While managing the inventory, three major cost are to be considered:
Material cost: purchase price or production cost of the material
Ordering cost: Cost is associated with placing the order for items each time you purchase the item. Costs of tender placement and order preparation are two examples of ordering cost.
Carrying cost: Cost associated with the carrying or storing of the purchased items for a certain period. It comprises of cost of insurance against stock, security of stock, warehouse rent, interest on capital engaged, spoilage, breakage, etc. Purchases in bulk quantity lead to higher carrying costs, like warehouse rent, stock insurance, and interest on capital invested in stock.
Material cost is calculated as cost per unit “p” multiplied by annual demand “D”. Ordering Cost (OC) is calculated as number of orders per period multiplied by cost per order “S” or annual demand “D” divided by the order quantity “Q” multiplied by cost per order. The Carrying Cost (CC) is calculated as carrying cost per unit per period “C”, multiplied by average inventory. Average inventory is given by order quantity divided by two.
The total inventory cost is given as follows:
Total Inventory cost = total (Material + Ordering + Carrying) cost
Total inventory cost = pD + (D/Q)S + (Q/2)C
Where, Q = lot size.
As seen from equation as the lot size increases the ordering cost is reduced since lesser orders are placed and vice versa. Conversely, if the lot size increases the carrying cost increases since number of units to be hold is increased.
Thus, to reduce the total inventory cost, the manager has to make tradeoff between ordering cost and carrying cost. EOQ technique helps to simplify the problem of quantity to be ordered and time of order by suggesting the most economic order quantity (Q*) of an item, while minimizing the total inventory cost.