Economic order quantity versus just-in-time inventory management at Smitheford Pharmaceuticals

Smitheford Pharmaceuticals

When it comes to inventory management, there are two basic methods that are used far more than any other structured and defined methods. Indeed, those two methods are just-in-time (JIT) and economic order quantity (EOQ). Both have their upsides and downsides but the structures of the two are notably different in what they focus on. However, the root goal of both is effective inventory management and that is a noble cause. While there is no "perfect" way to manage inventory from an ideological or mathematical perspective, it is held by many that just-in-time and economic order quantity are the two best official options out there.

Questions Answered

Basic EOQ Defined

According to Investopedia, the basic EOQ would be the square root of two times the order cost times the demand rate, all over the carrying cost per unit. Since the cost per unit is $48, the carrying cost per unit would be 48 * 0.15, which would be $7.20. In this case, the EOQ would be the square root of two times 28 times 400,000 over 7.20. This comes out to 1,763. This is the economic ordering quantity. In term of keeping costs minimized, this is the order quantity that provides the best "bang for the buck" given the demand quantity that exists and the costs required, both fixed and variable (Investopedia, 2016).

Total Cost Given a Specific EOQ

At 1,763 units, the total cost would be (1763 * 48) + $28. In other words, the per unit cost ($48) times the amount of units (1763) would show the variable cost and adding in the $28 (the fixed cost) would give the cost of the order. In this case, that would be 1764 (rounded up to the nearest unit since it was not a whole number answer) times $48 plus $28, or $84,700. This would be $48.0159 per unit (NCSU, 2016).

Total Cost at One Thousand Units

The overall cost would go down to $48,028. However, the average cost per unit would $48.028. Not a huge rise ... but a rise nonetheless (NCSU, 2016).

Other Observations & Facts

As mostly noted above, just-in-time centers on the idea that goods and materials needed for manufacturing and so forth arrive on time but not too soon before. In other words, the idea is to have them on hand for when they are needed but they should be arriving just before they are need rather than having a glut of supplies and inventory that is collecting dust. The latter leads to wasted space and a lot of other costs and unnecessary efforts that can be skipped by managing inventory more efficiently and only keeping on hand what is needed in the very near future. Of course, there has to be a balance between having an item too soon and having it too late. If the item is early, it has to be moved, stored and managed until it is needed. If the item arrives too late, then the thing being manufactured will have to be delayed because the necessary parts or supplies are not on hand. A major linchpin if making this all work is making sure that the supply is reliable and constant. If there are interruptions in supply, then just-in-time may not work as planned. For example, if an item is supposed to be hand precisely three days before it is needed and a supplier is out of stock and is backordered for more than three days, then just-in-time might lead to problems. However, there are ways to adjust and to provide for contingencies (Investopedia, 2016).

As for economic order quantity, the net goal is the same but the main focus is not on delivery date or inventory on hand but more on cost of ordering and keeping that cost of ordering, on average, at the lowest level possible. As evidenced by the calculations above, the difference between different order levels can be very slim and it might seem to be not be worth it. However, those fractions of a cent can add up to a lot of money over time and sometimes the intervals are much more pronounced depending on the situation and product at hand (Investopedia, 2016). There are certainly merits to both approaches. Minimizing costs is a good thing but avoiding a glut of inventory that is not currently usable (if it's usable at all) can lead to much bigger problems. The author of this report holds that having inventory on hand to deal with orders is probably more important as the cost of not being able to manufacture goods is going to be much higher than ordering the "economical amount." At the same time, it should be done in a diligent and reasonable way so as to avoid unnecessary work and wasted space.

Conclusion

At the end of the day, how much of an item is used per day and how soon it can be delivered upon order are probably the most important factors. Even so, if there are cost savings to be had by ordering in a specific way, that should be the way it is done unless there is a good economic or other reason why not. Every situation is different and the decision made has to be made based on the totality of the facts and figures as they exist at that time. When those facts and figures change, the answers might change as well.