Calculate Economic Order Quantity Principles of Cost Analysis

Calculate Economic Order Quantity Principles of Cost Analysis and Management 10. 4 1

What do you think? Corporal O’Reilly, the supply clerk, knows that it costs the Army money to generate a purchase order. To save money he proposes ordering the five years’ worth of ammunition at once. 2

Terminal Learning Objective Action: Calculate Economic Order Quantity Condition: FM Leaders in a classroom environment working as a member of a small group, using doctrinal and administrative publications, self-study exercises, personal experiences, practical exercises, handouts, and discussion. Standard: With at least 80% accuracy, you must: • Determine Batch Quantity Concepts • Apply Batch Cost Example • Determine Batch Quantity Concepts • Applying Holding Cost Example • Optimizing Order Quantity 3

Determine Batch Quantity Concepts • 4

Batch Cost Assumptions • Annual demand for units produced in batches is known • Every batch is the same size • i. e. same quantity of units produced 5

Batch Costs • 6

Batch Costs (Cont. ) • 7

Batch Costs (Cont. ) • 8

Batch Costs (Cont. ) • 9

Batch Costs (Cont. ) • 10

Batch Costs (Cont. ) • 11

Batch Costs (Cont. ) • Regardless of how you look at it: • More units in a batch mean fewer batches • Fewer batches mean lower Batch costs 12

LSA #1 Check on Learning Q 1. How does batch cost per unit change as batch size increases? A 1. Q 2. What are the key assumptions in batch quantity tradeoffs? A 2. 13

LSA #1 Summary 14

Apply Batch Cost Example • Purchasing supplies is a common example of a Batch cost • Each purchase order issued costs the organization $250 • Demand for supplies is 200 units 15

Batch Cost Example (Cont. ) • How much is purchasing cost if a separate purchase order is issued for each unit of supplies? 200 purchase orders * $250/ purchase order = $50, 000 • How much is purchasing cost if all 200 units are purchased using a single purchase order? 1 purchase order * $250/ purchase order = $250 16

Batch Cost Example (Cont. ) • 17

Batch Cost Example (Cont. ) • 18

Graph of Purchasing Cost $ X-Axis = Number of units per purchase order or batch As number of units per PO or batch increases, purchasing cost decreases 19

Questions to Consider • Using only this information for your decision, how many units should be ordered per purchase order? • Similarly, what savings might be achieved by training all of the soldiers needed for a particular task in one large group? • What else should be considered? 20

LSA #2 Check on Learning Q 1. How would you describe the graph of batch cost? A 1. 21

LSA #2 Summary • In this block, we’ve discussed Batch Costs while providing an example. 22

Determine Batch Quantity Concepts • Certain costs increase as quantity per purchase order increases • Inventory ties up cash and must be stored and maintained • Spoilage and obsolescence can occur • Time value of money – cash paid now is worth more than cash paid later • “Just in Time” ordering minimizes these “Holding Costs” 23

Questions to Consider • What might be the “holding costs” involved with training all of the soldiers required for a particular task in one large group or “batch”? 24

Holding Cost Assumptions • Annual Holding Cost is linear or variable on a per-unit basis • Units produced or purchased in batches are consumed or sold uniformly throughout the period 25

Holding Costs • Holding cost = $Holding Cost/Unit * Avg. #Units in Inventory • Average #Units in Inventory = #Units per Purchase Order/2 • Assumes Inventory is consumed uniformly throughout the year 26

Graph of Inventory Assumption (Cont. ) Inventory Level 60. 00 50. 00 40. 00 50 Units produced or purchased per batch 30. 00 20. 00 10. 00 X axis represents time 27

Graph of Inventory Assumption (Cont. ) 60. 00 Inventory Level 50. 00 40. 00 30. 00 25. 00 20. 00 10. 00 Units Consumed or Sold uniformly until all Inventory is gone 28

Graph of Inventory Assumption (Cont. ) Inventory Level 60. 00 50. 00 Average Inventory is 50/2 or 25 Units 40. 00 30. 00 25. 00 Average Inventory 20. 00 10. 00 X axis represents time 29

LSA #3 Check on Learning Q 1. What are the underlying assumptions related to holding costs? A 1. Q 2. How is average inventory calculated? A 2. 30

