Inventory control and EOQ

The essentials

Inventory includes raw materials, work-in-progress and finished goods. Inventory control aims to keep enough stock to avoid shortages while avoiding excess stock that blocks money and space. Two types of cost pull in opposite directions:

• Ordering cost: cost of placing and receiving an order (paperwork, transport, inspection). Larger orders mean fewer orders, so lower annual ordering cost.
• Carrying (holding) cost: cost of storing stock (rent, insurance, interest on money blocked, spoilage). Larger orders mean more average stock, so higher carrying cost.

The economic order quantity (EOQ) is the order size at which the total of annual ordering and carrying costs is lowest.

EOQ = √(2AO ÷ C)

• A = annual demand (units)
• O = ordering cost per order
• C = carrying cost per unit per year

Key points

• At EOQ, annual ordering cost equals annual carrying cost.
• Number of orders per year = A ÷ EOQ.
• Annual ordering cost = (A ÷ Q) × O; annual carrying cost = (Q ÷ 2) × C, where Q is the order size.
• Reorder level (with steady use and no safety stock) = daily usage × lead time in days.
• ABC analysis: "A" items are few but of high value and need strict control; "C" items are many but of low value.

Exam tips

• Check that C is per unit per year; if it is given as a percentage of price, multiply first.
• Practise computing EOQ, number of orders and total cost together.

Common mistakes

• Forgetting the "2" in the EOQ formula.
• Using the full order quantity instead of half of it (average stock) for carrying cost.