Inventory Management II: EOQ, Reorder Level and ABC Analysis
Course: Corporate Finance / Operations Management
Lecture: 4 – Inventory Management II
1. Economic Order Quantity (EOQ)
Economic Order Quantity (EOQ) is a classical inventory model that determines the order size which minimizes the sum of ordering and holding costs. It is widely used as a basic tool in inventory management. EOQ is most appropriate when demand and lead time are reasonably stable.
1.1 EOQ formula
The basic EOQ formula is:
EOQ = √( 2DS / H )
Where:
- D = Annual demand (units per year)
- S = Ordering cost per order
- H = Holding (carrying) cost per unit per year
EOQ balances the trade‑off between ordering more often in small quantities (high ordering cost, low holding cost) and ordering less often in large quantities (low ordering cost, high holding cost).
1.2 Numerical example
Suppose a firm has the following data:
- Annual demand, D = 10,000 units
- Ordering cost per order, S = 50
- Holding cost per unit per year, H = 2
Then EOQ is calculated as:
EOQ = √( 2 × 10,000 × 50 / 2 ) = √( 500,000 ) ≈ 707 units
This means the firm should order approximately 707 units each time to minimize the total of ordering and holding costs.
You can also ask students to compute:
- Number of orders per year: D / EOQ ≈ 10,000 / 707 ≈ 14 orders per year.
- Time between orders: 365 days / 14 ≈ 26 days between orders.
2. Reorder Level
The reorder level is the inventory level at which a new order should be placed so that stock will be replenished before it runs out.
A simple formula is:
Reorder Level = Maximum Usage × Maximum Lead Time
Where:
- Maximum usage: Maximum units used per period (such as per day or per week).
- Maximum lead time: Maximum delivery time in the same period units.
Example:
- Maximum usage = 80 units per day
- Maximum lead time = 7 days
Reorder Level = 80 × 7 = 560 units. When stock falls to 560 units, the firm should place a new order.
3. ABC Analysis
ABC analysis is a selective inventory control technique that groups items according to their importance, usually measured by annual consumption value (annual quantity × unit price).
- Category A: High‑value items, usually low in quantity. These may represent about 10–20% of items but 70–80% of the total inventory value. They require very tight control, accurate records, and frequent review.
- Category B: Moderate value and moderate quantity items. They receive a normal level of control and periodic review.
- Category C: Low‑value items, often high in quantity. These may be 50–70% of items but only a small share of total value. Simple controls and larger safety stocks are usually sufficient.
Basic steps in ABC analysis:
- List all inventory items with their annual quantity and unit cost.
- Calculate annual consumption value (quantity × unit cost) for each item.
- Rank items from highest to lowest consumption value.
- Classify top items as A, the next band as B, and the remaining items as C.
4. Numerical Exercise – EOQ
Exercise: Use the following data to calculate EOQ:
- Annual demand, D = 10,000 units
- Ordering cost per order, S = 50
- Holding cost per unit per year, H = 2
Required:
- Calculate EOQ.
- Calculate the number of orders per year.
- Calculate the approximate time between orders (assume 365 days per year).
Expected answers (for instructor):
- EOQ ≈ 707 units.
- Number of orders per year ≈ 10,000 / 707 ≈ 14 orders.
- Time between orders ≈ 365 / 14 ≈ 26 days.
5. Classroom Activity – ABC Classification Exercise
Activity outline:
- Provide students (individually or in groups) with a list of 10–15 items, their annual quantities, and unit prices.
- Ask them to compute annual consumption value for each item.
- Tell them to rank items from highest to lowest consumption value.
- Have them classify items into A, B, and C categories (for example, top 20% of items as A, next 30% as B, and the rest as C).
Discuss questions such as:
- Which items should management monitor most closely and why?
- How might ordering, safety stock, and review frequency differ between A and C items?
6. Homework – Lecture 4
Part A – EOQ practice
- Select a product from any retail or manufacturing setting (for example, a specific raw material or a finished product).
- Assume reasonable values for annual demand, ordering cost, and holding cost.
- Calculate EOQ and briefly explain what this order quantity means for the business. Show all steps.
Part B – ABC mini‑case
- Create a small list of at least six inventory items with assumed annual quantities and unit costs.
- Compute the annual consumption value for each item and rank them.
- Classify the items into A, B, and C categories.
- In 150–200 words, explain how a manager should treat A category items differently from C category items.
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