Why is the eoq formula not useful for spare parts
Calculating EOQ - Economic Order Quantity (Inventory Costs & Purchasing Costs)
hi guys the end Ronson from dried
success calm today we're gonna talk
about calculating economic or quantity
and we're going to use a very simple and
straightforward formula we're going to
use what's called the Wilson yo cue
formula this is a formula it's been
around for a hundred years that actually
started in 1913 and there's some pros
and cons to this to this formula but
it's important to note that a lot of
things have changed in terms of business
over the last hundred years so what
we're going to do today is we're going
to go over exactly how the formula is
used I'm going to go through this
example up here on the board I'm going
to show you how to determine your
economic order quantity and then we'll
just talk about some of the drawbacks
and the benefits of using the formula in
terms of identifying the ideal quantity
in terms of you know purchasing raw
materials or consumables what happened
okay so what we're going to do today is
we're going to go over these variables
and I'm going to show you how the
calculation is done and again the
calculation is very simple it's not
terribly difficult to understand
however it's there are certain variables
that go into the calculation that are
that are quite involved and they do take
some analysis on your part in order to
make sure that your calculation is
accurate because one of the biggest
mistakes companies make when it comes to
calculating genomic order quantity is
they they basically gloss over their
costs to purchase those raw materials
and their holding cost of inventory okay
so let's just basically go over these
variables and I'll show you exactly how
the calculation is done and when we get
to the cost of purposing the cost of
holding inventory I'll kind of delve
into that a little bit further
okay so annual usage is the simple
portion simplest portion of the
calculation you should know exactly how
much you use of a given raw material a
consumable or finish good that's that's
fairly simple okay in our example it's
three thousand units so this is going to
we're going to call this a alright again
the price it's fairly simple to
understand you know how much are you
paying for this part that you're buying
in this case it's twenty dollars the
cost to actually make the purchase now
this is not a per unit cost rather this
is the cost that is included in terms of
actually going ahead and getting an
approval doing a purchase requisition
placing the order
sending the order up to your van
emailing or faxing and you know
receiving the incoming shipment
inspecting the parts and putting them on
the shelf in your warehouse and then
paying your vendor now this may not seem
like that much what you've got to take
into consideration when you do this
portion of the equation is that your
cost of purchasing has to be taken
across all of the orders that you
process okay so it may not seem like a
lot but the fact is is that it's really
broken down in terms of how many orders
you process and what those after mention
costs are in terms of receiving
inspection putting them on the shelf and
doing all those other things okay
holding costs of inventory this is
critical now a link just popped up above
my head this link is going to give you a
sample Excel spreadsheets going to allow
you to determine your specific inventory
carrying cost okay or your specific
holding cost of inventory now these are
these are the costs to hold inventory
without sales now the thing is is that
the reason why you have to click on this
link and go to my website in order to
figure this out is because you know
you're holding costs as a company you
know are always different from one
company to the next okay
it's different for companies that
operate in business-to-business markets
it's different for companies that
operate in business the consumer markets
and it's not just your cost to finance
inventory a lot of companies think that
they're holding cost of inventory is
nothing more than the cost of financing
the inventory there's so much more
that's included in that first of all
there's the cost of obsolescence parts
finished goods and obsolescence in terms
of raw materials there's the cost of
pilferage okay Steph it's a big issue in
business to consumer markets the cost of
inventory damage cost of insurance the
per unit freight cost get parts into
your warehouse so that after mention the
length that I mentioned earlier it's
going to allow you to determine your
specific inventory holding costs by
giving you a percentage of the inventory
value on hand in our example we're just
going to take 3% because once you do the
calculation you're going to probably
come close to that 3% most companies
apply 3% as
holding cost for the inventory value on
hand okay and that's made up of all
those other things I mentioned cost of
financing obsolescence damage pilferage
insurance per unit freight cost cost of
counting handling all those things okay
so in this case the holding cost of
inventory we're going to take the price
of the unit which is $20 multiplied by
our holding cost of inventory which is
3% and it gives us 60 cents so let's put
this all into the equation okay so let's
call cost of purchasing I just don't
want it I don't want to forget about
this CP and holding costs we're going to
call this HC holding costs okay so the
calculation goes like this you're going
to take two okay and you're going to
multiply it by a and then you're going
to times this number times your cost to
purchase times CP and you're going to
divide everything by your holding costs
HC okay so we're going to plug
everything into the equation e oq equals
it's going to be two times three
thousand is going to be six thousand
multiplied by the cost of purchase which
is going to be two divided by zero point
six zero which is our holding cost okay
so this is going to be e oq is going to
equal to twelve thousand six thousand
times 2 divided by zero point six zero
and REO q is going to be square root of
20,000 okay so once you take twelve
thousand divided by 0.6 maybe 20,000
that means your EO q sorry
make sure that's e o q is going to equal
141
units okay 141 units that is the ideal
quantity where your costs to purchase
and your costs of holding inventory are
minimized now if you wanted to take this
ego cube quantity and say how many
orders are we going to place throughout
the year
you just take 3,000 units 3000 divided
by 141 and you're going to get 21 orders
so throughout the year you're going to
place 21 orders then you're going to buy
141 units at a time and in this case
what you've done is you have minimized
your cost of purchase and your holding
cost of inventory now this formula is
very straightforward it's not terribly
difficult however as I mentioned earlier
the problems arise when you have to
determine your specific costs to make
the purchase and what your specific
inventory holding costs are you've got
to calculate what this numbers okay
because as I said earlier you know your
holding cost of inventory depend upon
the type of market you operate in the
type of customers you sell to your
business model and you know again you
know business the business markets you
know issues of obsolescence and damage
or maybe more prevalent than business
the consumer markets where we're theft
and pilferage is a bigger concern so
make sure you calculate your holding
cost of inventory okay again this is a
very simple and straightforward formula
we've used it all we determine our
economic order quantity 141 units and
we're going to place 21 orders
throughout the year based on 3,000 units
purchased in the given year now let's
just talk about some of the drawbacks
okay first of all the eoq you formula
again it's a hundred years old and it
makes a lot of assumptions the first
thing is it assumes that the lead time
from your vendors is constant and
doesn't change we know that doesn't
happen it also assumes that the price
stays the same and again it doesn't
account for any discounts or anything
else like that that also assumes if
you're ordering costs are constant and
that they don't change and of course
that's not the case and it also assumes
that your demand and
the units that you're purchasing of the
year is going to be constant as well so
there's a lot of drawbacks to the
formula it's a good formula and it's
something you want to look at when you
look in terms of you know when you're
calculating safety stock and then the
link just popped up above my head this
will show you how to do a proper
calculation of safety stock and yo Q
plays a role in that in terms of when
you hit your reorder point so that's it
economic order quantity simple
calculation more difficult parts or cost
of purchasing holding constant inventory
so that's it economic order quantity Ian
Johnson driver success calm bye bye
