EOQ
A planning tool used with some MRP systems is the Economic Order Quantity (EOQ).
By Sav Pota
LEAD Associate
Lean Advisors Inc.
Lean and the Economic Order Quantity
You've got your set-up time reduction team in place, they've reduced machine down time by at least 75%. Your Kaizen program has been effective you managed to reduce costs on a majority of your products. The banks are not a problem; interest rates are at an all time low. Everything looks good but your MRP/ERP system is still telling you that your lot sizes need to be the same or even larger in some cases. If you keep following your system you'll need to sub-let some warehouse space. If you don't follow the system your expediters will be on your back and throw a wrench into everything you have accomplished with Lean.
If you are like most large organizations you probably have invested heavily in an MRP system. If you are even larger you invested, or looking to invest, in that modern day panacea to solve all of your system woes, the ERP system. In either case an MRP module is most likely part of your overall planning system. As you travel along your lean journey you may begin to question the necessity of an MRP system. With a purely visual system in place and one piece flow you can respond accordingly. Most of us are still working with legacy systems, in some cases out of necessity.
What we need to do is ensure that the planning process we are using supports our lean accomplishments. A planning tool used with some MRP systems is the Economic Order Quantity (EOQ). Anyone studying economics, business or industrial engineering has come across the EOQ. The EOQ attempts to minimize your overall product cost by determining the optimum amount of inventory that you should carry in consideration of your set-up or order costs, demand rate and your holding costs. Most planning systems may use some form of an EOQ to determine lot sizes, which are driven by the inputs that you provide.
Remember that inventory includes all items in production from raw materials, to work in process, to sub-assemblies, to finished goods stored in warehouses. In some cases an EOQ is used in every step, therefore, creating inventory at every stage of production.
A typical EOQ formula looks like this. Q - Economic order quantity, how much we will make at each batch or order or store in our finished goods warehouse to minimize our total costs.
S - Set up costs, this may be the cost of delivery of raw material, changing a die in a press, setting up an assembly area, all costs that under normal accounting principals are not considered direct labour costs and in some cases rolled up into overhead costs.
P - Actual product cost required to produce an item, again this can be the unit cost of raw material, the direct labour and material costs, etc.
i - Bank rate. Used to calculate opportunity cost of inventory. Ex.: If our avg. inventory is $10k, at today's interest rates we could earn about 2.5% or $250 (2.5% of $10k). We are missing an opportunity to earn $250 from the bank for our $10k investment in inventory.
D- our demand rate for our product. The EOQ is based on the following assumptions:
i) The demand rate is constant, and
ii) Stock is replenished as soon as it is depleted
What becomes evident in looking at the EOQ is that your lot size is proportional to your set-up costs and demand rate, and inversely proportional to your product costs and bank rate.
As you travel along your lean journey and start making some progress, your MRP may be giving you some undesirable results. For example; if you reduced your product costs your EOQ goes up. If the bank rates are low, your lot size will go up. In both of these cases your inventory levels will go up which is contradictory to one of the expected benefits of Lean. With a lower interest rate you'd be able to borrow at a good rate to build a new warehouse for all of the excess inventory. You also have to ensure that your inventory holding costs are reflective of all the costs of inventory: Examples: Forklift driver and forklift to move all the material around, Planning department (controlling the inventory is part of the cost as well).
One good Lean tool is Single Minute Exchange of Dies (SMED). One of the objectives of SMED is to reduce set-up time. You may have realized a reduction by externalizing all or some of your set-up time but not necessarily reduced your set-up costs. Although you have improved your up-time, your EOQ will not support a reduction of inventory. As your demand rate goes up so does your EOQ, and hence your inventory. Because of these 2 accomplishments you have become responsive to customer demand you don't need the inventory.
Most companies are not going to scrap their MRP modules as they travel along their lean journey. It is imperative that you have a good understanding on what is driving your MRP system. If it is an EOQ, you will want to take a close look at some of the input parameters to ensure that it's not going to conflict with your accomplishments. So what's your EOQ? Just remember unlike your IQ a lower EOQ is what you want to have!