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EOQ-Explained

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EOQ-Explained

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									Chapter 11 - Inventory Management See page 426, the page of formulae Notice, the page is divided into 8 sections, matching the layout of the chapter. The first 7 sections are all EOQ, or modifications of the EOQ. The 8th section stands alone as something different. EOQ is "traditional". 100 years ago, it was much more often a good idea to use the EOQ. Today, sometimes (pretty often, actually), your professor thinks many companies use EOQ when they ought not. EOQ = SQRT(2*Demand*OrderCost / HoldingCost) The EOQ attempts to balance the cost of placing an order against the cost of holding inventory. What are the defects of the EOQ? 1 Deterministic demand (and even stochastic demand) is unrealistic. Real demand is dynamic. 2 We assume that it is possible to manage inventory orders in a tightly defined systematic fashion. (This would require an elimination of many political and information inefficiencies that exist in real-world companies.) 3 To use the EOQ, we need to estimate a static, and fairly well-known order cost value. We also need to believe that the order cost value is more important than the underlying time that causes the cost. 4 Often, the H value is underestimated, because the EAC's only consider the the time value of money in estimating Holding Cost, and they don't consider the costs of shrinkage and storage/handling. 5 Because the EOQ is on the surface a formula that impresses people just enough, it feels a little too good to use. (It's complicated, but not too bad. So I can use it, but you can't challenge me on it.)

The first 7 sections of page 426. 1 Basic EOQ 2 EPQ: We don't send the kid off to Costco to buy the 7-UP. Instead, the kid makes the 7-UP from a machine in the back. 3 Quantity Discounts. Buy more than the EOQ! Special price if you buy in bulk. 4 Planned Shortage, closely related the next model ---5 ROP, which is even more closely related to the next model ----6 Shortages in the ROP. 7 Periodic Ordering (the kid goes to Costco every Monday at 9AM, for example) 2 more examples of how EOQ thinking can lead to problems. 1 Toyota / GM 2 Dishwashers (tease. Come on Tuesday. 09/25)

olding inventory.

e just enough,

The "EOQ" question is closely tied to how the company decides to conduct its cost accounting. (Cost accounting, also known as "management accounting", is the internal counting of numbers, conducted to help operations managers make better decisions. The methods of cost accounting are not governed by all the many laws and regulations of financial accounting, because the numbers are not for investor reporting purposes, or anything else external.) Example: At the Hurl Pack computer company, we make Pav computers. Suppose each Pav computer costs $400 in material purchases, and $50 in direct labor costs. Can HP sell the Pav for $500 and make a profit? No, probably not, because there are other costs. HP has an enormous office building, a huge internal IT staff, Marketers, Accountants, a President, etc. The revenues from the Pav have got to pay for all that too. It's called "overhead burden". Suppose that the company estimates it will 1,000,000 Pav computers this year, and that total overhead costs are going to be $100,000,000 USD. Somehow, the accountants need to have a way to slap the overhead costs onto the unit costs for the Pav, to be sure that we charge a high enough price to make a profit. The numbers above might suggest that HP needs to charge a minimum of $550 just to break even. But it won't be quite that simple in real life. For one thing, not all the Pavs are quite the same. Some of them are 15" and some 17" screens, and the 17" screens get manufactured using a special piece of equipment (expensive). After considering all the product variations (in real life, thousands), and uncertainties, it's very complicated. How can we make it easy? A long time ago, evil cost accountants decided to make it all easy by simply applying overhead burden to the direct labor costs. How does that work? Basically, you would say: we expect to have $50,000,000 USD in direct labor costs this year, and I have $100,000,000 USD in overhead, so… every time we do a cost calculation that includes labor costs, add $2 of overhead burden for every $1 in real direct labor costs. The result is that we place EOQ orders that are way too high, thinking that we are saving money by not placing frequent orders. But it's a phantom savings.

ery complicated.

or every $1 in


								
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