economic order quantity modela method used in STOCK CONTROL of raw materials, components or finished goods which seeks to balance stockholding costs and delivery costs for a STOCK item in order to determine the optimum order quantity for that item.
The principal objective of stock-control procedures is to maintain stocks at the lowest total cost consistent with satisfying demand. This involves balancing two sets of cost:
- stockholding costs: the cost to firms of holding stocks of finished products and raw materials in order to provide immediate customer service or to prevent disruptions to production caused by lack of materials. Stockholding costs include costs of warehouse space, insurance, deterioration and obsolescence of stored items and interest on capital tied up in stocks. Such costs are roughly proportional to the value of the stock held, and to contain such costs, stock levels need to be kept low;
- order costs: costs for ordering and delivering goods for stock such as communicating with suppliers or the firm's own production department, accounting transactions, transport and unloading and inspecting goods. Many of these ordering and delivery costs will remain the same irrespective of the size of the order. Since many order and delivery costs are fixed costs, in order to reduce these costs the firm should place large orders at infrequent intervals, and such a policy would have the additional benefit of allowing the firm to earn price discounts for BULK BUYING. However if orders are placed at in frequent intervals then stocks, and thus stockholding costs, will be high. It is desirable to strike a balance between these two groups of costs so as to achieve the minimum stock cost, as in Fig. 81 which shows the optimum order quantity or economic order quantity which serves to minimize total stock cost. Order and delivery costs decrease as larger and less frequent deliveries are made; however, larger deliveries at less frequent intervals involve holding a larger average stock and thus entail higher carrying costs. The optimum order quantity OB corresponds to the minimum point on the total stock-cost curve. See BATCH SIZE.
Collins Dictionary of Business, 3rd ed. © 2002, 2005 C Pass, B Lowes, A Pendleton, L Chadwick, D O’Reilly and M Afferson