How Much You Should Buy – Part II
Last month we began a discussion of the economic order quantity (EOQ) formula. The economic order quantity is a mathematical equation. It will always provide the replenishment quantity that provides the lowest total cost. That is, the quantity that will maximize your profits. But, sometimes the result is not a practical stocking quantity. For this reason, many distributors apply the following limits to the results of the EOQ formula:
REDUCE THE EOQ QUANTITY, IF NECESSARY, TO EQUAL A MAXIMUM OF “X” TIMES THE DEMAND FORCAST. In the last example, the calculated economic order quantity was greater than one year’s supply of the product. This assumes that demand, unit cost, the reordering cost, and carrying cost will remain constant for the entire year. While the reordering cost and carrying cost change infrequently, the forecast and the unit cost of many items will fluctuate on a regular basis. And it is an unfortunate fact that inventory shrinkage (loss, theft, breakage, etc.) and obsolescence increase dramatically when inventory remains in a warehouse for an extended period of time. For this reason, best practice is to put an upper limit on the replenishment quantity. Most companies will limit the economic order quantity to equal a three to six-month supply of a product.
- THE EOQ WILL BE INCREASED, IF NECESSARY, TO EQUAL DEMAND DURING THE UPCOMING ORDER CYCLE. The order cycle is the amount of time necessary to build a target order with the vendor. If you order a vendor line once a month, you want to order at least enough of a product to meet your needs until you can place another order with the vendor. That is, you don’t want to order a one-week supply of an item in that vendor line just once a month.
- LIMIT THE EOQ TO THE SHELF LIFE OF THE ITEM. If a product has a shelf life of three months, you never want to order a six-month supply, regardless of the results of the EOQ formula. Most companies specify a shelf life in their computer equal to half the actual shelf life of the product. After all, very few people want to buy a product the day before its expiration date.
- LIMIT THE EOQ TO AVAILABLE STORAGE SPACE. This is particularly true for large, bulky items or material that needs to be stored in a special environment. You don’t want to order a two-month supply of an item if you only have available space for a one-month supply.
- ROUND THE EOQ TO THE NEAREST PACKAGE QUANTITY. If a product comes in a vendor package of 144 pieces, you probably cannot order an economic order quantity of 131 pieces or 165 pieces. The EOQ should be rounded to the nearest multiple of the vendor’s standard package quantity. But, when a product needs to be replenished, at least one vendor package must be ordered, regardless of the EOQ quantity.
The EOQ modified by these limits is commonly referred to as the standard order quantity or SOQ. Have your buyers evaluate calculated economic order quantities. You will probably find that it provides you with an automated method of determining your “best buy” purchase amounts of each stocked product.