Don’t Be Fooled Using EOQ

If you’re using EOQ to manage your ordering and inventory, STOP! Economic Order Quantity was never intended to be used in MRO Storeroom systems. 

In theory, Economic order quantity (EOQ) is the ideal quantity of units a company should order to meet demand while minimizing inventory costs such as storage and ordering costs. This production-scheduling model was developed in 1913 by Ford W. Harris while working at Westinghouse. The method was created with the clear objective of ordering production goods that are periodically held in the warehouse and defining the quantity and date on which orders must be placed with suppliers.

Although this system is commonly used to structure the purchase of raw materials, it can be applicable to optimizing the purchase of any product required by the company provided costs can be determined in terms of item cost, ordering cost, known usage rate, and carry costs.

The following basic conditions must be known, otherwise the calculations cannot be made accurately:

• It’s based on the items known usage and without major fluctuations during the year. So, usage rate in consistent throughout the year
• The unit cost of the item must be fixed throughout the year
• The cost to place to order
• Carrying costs are also known and dependent on the level of stock
• The supplier’s lead-times are constant and known

So why is EOQ not recommended to be used for MRO material ordering?  Let’s look at the 4 main calculations used to determine the optimal order quantity.

1.  Known Usage: Outside of the items used for any Preventive Maintenance (PM) replacement schedule, what other spare parts have a yearly “known usage” rate? Without this, we may be ordering too many or too few. Either way we’re either carrying too much inventory or not enough resulting in ordering more often.

2.  Item Cost: According to the formula, the unit cost must be locked in for a year. With today’s supply and everyone trying to “lean” out the supply logistics chain, the cost of item can fluctuate every time the item is ordered. Inflation is also another consideration. The price you paid in January may not be the price you pay in October.

3. Ordering Cost: How much does it cost an organization to place an order for an item? Back in my day, we had to research the part, contact the supplier to check inventory, fax over an RFQ, get the pricing and availability, cut a PO, fax back the PO, and confirm the order. Now, it's click, click, add to cart. How much is that costing??

4.  Carry Costs: Has anyone ever calculated the true cost of carrying inventory? What’s carrying cost? It’s the amount that a business spends on holding inventory over a period. It’s the costs involved in owning, storing, and keeping the items in inventory. Carrying costs include warehouse expenses (i.e. utilities, office supplies, software/hardware), taxes, insurance, employees’ salaries, loss/shrinkage, spoilage, depreciation, obsolescence and opportunity costs (interest rates).

Now, let’s throw in lead-times! Regardless of where I am in the world, I hear the same two things (1) lack of skilled resources and (2) supplier lead-times. As mentioned above, everyone is trying to lean out inventory.  Inventory ties up cash flow and therefore it is very expensive for organizations upstream or downstream to hold inventory.  It’s all about inventory turns.  Like a waitress in a restaurant, how many times can a table turn so they can make more money on tips? I’ve witnessed organizations add buffer or safety stock to inventory as a “just-in-case” or CYA as an option. I’ll never agree to adding more inventory without first understanding the issues whether it’s supplier or uncertainty in supply issues.

So, how can we manage MRO Spare Parts without using EOQ? Here are some suggestions:

• Determine accurate min/max levels.  These are determined by the average consumption rate. Min levels are established by knowing the average consumption rate during the lead-time period. That’s the point of reordering. Max levels can be determined by a number of factors such as minimum order quantities from suppliers, or cases, lbs, gallons, etc.
• ·Supplier agreements. Understanding that your supplier is in the business to make money is a start.  Never try to nickel and dime your suppliers. That will only go so far before they come back to tell you to go pound sand. Look into vendor managed inventory (VMI) or consignment programs. I strongly recommend MRO vending machines. Stocking programs as an alternative, blanket PO’s or strategic procurement where volume discounts are offered or check into buying groups for the most common MRO items that other organizations are purchasing from to leverage your buying power.

 As you can see, EOQ was never intended to be used for MRO Spare Parts ordering.  In fact, you can actually do more harm than good using it. There are a multitude of options for organizations to optimize their inventories without using EOQ.