September 14, 2005
A Subjective Look at Order Quantities
For the most part, this site focuses on mathematical optimization techniques and descriptions of optimization techniques. This article is intended to give a brief introduction of other factors to consider when managing inventory levels.
In a previous article, I detailed the economic order
quantity (EOQ), which is the mathematically "perfect" amount of
inventory to order designed to minimize holding costs and ordering costs based
on a given demand. Generally speaking,
this is a very good level to order. Now
I am going to provide potential reasons why perhaps it might be a good idea to
order a different amount:
EOQ is too large
For whatever reason, your holding costs are very low for a
particular item and you simply do not want to hold that much inventory. Maybe you don’t even have enough space for
it. In some cases the EOQ may
necessitate an increase in warehouse space which will drive up fixed costs to
an undesirable level.
A large economic order quantity may result in inventory
levels that carry too much risk. Computer companies such as Dell or Apple have a particular level of
concern regarding obsolescence risk. Ordering a year's worth of processors may prove to be a poor decision in
the event that a better processor is released three months after the shipment
arrives. The fashion industry is also at
great risk for obsolescence.
Other firms may be more concerned about damage to large
levels of inventory in the event of theft, fire, or other natural disasters. The less inventory you have on hand, the less
than can be destroyed while you are responsible for it.
EOQ is too small
Potentially, you may feel that the EOQ is too low for a
number of possible reasons. Perhaps you
fear a rise in the cost of your raw materials and a futures contract isn't
appropriate for your situation. You may
decide that the additional holding costs incurred by ordering a large quantity
are less than the raise in price your supplier could soon be charging you.
Perhaps you just don't want to bother with the EOQ. One firm I worked with had so much excessive
space and was ordering materials that were so inexpensive compared to the rest
of their operations that it wasn't even worth a second thought in trying to
determine how many suppliers to order. They decided it was worth their while to just order as many as they
thought they could reasonable expect to eventually use up.
I generally don't recommend this method for firms with large inventory expenses, but if inventory is a very small part of an overall operation, maybe it's not worth the hassle to try and optimize.
Prefer to use multiple suppliers
Many firms feel more comfortable when they order from
multiple suppliers, which can have many advantages. Two that come to mind right away are
potential price and quality leveraging advantages and reliability
insurance. Having multiple suppliers
provides the opportunity to keep suppliers fighting to give you the best
quality at the best price in fear that they may lose your business. Multiple suppliers also allow reliability
because one supplier's inability to fill your order can be another supplier's
opportunity to gain business.
Unfortunately, if you do decide to receive shipments from multiple
suppliers, you may lose out on quantity discounts and you may be forced to
spend more time ordering. In an ideal
situation you could switch off between the suppliers and order from two or more
with the frequency in which you would order from just one. Regardless of increased ordering, utilizing
multiple suppliers does bring up questions regarding the strict following of
EOQ which should be evaluated prior to switching to or from multiple suppliers.
What I have just listed is a partial list of reasons that could be taken into consideration with evaluating EOQ at your firm. This article is intended as a reminder that there are more variables to order quantities than merely holding costs, ordering costs, and demand. This is not to say that the EOQ formula is worthless, but rather that while it is an important part of managing inventory, it should not be followed blindly. Like all aspects of inventory management, remember to look at the inventory policy in conjunction to the rest of your firm’s policies.
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