Management Notes

Reference Notes for Management

The primary purpose of the basic economic order quantity model shown below is

The primary purpose of the basic economic order quantity model shown below is

 Options:

A. to calculate the reorder point, so that replenishments take place at the proper time
B. to minimize the sum of carrying cost and holding cost
C. to maximize the customer service level
D. to minimize the sum of setup cost and holding cost
E. to calculate the optimum safety stock

The Correct Answer Is:

D. to minimize the sum of setup cost and holding cost

Correct Answer Explanation:

The Economic Order Quantity (EOQ) model plays a crucial role in inventory management, aiming to strike a balance between ordering and holding costs to optimize inventory levels. The correct answer, D, emphasizes the minimization of the sum of setup cost and holding cost, which aligns with the fundamental objective of the EOQ model.

Here’s an in-depth explanation:

D. to minimize the sum of setup cost and holding cost:

The EOQ model aims to find the ideal order quantity that minimizes the total cost incurred by a business. This includes the setup cost associated with placing an order (ordering cost) and the holding cost of maintaining inventory.

The setup cost involves expenses like order processing, paperwork, and preparation necessary to initiate a purchase. It’s incurred each time an order is placed, and minimizing this cost is crucial to efficiency.

Simultaneously, holding or carrying costs refer to expenses related to storing inventory, such as warehousing, insurance, obsolescence, and opportunity cost of tying up capital in inventory. By finding the optimal order quantity, the EOQ model minimizes the sum of these two costs.

The formula for EOQ considers these expenses to determine the most cost-effective quantity to order at any given time, striking a balance between setup and holding costs.

Why the other answers are not correct:

A. To calculate the reorder point, so that replenishments take place at the proper time:

The reorder point is the inventory level at which a new order needs to be placed to avoid stockouts during lead time. While EOQ indirectly influences the reorder point by optimizing order quantities, its primary focus is not specifically to calculate this point.

The EOQ model centers on minimizing costs by determining the most economical order quantity to balance setup and holding costs rather than precisely calculating when to reorder.

B. To minimize the sum of carrying cost and holding cost:

Carrying cost and holding cost essentially refer to the same expense costs associated with holding inventory. EOQ aims to minimize the sum of setup cost and holding cost instead of carrying cost.

Carrying cost typically includes expenses like storage, insurance, obsolescence, and capital costs. While EOQ considers holding costs, it doesn’t directly focus on minimizing carrying costs.

C. To maximize the customer service level:

The EOQ model is primarily concerned with cost efficiency in inventory management. While maintaining optimal inventory levels through EOQ can indirectly enhance customer service by ensuring products are available when needed, maximizing customer service isn’t its core objective.

EOQ’s focus is more on minimizing costs associated with ordering and holding inventory rather than maximizing service levels.

E. To calculate the optimum safety stock:

Safety stock is additional inventory held as a buffer against unexpected demand or supply chain disruptions. While EOQ indirectly influences safety stock levels by optimizing order quantities, its primary objective isn’t specifically to calculate safety stock.

EOQ is more concerned with minimizing costs by finding the optimal order quantity rather than directly determining safety stock levels.

In essence, while EOQ impacts and interacts with these elements reorder points, carrying costs, customer service levels, and safety stock its core purpose remains centered on minimizing costs associated with ordering and holding inventory.

By determining the most economical order quantity, it aims to strike a balance between setup costs incurred with each order and the holding costs associated with maintaining inventory.

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