Key Concepts: Week 5 Lesson 3:

Economic Order Quantity (EOQ) Extensions

Learning Objectives
Understand impact of a non-zero deterministic lead time on EOQ
Understand how to determine the EOQ with different volume discounting schemes
Understand how to determine the Economic Production Quantity (EPQ) when the inventory
becomes available at a certain rate of time instead of all at once.

Lesson Summary:

The Economic Order Quantity can be extended to cover many different situations. We covered three
extensions: lead-time, volume discounts, and finite replenishment or EPQ.

We developed the EOQ previously assuming the rather restrictive (and ridiculous) assumption that lead-
time was zero. That is, instantaneous replenishment like on Star Trek. However, we show in the lesson
that including a non-zero lead time, while increasing the total cost due to having pipeline inventory, will
NOT change the calculation of the optimal order quantity, Q*. In other words, lead-time is not relevant
to the determination of the needed cycle stock.

Volume discounts are more complicated. Including them makes the purchasing costs relevant since they
now impact the order size. We discussed three types of discounts: All-Units (where the discount applies
to all items purchased if the total amount exceeds the break point quantity), Incremental (where the
discount only applies to the quantity purchased that exceeds the breakpoint quantity), and One-Time
(where a one-time only discount is offered and you need to determine the optimal quantity to procure
as an advance buy). Discounts are exceptionally common in practice as they are used to incentivize
buyers to purchase more or to order in convenient quantities (full pallet, full truckload, etc.).

Finite Replenishment is very similar to the EOQ model, except that the product is available at a certain
production rate rather than all at once. In the lesson we show that this tends to reduce the average
inventory on hand (since some of each order is manufactured once the order is received) and therefore
increases the optimal order quantity.

Key Concepts:

Leadtime is greater than 0 (order not received instantaneously)

o Inventory Policy

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 o Order Q* units when IP=DL
o Order QI unties every T* time periods
Discounts
o All Units DiscountDiscount applies to all units purchased if total amount exceeds the break
point quantity
o Incremental DiscountDiscount applies only to the quantity purchased that exceeds the
break point quantity
o On Time Only DiscountA one time only discount applies to all units you order right now
(no quantity minimum or limit)
Finite Replenishment
o Inventory becomes available at a rate of P units/time rather than all at one time
o If Production rate approach infinity, model converges to EOQ

Notation:

c: Purchase cost ($/unit)

ci: Discounted purchase price for discount range i ($/unit)
e
c i: Effective purchase cost for discount range i ($/unit) [for incremental discounts]
ct: Ordering Costs ($/order)
ce: Excess holding Costs ($/unit/time); Equal to ch
cs: Shortage costs ($/unit)
cg: One Time Good Deal Purchase Price ($/unit)
Fi: Fixed Costs Associated with Units Ordered below Incremental Discount Breakpoint i
D: Demand (units/time)
DA: Actual Demand (units/time)
DF: Forecasted Demand (untis/time)
h: Carrying or holding cost ($/inventory $/time)
L: Order Leadtime
Q: Replenishment Order Quantity (units/order)
Q*: Optimal Order Quantity under EOQ (units/order)
Qi: Breakpoint for quantity discount for discount i (units per order)
Qg: One Time Good Deal Order Quantity
P: Production (units/time)
T: Order Cycle Time (time/order)
T*: Optimal Time between Replenishments (time/order)
N: Orders per Time or 1/T (order/time)
TRC(Q): Total Relevant Cost ($/time)
TC(Q): Total Cost ($/time)

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Formulas:
Average Pipeline Inventory
The amount of inventory, on average, is the annual demand times the lead time. Essentially, every item
spends L time periods in transit.

Total Cost including Pipeline Inventory

The TC equation changes slightly if we assume a non-zero leadtime and include the pipeline inventory.

= + ! + ! + + ! [ ]
2

Note that as before, though, the purchase cost, shortage costs, and now pipeline inventory is not
relevant to determining the optimal order quantity, Q*:

2!
=
!

Discounts
If we include volume discounts, than the purchasing cost becomes relevant to our decision of order
quantity.

All Units Discounts

The procedure for a single range All Units quantity discount (where new price is c1 if ordering at least Q1
units) is as follows:

1. Calculate Q*C0 , the EOQ using the base (non-discounted) price, and Q*C1 , the EOQ using the
first discounted price
2. If Q*C1 Q1, the breakpoint for the first all units discount, then order Q*C1 since it satisfies the
condition of the discount. Otherwise, go to step 3.
3. Compare the TRC(Q*C0), the total relevant cost with the base (non-discounted) price, with
TRC(Q1), the total relevant cost using the discounted price (c1) at the breakpoint for the
discount. If TRC(Q*C0)< TRC(Q1), select Q*C0, other wise order Q1.

Note that if there are more discount levels, you need to check this for each one.

= ! 0 ! = ! !

= ! + ! + ! 0 !
2

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= ! + ! + ! !
2

Incremental Discounts
The procedure for a multi-range Incremental quantity discount (where if ordering at least Q1 units, the
new price for the Q-Q1 units is new price is c1) is as follows:

1. Calculate the Fixed cost per breakpoint, Fi ,

2. Calculate the Q*i for each discount range i (to include the Fi)
3. Calculate the TRC for all discount ranges where the Qi-1 < Q*i < Qi+1 , that is, if it is in range.
4. Select the discount that provides the lowest TRC.

The effective cost, cei, can be used for the TRC calculations.

! = 0 ; ! = !!! + (!!! ! )!

2(! + ! )
=
!

!
!! = ! +
!

One Time Discount

This is a less common discount but it does happen. Simply calculate the Q*g and that is your order
quantity. If Q*g =Q* then the discount does not make sense. If you find that Q*g < Q*, you made a
mathematical mistake check your work!

! !
= + = 2! +

= !"

! ! ! !
= 2! + ! ! + ! + !
2

+ ( ! )
! =
!

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Finite Replenishment or Economic Production Quantity
One can think of the EPQ equations as generalized forms where the EOQ is a special case where
P=infinity. As the production rate decreases, the optimal quantity to be ordered increases. However,
note that if P<D, this means the rate of production is slower than the rate of demand and that you will
never have enough inventory to satisfy demand.

! 1
= +
2

2!
= =

1 1

Additional References:
There are more books that cover the basics of inventory management than there are grains of sand on
the beach! Inventory management is also usually covered in Operations Management and Industrial
Engineering texts as well. A word of warning, though. Every textbook uses different notation for the
same concepts. Get used to it. Always be sure to understand what the nomenclature means so that you
do not get confused.

I will make references to our core texts we are using in this course but will add some additional texts as
they fit the topics. Inventory is introduced in Nahmias Chpt 4 and Silver, Pyke & Peterson Chpt 5, and
Ballou Chpt 9.

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