Economic Ordering Quantity the Two

Economic Ordering Quantity

The two basic types of cost that are involved in the calculation of the optimal economic ordering quantity -- the lowest level of inventory that can be kept/ordered to minimize ordering costs and remain profitable and well-supplied for sales, are setup costs and production costs. Costs associated with the production and shipment of a given product tend to decrease per unit as the volume of manufacture/order increases, so production costs can be a highly variable part of the economic ordering quantity equation. Setup costs tend to remain more consistent, but can also vary depending on the volume of inventory being ordered. A consideration of both of these costs together, along with other factors such as the demand rate for the product being ordered and the hypothetical and/or real applicable interest rate on money spent that could be used as productive capital, are necessary for the determination of the optimal economic ordering quantity. Adjustments to any of these factors will necessarily have an effect on the economic ordering quantity at any given time.

Though there is a mathematical definition for when the optimal economic ordering quantity has been reached, the concept can also be very simply stated using words. Essentially, the optimal economic ordering quantity has been reached when all costs associated with the ordering and stocking of inventory, from the cost of production and shipment to the costs of storing the product prior to sale/use (i.e. production and setup costs) are at the lowest levels possible that still allow them to meet the consumer/business demand for the product. This is the most efficient use of business dollars when it comes to ordering, as it ensures that there is not a high degree of excess product ordered causing higher setup costs and an overly-large outlay of capital, while maintaining adequate levels for continued operation.

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The issue of finding and utilizing the optimal economic ordering quantity can also be illustrated in a relatively straightforward manner using a simple hypothetical situation. Imagine, for instance, that there is a bakery with a standing order for flour from their distributor. Assuming the bakery uses a consistent amount of flour, it should be fairly easy for the bakery to determine the optimal economic ordering point for their flour supply. For instance, let us imagine that this hypothetical bakery goes through two one-hundred pound bags of flour everyday, and the there is a sharp discount form the distributor on orders of twenty bags or more (or two thousand pounds of flour). As long as there is adequate room in the bakery's storeroom to hold up to twenty-four bags of flour without allowing it to spoil, ordering twenty bags at a time every ten days would be the optimal economic ordering quantity for this firm -- it would allow them to have a ready supply of flour at the cheapest available price without taking up undue space in the business and thus costing the company extra money, and without using up inordinately large amounts of capital for a product that will simply take up room for a large period of time -- the bakery's flour inventory will be completely used up and changed out every ten days.

It might seem more economically beneficial for the company to store a maximum of only twenty bags of flour, as this is the minimum amount that the company needs to receive from the distributor in order to receive the discount, but this would not leave them any safety supply. With twenty-four bags of flour stored at a maximum, the bakery will have four extra bags of flour -- two days' worth of inventory -- on hand at the time of scheduled deliveries. This will allow them to continue operations for two days even with an interruption or delay in the delivery of the flour.

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