January 10th, 2018
How Economic Order Quantity (EOQ), cycle time and total cost change with increasing: (a) Carrying costs, (b) ordering costs and (c) demand
Economic order quantity (EOQ) model is aimed at calculating the optimal order quantities that achieves maximum economy in inventory holding and ordering costs (Drury, 2006). The formula for its calculation is given by: EOQ = √ (2DO/H) where D is the annual demand, O the cost for placing a single order and H the annual holding costs per unit inventory (Drury, 2006, p. 69). From the formula increases in ordering costs and demand will increase EOQ since they form the numerator of the fraction term under square root. Increases in carrying costs will lead to a decrease in EOQ since they represent the holding costs which are the denominator in the fraction term under the square root.
Using the EOQ and annual demand (D) the number of orders (n) needed in a particular year can be determined; n = D/ EOQ (Drury, 2006). Increased demand will increase n hence decrease the time period between one order and the other – order cycle. Since increasing ordering costs increases EOQ, n will decrease hence lead to increased order cycle. Conversely, increased carrying costs will decrease order cycle by its opposite effect to that of ordering costs on EOQ. For the total cost (TC) a relationship exists where TC = DO/Q + QH/2 where Q is the quantity ordered in units, the other initials being similar to their representation in EOQ formula (Drury, 2006, p. 69). From this relationship increases in carrying cost, ordering costs, and demand increases total cost since these form numerators of their respective fraction terms in the TC equation.
Drury, C. (2006). Cost and Management Accounting. (6th Ed.). London: Thomson Learning.