A classic inventory management calculation that's been used for years by supply chain groups is Economic Order Quantity (EOQ). This metric calculates the optimal order size to replenish inventory of a particular product item or Stock Keeping Unit (SKU).
EOQ is calculated as the order size where the cost to place and receive an order, the Acquisition Cost (AC) equals the cost of holding inventory, the Carrying Cost (CC). It was a very essential formula as supply chain groups sought to balance the cost of investing in inventory with the transactional costs of placing an order and receiving the product.
As I've trained major company groups recently on Best Practices in Inventory Management, we've begun to increasingly focus on Total Cost of Ownership (TCO) methodology as an potentially more-beneficial means of determining order quantities than EOQ.
Why is EOQ Less Meaningful Today? In past days some of us still recall, the cost was much higher to create and place a purchase order, receive a shipment, and place product into inventory. In the days when EOQ modeling first became popular, (i) purchase orders were manually-typed, (ii) buyers placed PO's via telephone or mail to suppliers, (iii) multi-part forms were burst and parts physically distributed to departments and suppliers, (iv) acknowledgement copies physically solicited, (v) receiving copies completed upon delivery fulfillment, (vi) physical matching performed by payables personnel, and (vii) checks manually printed and mailed.
But that isn't todays reality, is it? With automated purchasing, inventory, and payables technologies in play, most of the foregoing process is now automated. The Acquisition Cost (AC) has dramatically shrunk to levels far below those of 10, 20, or 30 years ago.
And if AC is lower, there has been a formulaic shift in the average EOQ formula calculation...which is the core of many MRP, MRP II and ERP technology module calculations. If AC drops in value, then the average order size calculated by our technology tool is going to be skewed towards being smaller as well.
How Does a Shrinking EOQ Impact TCO? For those of us with a sourcing background, the answer is immediately clear. Placing repetitive small-quantity orders will increase the typical supplier's cost of doing business with our firm. And when the supplier's cost goes up, our TCO typically does as well.
If we can just put on the supplier's shoes for a moment, it makes sense that most firms can produce and ship products at a lower average unit cost for larger quantitites than for lower ones. So of course it makes sense that to place a fewer number of orders may result in a lower cost.
One of Strategic Procurement Solutions' services is staff augmentation. We place (on a direct recruit or temporary project basis) skilled procurement professionals with many leading companies. Recently, one of the largest global energy firms has been utilizing us to find senior materials experts to increase the efficiency of their international SCM operations. As I was conducting second-round screening interviews with three top finalists this week, all three commented that EOQ was becoming less and less meaningful. to them and their employers (you don't think I came up with this article topic myself, do you?).
So What Can Be Done? Leading supply chain organizations seem to be taking the following paths to identify optimal order sizes...
First, some I.M. modules of ERP systems have the ability (or can be customized to have the ability) to plug in variable/tiered unit pricing for differing order sizes. This functionality exists in some of our firm's client SAP, Oracle, and Epicor installations, and most-likely exists in your organization's as well. This functionality may allow you to alter the EOQ calculations to properly reflect the benefits of order size optimization.
Second, it is important to understand that EOQ calculations can work well in certain spend categories. These are typically categories where (i) demand is consistent, (ii) supplier costs do not vary dramatically by order quantity (for example, a distributor rather than manufacturer), and (iii) lead times are relatively short. An example where EOQ can work well is in Maintenance, Repair, and Operating (MRO) supplies. With some exponential smoothing, EOQ fits this spend category pretty well, even in today's environment.
Third, there are many other cost-drivers beside AC and CC. Leading companies are starting to utilize TCO calculations at a SKU level to determine optimal order quantities. One of our clients is a Multi-Billion Dollar producer of children's toys, which are manufactured and distributed internationally. This company's supply chain team chose not to utilize their SAP system's EOQ functionality to determine reorder points and quantities, but rather is utilizing TCO modeling to select the optimal procurement patterns.
Economic Order Quantity is still a valid tool to use, but should not be implemented in a blanket manner without some strategic thought. Other scheduling techniques may yield better value to your organization.
About the Author: Mark Trowbridge is one of Strategic Procurement Solutions' founding principals. He is a featured author in supply chain publications like Inside Supply Management, Supply Chain Management Review, eSide Supply Management, and Strategic Procurement Solutions' own Best Practices in Supply Management Journal. He is an invited speaker at international supply chain conferences, and his consulting travels have taken him throughout North America, Europe, Asia, Malaysia, and the Middle East.
If you would like information about our 360o Supply Management Efficiency Reviews, onsite training programs like Best Practices in Inventory Management, or Staff Augmentation Services, please visit our website at www.StrategicProcurementSolutions.com