Question

The simple economic order quantity (EOQ) model shows how much to order (i.e., lot size) in terms of holding costs, setup (ordering) costs, and total inventory cost.  In terms of this model, why is it necessary to reduce setup cost if we desire smaller lot sizes? Draw the inventory cost curves diagram and fully explain.

Answer 1

Total inventory cost is the sum of two costs - holding cost, and ordering cost. If we order large quantitites, more units will have to be stored per cycle and total cost of holding the inventory will be high, while the ordering cost will be less due to lesser number of orders ( as order size is large). If order size is less, the inventory holding cost will be less but there will be more orders per unit time, and the ordering cost will be high. It is therefore worthwhile to find out a quantitiy at which the sum of two costs is minimum. This quantity is known as economic order quantity. It is clear, that the set up ( ordering ) cost need to be reduced if smaller lot sizes are to be used. It will help to reduce the total cost where the holding cost will be reduced due to smaller inventory and set up cost will be reduced owing to low cost per set up.