Purchasing cost is simply the cost of the purchased item itself. If the firm purchases a part that goes into its finished product, the firm can determine its annual purchasing cost by multiplying the cost of one purchased unit (P) by the number of finished products demanded in a year (D). Hence, purchasing cost is expressed as PD.
Now total inventory cost can be expressed as:
Total = Holding cost + Set-up/Order cost + Purchasing cost or Total = H(Q/2) + S(D/Q) + PD
If holding costs and set-up costs were plotted as lines on a graph, the point at which they intersect (that is, the point at which they are equal) would indicate
the lowest total inventory cost. Therefore, if we want to minimize total inventory cost, every time we place an order, we should order the quantity (Q) that corresponds to the point where the two values are equal.
There are a number of assumptions that must be made with the use of the EOQ. These include:
Only one product is involved.
Deterministic demand (demand is known with certainty). Constant demand (demand is stable through-out the year)
No quantity discounts.
Constant costs (no price increases or inflation).
While these assumptions would seem to make EOQ irrelevant for use in a realistic situation, it is relevant for items that have independent demand. This means that the demand for the item is not derived from the demand for something else (usually a parent item for which the unit in question is a component). For example, the demand for steering wheels would be derived from the demand for automobiles (dependent demand) but the demand for purses is not derived from anything else; purses have independent demand.
Recent industry reports show that inventory costs as a percent of total logistics costs are increasing. Despite this rise, many organizations have not taken full advantage of ways for lowering inventory costs. There are a number of proven strategies that will provide payoff in the inventory area, both in client service and in financial terms. Some of these strategies for lowering inventory costs involve
having less inventory while others involve owning less of the inventory you have. Regardless of which techniques you employ, proactive inventory management practices will make a measurable difference in your operations.
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