, it is not done. Software vendors tend to assume that companies will periodically calculate the value externally.

## Conclusion

The history of the development of economic order quantity turns out to be interesting. It’s a story of how a high school educated engineer made of the most enduring contribution to inventory management. The EOQ formula is coded into nearly every supply and production planning application that exists.

To calculate the EOQ formula online, see our EOQ Calculator at this link.

• ## Want Help with Supply Planning?

It is difficult for most companies to make improvements in supply planning without outside advice. And it is close to impossible to get knowledgeable supply planning advice from large consulting companies. We offer remote unbiased multi-dimension supply planning support.

## Order Sizing and Optimization

Order optimization is necessary in order to get the predicted value from ERP and other supply planning applications. The Brightwork MRP & S&OP Explorer does exactly this, and it is free to use in the beginning until it sees “serious usage.” It is permanently free to academics and students. See by clicking the image below:

## References

I cover EOQ in depth in the following book.

## Lean and Reorder Point Planning: Implementing the Approach the Right Way in Software

### A Lost Art of Reorder Point Setting?

Setting reorder points is a bit of a lost art as company after company over-rely upon advanced supply planning methods to create the supply plan. Proponents of Lean are often in companies trying to get a movement to Lean. However, how does one implement Lean in software?

### Implementing Lean in Software

All supply planning applications have “Lean” controls built within them. And there are in fact some situations where reorder points will provide a superior output. With supply planning, even within a single company, it is not one size fits all. The trick is understanding when to deploy each of the approaches available in software that companies already own.

### Are Reorder Points Too Simple?

Reorder points are often considered to be simplistic, but under the exact circumstances, they work quite well.

There are simply a great number of misunderstandings regarding reorder points – misunderstandings that this book helps clear up.

Rather than “picking a side,” this book shows the advantages and disadvantages of each.

• Understand the Lean Versus the MRP debate.
• How Lean relates to reordering points.
• Understand when to use reorder points.
• When to use reorder points versus MRP.
• The relationship between forecastability and reorder points.
• How to mix Lean/re-order points and MRP to more efficiently perform supply planning.

### Chapters

• Chapter 1: Introduction
• Chapter 2: The Lean versus MRP Debate.
• Chapter 3: Where Supply Planning Fits Within The Supply Plan
• Chapter 4: Reorder Point Planning
• Chapter 5: Lean Planning.
• Chapter 6: Where Lean and Reorder Points are Applicable
• Chapter 7: Determining When to use Lean Versus MRP
• Chapter 8: Mixing Lean and Reorder Points with MRP-Type Planning

EOQ is calculated in supply planning systems.

## Software Ratings

Brightwork Research & Analysis offers the following free supply planning software analysis and ratings. See by clicking the image below:

## Executive Summary

• This is an introduction to reorder points and how to use the reorder level vs the reorder quantity.
• The Brightwork ROP calculator sets a dynamic reorder point.

## Introduction to Reorder Points

As discussed in this article, reorder level and reorder quantity are both significantly underused in companies and can be set some ways in systems like SAP SNP. You will learn about reorder points and how they are set in production systems.

## The Significant of Reorder Points

Reorder level and reorder quantity planning is significantly underestimated. This is because companies so frequently overestimate their ability to effective forecast. Most companies don’t have the capacity to leverage even basic forecasting functionality which is available. This functionality has been available within forecasting applications for years.

Reorder level and reorder quantity work well for both highly forecastable products and products that are difficult to forecast. Any product which received a level forecast assignment using a best fit procedure can have their supply planning emulated by using a reorder point.

By placing a substantial portion of the company’s product database on reordering level and reorder quantity there are several benefits.

• It saves time.
• It allows the company to focus on those products that can be improved through forecasting.

The graphic below explains this.

## Order Point Versus Reorder Point

The term order point is infrequently used. People most often use the term reorder point rather than order point. However, order point and reorder point are the same thing. An order point is a level of inventory where an order is generated. Rather than an order point, a reorder point simply implies that the ordering is perpetual.

## The Uses of Dynamic Reorder Level and Reorder Quantity

The beautiful thing about the dynamically reorder point calculation is that it adjusts across the following dimensions:

• Service level
• Lead time and forecast error both in variability (for lead time and forecast error) as well as lead time duration.

Dynamic Reorder point analysis can be used for an SKU or any aggregation level. For instance, this form can be used to model the inventory and supply chain of an entire company. Instead of entering the values for a single SKU, the overall or average values can be used.

This allows one to see the relationships between things like service level and the total amount of stock carried. This can also be used to create a service level to inventory curve. An inventory service curve is something which many companies do not have.

It will not, of course, include the total stocking level. So the total stocking level should be estimated and added. Only the reorder point should flex — while the cycle stock should stay the same.

## Using Dynamic Reorder Level and Reorder Quantity in Production Systems

As is discussed in this article, reorder points can be set some ways in systems like SAP SNP, ToolsGroup or Demand Works Smoothie.

Most importantly, they can set to work without a forecast or with a forecast.

