EOQ Calculation in 13 min.
- How to Calculate Economic Order Quantity Model or EOQ Model
Hello and welcome back again to MBAbullshit.com.
So our topic for this video is the Economic Order Quantity Model or EOQ.
Remember you can always go back to MBAbullshit.com.
Alright, now this video talk about the basic EOQ model, Economic Order Quantity Model and
after this you can move on to my next video on MBAbullshit.com on “EOQ with Quantity
Discounts”.
Also check out my other related free video on “Re-Order Point” or the basic ROP Model.
And after that, you can move on to my next video on MBAbullshit.com about Re-order Point
with Safety Stock.
Now, let’s start with a story to make it easy to understand.
Let’s say that your friend Bob wants to buy basketballs from a factory and sell them
to his neighborhood.
Bob can buy the basketballs at $ 10 each from the factory, and he plans to sell it in his
neighborhood shop for $ 20 each.
He estimates he’ll sell around 1200 basketballs a year.
At first, Bob thought of just buying around 100 basketballs per month from the factory,
which will equal his 1200 basketballs by the end of the year.
However, Bob is kind of irritated at the factory because aside from the $ 10 cost of the basketball,
the factory charges him a silly crazy $90 “Ordering Fee” every time he makes an
order.
Maybe you’d experienced this when you buy stuff from say discount Airlines or whatever
they’d like to add on these crazy silly fees to earn extra money.
Anyway, so every time he makes an order, they charge him $ 90 ordering fee.
Now, in MBAbullshit language, we call this Ordering Cost or Set-up Cost.
Because sometimes it’s not a fee for ordering, it’s a fee to set-up something because every
time they service you, maybe they have to set-up something new just to service you to
give you the service so they charge you a Set-up Cost.
So if he or Bob orders every month, then he’ll have an added ordering fee cost of $ 90 a
month or $ 1,080 a year!
So Bob comes up with a clever plan.
“I’ll just order all 1200 basketballs only once for the whole year, so I’ll just
pay the $ 90 ordering fee one time”.
That’s what Bob says.
So he decides to pay $ 90 a year ordering fee instead of $ 1,080.
But just when Bob thought he had the problem solved, he sees another problem!
He doesn’t have a space in his shop to keep many basketballs.
He needs to rent extra space from his greedy rich neighbor who has a big garage.
For any extra space just enough to store 1 basketball, his neighbor charges $ 3 per year.
We’ll call this “Holding Cost per unit per year”.
Per unit in this case, we mean for each basketball because 1 basketball is 1 unit.
So in other words, it’s expensive for Bob if he orders few basketballs at a time because
of the ordering fee or set-up cost which is $ 90 per order.
And it’s also expensive for Bob if he orders only a lot of basketballs at one time; because
of the storage rental fee or “Holding Cost” which will cost him $ 3 per basketball per
year ($ 3 per unit per year).
So what should Bob do now?
Should he order a lot at one time or should he order a little every month?
What is the best number of basketballs that Bob should order at one time?
So that number that we’re looking for now is called the “Economic Order Quantity”
or EOQ.
To find out the best or optimal number of basketballs or EOQ that Bob should order at
one time, we use this super simple formula: the EOQ equals the square root so that this
funny looking thing over here is called square root and you can find it in your scientific
calculator.
The square root of 2 multiplied by 1,200 multiplied by $ 90 divided by 3: EOQ = ? [2(1,200)($90)]/$3
. Now, where did we get these numbers over here?
First of all, this square root over here is given as part of the formula and this number
2 over here is also given as part of the formula.
We did not get it from the story about Bob.
Where did we get the 1,200, the 90 and the 3?
It comes from the basic formula over here: EOQ = ? [2xDxS]/H. 1,200 is the demand for
year so if you remember earlier in the story it was given in the story that Bob expects
to sell about 1,200 per year so that’s where we get it.
Where did we get this $ 90?
That is the Set-up Cost or letter S. Remember every time Bob orders from the factory, that
greedy factory charges him a silly crazy fee of $ 90 per order or $ 90 ordering fee or
$ 90 in Set-up Cost which is over here.
Where did we get this $ 3?
That is the holding cost per unit that’s why we have letter H here.
Remember his greedy neighbor charges Bob $ 3 for every basketball per year that Bob stores
it.
So that is the holding fee per year for one unit of basketball.
So that’s here.
Alright, so if we simplify that further, 2 multiplied by 1,200 multiplied by 90.
By the way, these letter Xs over here, you see these letter Xs?
Those are multiplication signs.
Those are not variable.
So 2 multiplied by 1,200 multiplied by 90 equals to 216,000 divided by 3: EOQ = ? $216,000/$3.
We simplified that further looks like this 216,000 divided by $3 equals 72,000: EOQ = ? 72,000.
And then we get the square root of that, so how do you do that on your calculator?
Well that depends on your calculator but on my calculator which is a Casio, you first
press the square root number and then you write the 72,000.
So on my calculator you first press the square root and then you input the number.
Make sure that you do this square root thing in the last part.
Do not type the square root first and then do all these crazy computations.
You only use this square root function on your calculator after you have only one figure
left inside it and you push the square root button and then input the number.
So the square root of 72,000 is 268.33.
So what do we learn from this?
We learned that Bob should order 269 basketballs at a time at each time.
So if Bob orders 269 basketballs at a time, he will have the lowest cost overall instead
for example if he buys 250 basketballs at a time his cost will go up.
Why?
Because it’s less than 269.
If Bob orders more than 269 basketballs at a time, if he buys 280 basketballs at a time,
his cost will also go up.
The optimum best number is 269.
You might wonder why is this 269.
We have the result of 268.33 because we always round it up to a nearer whole number but actually
in this case it’s up to you if you want to round it off to 268 or 269.
But you do not leave a decimal place in your actual number.
Why don’t you leave a decimal place?
Because you cannot buy 0.33 of a basketball.
Bob cannot tell the factory “Hey, give me 268 basketballs and also give me 0.33 of 1
basketball.
You cannot do that.
So Bob should order 268 or 269 basketballs at a time at each time.
Now, here’s a tip; at this number, 269 or 268.
By the way, do you round it off to the higher number 269 or 268?
My professor likes to round it off to the higher number 269 but your professor might
prefer 268, so check out that with him which one he prefers.
Now here’s the tip; at this number of 269 basketballs, your set-up or ordering fee per
year will equal your holding and rental cost per year.
So the total cost is more expensive when the set-up cost and the holding cost is uneven
when they are not the same.
So what we’re actually doing with this formula is we’re finding the number over here with
which your set-up cost per year or ordering fee per year will equal your holding and rental
cost per year.
Alright so that’s how simple it is.
You’re now ready for my next video on MBAbullshit.com about EOQ or Economic Order Quantity with
Quantity Discounts.
And you can also check out my other free video on “Re-Order Point” or the basic Re-Order
Point Model.
And after that, you can move on to my next video on MBAbullshit.com about “Re-Order
Point with Safety Stock”.
So there it is.
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