The Effect of Economic Order Quantity

How much should we optimize the batch size?

By Amir Weisenstern Based on Theory of Constraints, Dr. Eli Goldratt

What should be the batch size?

Our objective Earn more money to the company Naturally, we think we must reduce the cost per unit The batch size controls both inventory levels and their cost derivatives as well as the amount of setups and efficiency How should we calculate the optimal batch size?
o Should we enlarge batch size to save setup time o Should we reduce the batch size in order to save carrying costs?

Two cost-per-unit graphs

Cost per unit

Carrying cost curve: a larger batch means a longer time to hold inventory. The curve is linear

Setup cost curve: a larger batch means that setup is divided to more units. The curve is a/x Batch size

The unified cost-per-unit graph

Cost per unit

Cost-per-unit curve: Summation of carrying cost and setup cost curves

Optimal point

Batch size

From cost world to profit world a different view on the subject

Our real goal is: make more money. The meanings are:
1. Better profit per unit 2. Better ROI per unit

Assuming the sales price per unit is fixed: Cost per unit and profit per unit have a reverse (mirror) relationships
o o When cost increases When cost decreases profit decreases profit increases

Therefore the profit-per-unit graph is a mirror of the cost per unit graph

The Profit-per-unit graph

Profit per unit

Optimal point

Batch size

The optimal profit per unit is not that sensitive

The optimal point of profit per unit is in a flat area of the graph Therefore we can choose a non optimal point to the left or to the right of the optimal point and still have a very good profit per unit
Profit per unit

Non Optimal Optimal Non Optimal point: almost point point: almost as good as as good as the optimal the optimal

Batch size

Return of Investment (ROI) Investment is in correlation to batch size:

o Because when batch size increases we need to invest more money to keep inventory (raw material, work in process and finished goods) in the system

Therefore, we can replace X axis from batch size to inventory

o The scale may change but the graph remains the same due to the linear correlation between batch size and inventory

ROI and profit-per-unit

Better ROI is achieved in the left non optimal point in the flat area than to the right of it The right non optimal point may need to invest twice the money from the left non optimal point. Therefore achieving the ROI
Profit per unit

Good profit per unit , better ROI

Optimal Good profit point per unit point, worse ROI

Investment

Survival vs. bankruptcy scenario

Suppose we have cash available for investment somewhere in a point between the left non optimal and the right non optimal (could be to the left of the optimal point!) If we chose our batch size to the right of our cash point we will go bankrupt at the end of the day If we chose our batch size to the left of the cash point we survive and even flourish

Profit per unit

Good profit Available Good profit per unit point, cash per unit point, better ROI, worse ROI, survival bankruptcy

Investment

Summary
Many people tend to maximize cost-per-unit as a local objective. For that they use mathematic formulas to calculate optimal batch size. Cost-per-unit is not that sensitive around the optimal point Profit-per-unit is therefore not that sensitive around the optimal point Profit-per-unit can be close to optimum. Many times, even when cutting the current batch drastically A much better ROI is achieved with a much smaller batch A much smaller batch size means much less investment. There are cases that this is the difference between bankruptcy and survival People forget their real global objective which is: make more money