One of the of the confusing things about setting up a reorder level and reorder quantity is what to do with the forecast that has been generated for the products that are moved to reorder level and reorder quantity or reorder point. A prediction is still required for things like budgeting. It still makes sense to generate a forecast for them. Another reason for this is that products that are set on reorder point — don’t necessarily stay on reorder point in the future — and vice versa.

The demand history will tell the company when a product should be moved to reorder point planning. It will also tell the company when a product should be moved away from reordering point planning. That is when it is to become an actively forecasting item.

## What Makes This Reorder Point Calculator Unique

Most of the reorder point calculators that online calculate a static reorder point typically based upon just lead time, safety stock, stock, and sales. There is no measure of variability in either lead times or the forecast, and it asks the user to input the safety stock as well as the stock. However, variability dramatically changes the safety stock – which is part of the reorder point calculation. Most of these online calculators are not helpful to people need to see the relationships between multiple factors and who don’t have the stock information and require estimates.

The authors seem to have put in the absolute minimum level of work so that they could say their website has a safety stock calculator.

This calculator below does not ask for existing stock or safety stock but does ask for variability. If the variability is not known, then zero standard deviations can be added to the form — to mostly hold those values static.

## ROP Formula, or Reorder Point Formula

• An ROP formula or reorder point formula are all synonyms for the same thing.
• A ROP formula or reorder point formula are all used to determine the reorder point.
• The reorder quantity formula shows the amount to be ordered once the reorder point is reached. A reorder quantity formula is often called an economic order quantity.

## How the Calculation Form Works

This reorders point calculator provides the intermediate values, along with explanations so that the overall logic of the dynamically reorder point calculator can be fully understood by both students and practitioners.

This form requires input to provide output. However, it also has default values. You can change any input value and the rest of the formula — the output will change immediately. You can continue making changes, and the form will always update without having to press any button or refresh.

Note: For some reason, the drop down field below does not appear to work in Firefox – so if you are using that browser try a different one. Second, when you enter a decimal into the Standard Deviation of Demand and Standard Deviation of Lead Time, you may receive a message “Please enter only digits.” You can ignore that message. The calculator works fine with a decimal point.

To determine the EOQ, see the EOQ calculator see this link.

• ## Want Help with Supply Planning?

It is difficult for most companies to make improvements in supply planning without outside advice. And it is close to impossible to get knowledgeable supply planning advice from large consulting companies. We offer remote unbiased multi-dimension supply planning support.

## Order Sizing and Optimization

Order optimization is necessary in order to get the predicted value from ERP and other supply planning applications. The Brightwork MRP & S&OP Explorer does exactly this, and it is free to use in the beginning until it sees “serious usage.” It is permanently free to academics and students. See by clicking the image below:

## Lean and Reorder Point Planning: Implementing the Approach the Right Way in Software

### A Lost Art of Reorder Point Setting?

Setting reorder points is a bit of a lost art as company after company over-rely upon advanced supply planning methods to create the supply plan. Proponents of Lean are often in companies trying to get a movement to Lean. However, how does one implement Lean in software?

### Implementing Lean in Software

All supply planning applications have “Lean” controls built within them. And there are in fact some situations where reorder points will provide a superior output. With supply planning, even within a single company, it is not one size fits all. The trick is understanding when to deploy each of the approaches available in software that companies already own.

### Are Reorder Points Too Simple?

Reorder points are often considered to be simplistic, but under the exact circumstances, they work quite well.

There are simply a great number of misunderstandings regarding reorder points – misunderstandings that this book helps clear up.

Rather than “picking a side,” this book shows the advantages and disadvantages of each.

• Understand the Lean Versus the MRP debate.
• How Lean relates to reordering points.
• Understand when to use reorder points.
• When to use reorder points versus MRP.
• The relationship between forecastability and reorder points.
• How to mix Lean/re-order points and MRP to more efficiently perform supply planning.

### Chapters

• Chapter 1: Introduction
• Chapter 2: The Lean versus MRP Debate.
• Chapter 3: Where Supply Planning Fits Within The Supply Plan
• Chapter 4: Reorder Point Planning
• Chapter 5: Lean Planning.
• Chapter 6: Where Lean and Reorder Points are Applicable
• Chapter 7: Determining When to use Lean Versus MRP
• Chapter 8: Mixing Lean and Reorder Points with MRP-Type Planning

## Setting the Right Inventory Carry Cost Percentage

• What is the Background on Inventory Carry Cost?
• What Inputs Make Up the Carry Costs?
• Experience in Estimating Inventory Carry Cost
• Estimating Inventory Carrying Cost
• What Factors Increase or Decrease the Inventory Carry Cost Percentage that is Applied?
• What Do You Know About EOQ?
• Our Work on EOQ

## Introduction

Inventory carry cost is necessary for the supply chain as it allows a company to determine its costs of keeping inventory. It is also a key input into the economic order quantity, which in its base formulation (there are many EOQ formulas) trades off the cost of carrying inventory versus the cost of ordering inventory. EOQ sounds like a very straightforward formula until you ask companies to estimate their inventory carry cost and order cost.

