National Center for Freight and Infrastructure Research and Education C FIRE

# National center for freight and infrastructure

This preview shows page 3 - 10 out of 51 pages.

National Center for Freight and Infrastructure Research and Education ( C FIRE) University of Wisconsin – Madison. Instructor: Bruce X. Wang and Ernie Wittwer. - 3 - Economic Order Quantity (EOQ) model The EOQ model tries to make a balance between ordering cost and inventory holding cost. If less is ordered each time and orders are placed more frequently, the average inventory will be lower. One might think this would decrease the average inventory carrying cost and would be most preferable. However, there is a trade-off here with the administrative cost, called ordering cost. The ordering cost is a fixed cost associated with placing an order. It includes direct labor time/cost for paperwork, equipment leasing (e.g. for shipping), documentation of ordered items, and unloading. The EOQ model is the most basic model for deciding the optimal order quantity that balances these costs. Where D = Demand; K = fixed ordering cost; h = inventory carrying cost per unit; Q = optimal order quantity. Example A distribution center (DC) manages distribution of a product. The unit value of this product (purchase cost) is \$50.00. The annual demand for this product that goes through the distribution center is 4000 units. A cost of placing the order each time is \$400. If the inventory carrying cost is 20% of the tied inventory value, how many units shall be ordered each time? 4000 * 400 * 2 566 (units). To conclude, the optimal ordering size is 566 units each time. The order frequency is determined by the total annual demand and order size. At first glance, the EOQ model does not appear to capture the effect of transportation. In fact, transportation does not affect the quantity ordered each time. The EOQ model introduced might leave readers with an impression that logistics activities are independent of transportation. Since transportation cost is not considered in the EOQ model, one might suspect that the shipping behavior has been driven by other factors than transportation. This is true in that transportation is only one component of a very large supply chain system. Shipping decisions are often not affected by transportation cost. However, if the shipping volume dramatically changes the freight rate so that the h KD Q 2 * = h KD Q 2 * =