Question

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Q: Answer both questions below about the EOQ model.

(a) In the EOQ model, unit product cost or selling price, C, is not included in the formula we use to solve for the economic order quantity. Explain why it is not necessary to include this information in the EOQ formula.

(b) What are the major limitations of the EOQ model?

A:

A). In the EOQ model, C is not included because unit product cost and/or selling price is assumed to be constant. With this assumption of course, trade discounts and other discounts are not accounted for.

B). The limitations of this model are that it does not account for trade discounts, fluctuations in demand, and any external factor that is not reasonably predictable such as competitors, substitutes, etc.

Answer 1

A) EOQ formula derives the minimum point of the total cost function.

Assuming C = unit product cost/selling price

D = annual demand

Q= order quantity

Q^*= optimal order quantity

k = setup cost, h = annual holding cost per unit

Total cost = purchase cost + setup cost + holding cost

= C*D + D*K/Q + h*Q/2

Derivativing total cost with respect to Q and setting the result equal to zero (other variables to be constant) to get the optimal order quantity which minimizes total cost,

  

-D*K/Q² + h/2 = 0

Solving for Q, which gives optimal order quantity Q^*

Q^* =

Thus, optimal order quantity in EOQ model is independent of unit product cost/selling price. It is a function of only setup cost, annual demand and holding cost.

B) Major limitations of the EOQ model are the model assumes demand is always constant and is replenished immediately without any lead time. Seasonal or economic fluctuations are not considered when estimating the demand. Also in real world scenerio, ordered quantity cannot be replenished immediately due to various reasons such as production stops, shipping obstructions. Also, EOQ model takes into account only one product into one order. Combining multiple product into same order is not allowed.