## Inventory Carrying Cost Inputs

You generally cannot simply go to the finance department in a company as they tend to know the cost of money, or the capital cost of the company, but not the other costs associated with inventory carry cost. This is a combined cost which accounts for:

1. The cost of capital
2. The cost of the storage facility for the product
3. The cost of the product becoming obsolete or going bad (say as in in the case of perishables)
4. The cost of the product being damaged while being stored

## Experience in Estimating Inventory Carry Cost

I have asked about this value for many clients to perform modeling and create EOQ driven ordering quantities and frequencies. They almost always tell me that they don’t have a good number. They then ask me if I know of one.

George Plossl does a good job of explaining the arbitrary nature of such estimations in the book.”

Production and Inventory Control.” I have a quote from the book below:

“Inventory Carrying Cost: The inventory carrying cost is a useful concept (albeit an artificial one) required by the mathematical formulas used in lot-sizing calculations. As listed earlier, many separate elements are assumed to make up this cost. Obsolescence is a reality in any inventory but this cost element in the inventory carrying cost varies widely with time and is not the same for different items in an inventory (that is, it is highest for style items). This would indicate that a different carrying cost might be used for each item in the stock list. This is obviously impractical and an average figure is usually chosen, either for all products or for each major type of product. Identical reasoning applies to deterioration costs. The whole discussion is purely academic. The inventory carrying cost has practical use only as a management policy variable which, rather than being a fixed. magic number, is one that should be manipulated to attain the overall objectives of the company. “ George Plossl

## Estimating Inventory Carrying Cost

Inventory carrying cost is an estimation of the percentage of the product cost that in consumed in holding the product for one year. It is often used in inventory formulas as well as cost optimization. In many popular articles that cover the subject superficially, it is often stated that a good inventory carrying cost is between 20 to 25%.

I could spend lots of time estimating this for each company, as pointed out by George Plossl, the value would always be an average. And will be too high for some products and too high for others. The major item I look for is how perishable the company’s product is. If it is more towards the perishable end of the spectrum, I increase the inventory carry cost; If it is not, I decrease the inventory carry cost.

## Conclusion

One of the current (2016) issues with using a value between 20 and 25% is that they have tended to be created when interest rates and inflation (which is built into interest rates) was higher. Therefore, those companies that use the higher figure would tend to overestimate inventory carry cost. One of the perplexing things about using quantified values for both order cost and inventory carry cost is that the order quantities become much higher than is “politically acceptable” within companies.

This is one reason that companies often ignore quantification of order quantities and determine the order quantity using judgment methods.

See our EOQ calculator at this link.

• ## Want Help with Supply Planning?

It is difficult for most companies to make improvements in supply planning without outside advice. And it is close to impossible to get knowledgeable supply planning advice from large consulting companies. We offer remote unbiased multi-dimension supply planning support.

## Order Sizing and Optimization

Order optimization is necessary in order to get the predicted value from ERP and other supply planning applications. The Brightwork MRP & S&OP Explorer does exactly this, and it is free to use in the beginning until it sees “serious usage.” It is permanently free to academics and students. See by clicking the image below:

## References

Production and Inventory Control: Techniques and Principles 2nd Edition,” George Plossl, Prentice Hall, 1985

## Lean and Reorder Point Planning: Implementing the Approach the Right Way in Software

### A Lost Art of Reorder Point Setting?

Setting reorder points is a bit of a lost art as company after company over-rely upon advanced supply planning methods to create the supply plan. Proponents of Lean are often in companies trying to get a movement to Lean. However, how does one implement Lean in software?

### Implementing Lean in Software

All supply planning applications have “Lean” controls built within them. And there are in fact some situations where reorder points will provide a superior output. With supply planning, even within a single company, it is not one size fits all. The trick is understanding when to deploy each of the approaches available in software that companies already own.

### Are Reorder Points Too Simple?

Reorder points are often considered to be simplistic, but under the exact circumstances, they work quite well.

There are simply a great number of misunderstandings regarding reorder points – misunderstandings that this book helps clear up.

Rather than “picking a side,” this book shows the advantages and disadvantages of each.

• Understand the Lean Versus the MRP debate.
• How Lean relates to reordering points.
• Understand when to use reorder points.
• When to use reorder points versus MRP.
• The relationship between forecastability and reorder points.
• How to mix Lean/re-order points and MRP to more efficiently perform supply planning.

### Chapters

• Chapter 1: Introduction
• Chapter 2: The Lean versus MRP Debate.
• Chapter 3: Where Supply Planning Fits Within The Supply Plan
• Chapter 4: Reorder Point Planning
• Chapter 5: Lean Planning.
• Chapter 6: Where Lean and Reorder Points are Applicable
• Chapter 7: Determining When to use Lean Versus MRP
• Chapter 8: Mixing Lean and Reorder Points with MRP-Type Planning

## Software Ratings

Brightwork Research & Analysis offers the following free supply planning software analysis and ratings. See by clicking the image below: