Q. Explain about economic order quantity?
The economic order quantity (EOQ) model is basis on a cost function for holding inventory which has two terms: holding costs as well as ordering costs. Through the EOQ the total cost of having inventory is minimised when holding cost is equal to ordering cost. The EOQ model presumes certain knowledge of the variables on which it depends and for this reason is called a deterministic model. Demand for inventory holding cost per unit per year as well as order cost are assumed to be certain and constant for the period under consideration. In practice demand is probable to be variable or irregular and costs will not remain constant. The EOQ model as well ignores the cost of running out of inventory (stockouts). This has reason some to suggest that the EOQ model has little to recommend it as a practical model for the management of inventory.
The model was developed on the foundation of zero lead time and no buffer stock but these aren't difficulties that prevent the practical application of the EOQ model. As our previous analysis has shown the EOQ model is able to be used in circumstances where buffer stock exists and provided that lead time is known with certainty it can be ignored.
The EOQ model as well serves a useful purpose in directing attention towards the costs that arise from holding inventory. If these costs are able to be reduced working capital tied up in inventory is able to be reduced and overall profitability can be increased.
If uncertainty subsist in terms of demand or lead time, a more complex inventory management model using probabilities (a stochastic model) such as the Miller-Orr model can be used. This model computes control limits that give guidance as to when an order must be placed.