CHAPTER 52How Much Should We Order and When Should We Order?
Suppose you are the manager of your local Target store. You sell thousands of items (often called SKUs, or stock keeping units.) For each SKU (to be specific, let's focus on an Xbox game console), you face two key decisions:
- When I place an order for Xbox consoles, how many should I order?
- How low should I let my inventory level go before I order more Xbox consoles?
In this chapter, you will learn how the economic order quantity (EOQ) model is used to determine the optimal order size. Then you will learn how the concept of service level is used to determine the reorder point, which is the inventory level that triggers the reordering of a product.
The Economic Order Quantity Model
In 1913, Ford Harris (1877–1962) of Westinghouse developed the EOQ model, which is widely used to determine the cost-minimizing order quantity. The size of an order that minimizes the sum of the annual inventory and ordering costs can be determined after the following parameters are known:
- K = Cost of placing an order (does not depend on size of the order)
- h = Cost of holding one unit in inventory for a year
- D = Annual demand for a product
We assume that orders arrive the instant the order is placed. It turns out (see the “Excel Calculations” section later in this chapter) that the order quantity minimizing the sum of annual inventory and annual ordering costs is given by
When you use the EOQ, keep the following points in mind:
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