There are different ways to use variables in order to
calculate the economic order quantity for an inventory. In order to calculate
the formula of EOQ lets assume the following parameters:-
Q= the Order Quantity
Q* = the optimal or economic order
quantity
D = Annual Demand of the Material
S = Fixed Cost associated with each
order
H = Annual holding cost associated
with the each unit of the order
In the above mentioned parameters the fixed costs are the
costs that remain constant such as shipping cost, cost of handling the goods
and delivery cost of the goods. The actual production cost of the goods is not
included in the fixed costs.
Now we can find out the Total cost associated with each item
of the order
Total Cost = Purchase cost of the
order + Ordering cost + handling cost of the order
Where,
Purchase Cost = it is the variable cost that is associated
with each unit of the order. It can be calculated as under:-
Purchase cost= unit purchase price x
the annual demand quantity of the order
PC= P X D
Ordering cost is the cost that associated with placing the
orders. As we know that each order has a fixed cost S associated with it. The
number of orders we need to place per year are demand of the order divided by
the order quantity. So ordering cost can be calculated as under
Ordering
Cost = Fixed Cost x Demand / Order Quantity
OC = SD/Q
Now the last cost is the holding cost and it is the cost associated
with holding the average order in the inventory for a specific period of time.
Holding Cost = HQ/2
Now,
The Total Cost associated with the
order = PD + SD/Q +
HQ/2
Now assume that price and demand are constant and set to
zero. In order to calculate the minimum point of the curve of cost we
differentiate the total cost with respect to Q and set its value equals to
zero. The resultant equation will be:-
0= -
DS/Q2 + H/2
Q* =
2DS/H
Example:-
Annual required quantity = 1000 units
Cost associated with each order = $2 per order
Cost per unit = $8
Holding cost per order = $0.16
Economic Order Quantity = 2Q x CO / CU x CC%
Economic Order Quantity = 2x
10000x 2/ 8 x 0.02
Economic Order Quantity = 500 units