LSA #3 Summary • During this discussion, we spoke of Holding Costs and assumptions, as well as graphed it out for learning reinforcement. 31

Applying Holding Cost Example • Annual holding cost for supplies is $50 per unit • What is holding cost if each unit of supplies is purchased on its own purchase order? • Average inventory = 1 unit/2 or ½ unit • ½ unit * $50/unit = $25 • What is holding cost if all 200 units of supplies are purchased on one purchase order? • Average inventory = 200 units/ 2 or 100 units • 100 units * $50/unit = $5, 000 32

Holding Cost Example • Annual holding cost for supplies is $50 per unit • What is holding cost if each unit of supplies is purchased on its own purchase order? • Average inventory = 1 unit/2 or ½ unit • ½ unit * $50/unit = $25 • What is holding cost if all 200 units of supplies are purchased on one purchase order? • Average inventory = 200 units/ 2 or 100 units • 100 units * $50/unit = $5, 000 33

Holding Cost Example • Annual holding cost for supplies is $50 per unit • What is holding cost if each unit of supplies is purchased on its own purchase order? • Average inventory = 1 unit/2 or ½ unit • ½ unit * $50/unit = $25 • What is holding cost if all 200 units of supplies are purchased on one purchase order? • Average inventory = 200 units/ 2 or 100 units • 100 units * $50/unit = $5, 000 34

Graph of Holding Cost $ When quantity per purchase order is 10 Average Inventory = 5 and holding cost is $250 When quantity per purchase order is 100 Average Inventory = 50 and purchasing cost is $2, 500 X-Axis = Number of units per purchase order As number of units per purchase order increases, holding cost increases 35

LSA #4 Check on Learning Q 1. How does holding cost change as batch quantity changes? A 1. Q 2. How is holding cost represented on the graph? A 2. 36

LSA #4 Summary • Again, during this discussion, we spoke of Holding Costs examples, as well as a graphic representation for learning reinforcement. 37

Optimizing Order Quantity • Total Costs Related to Order Quantity = Purchasing Cost + Holding Cost • What is Total Cost when Quantity per order is 10 units? 5000 + 250 = 5250 • What is Total Cost when Quantity per order is 100 units? 500 + 2500 = 3000 38

Optimizing Order Quantity (Cont. ) • Total Costs Related to Order Quantity = Purchasing Cost + Holding Cost • What is Total Cost when Quantity per order is 10 units? 5000 + 250 = 5250 • What is Total Cost when Quantity per order is 100 units? 500 + 2500 = 3000 39

Optimizing Order Quantity (Cont. ) • Total Costs Related to Order Quantity = Purchasing Cost + Holding Cost • What is Total Cost when Quantity per order is 10 units? 5000 + 250 = 5250 • What is Total Cost when Quantity per order is 100 units? 500 + 2500 = 3000 40

Graph of Total Costs Total Cost is minimized where Purchasing Cost = Holding Cost ≈45 X-Axis = Order quantity in units 41

Optimizing Order Quantity (Cont. ) • Total Cost is minimized at the order quantity where Holding Cost = Purchasing Cost • Computation of this “Indifference Point” requires calculus beyond the scope of this course 42

Optimizing Order Quantity (Cont. ) • 43

Calculating EOQ • 44

LSA #5 Check on Learning Q 1. What are three variables used in the Economic Order Quantity formula? A 1. Q 2. How will EOQ change if holding cost per unit increases while all other variables remain the same? A 2. 45

LSA #5 Summary • In this lesson, we spoke of Optimizing Order Quantity, provided a graphic representation, and solved for the EOQ. 46

TLO Check on Learning 47

TLO Summary Action: Calculate Economic Order Quantity Condition: FM Leaders in a classroom environment working as a member of a small group, using doctrinal and administrative publications, self-study exercises, personal experiences, practical exercises, handouts, and discussion. Standard: With at least 80% accuracy, you must: • Determine Batch Quantity Concepts • Apply Batch Cost Example • Determine Batch Quantity Concepts • Applying Holding Cost Example • Optimizing Order Quantity 48

TLO Summary 49

Practical Exercises 50

Batch Quantity Spreadsheet Enter batch cost, holding cost, and demand into the spreadsheet to generate the graph of total cost © Dale R. Geiger 2011 51