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Chapter 12 Inventory planning and control 355
could prove far more costly. Similarly with stock-holding costs – although many companies
make a standard percentage charge on the purchase price of stock items, this might not be
appropriate over a wide range of stock-holding levels. The marginal costs of increasing stockholding
levels might be merely the cost of the working capital involved. On the other hand,
it might necessitate the construction or lease of a whole new stock-holding facility such as a
warehouse. Operations managers using an EOQ-type approach must check that the decisions
implied by the use of the formulae do not exceed the boundaries within which the cost
assumptions apply. In Chapter 15 we explore the just-in-time approach which sees inventory
as being largely negative. However, it is useful at this stage to examine the effect on an EOQ
approach of regarding inventory as being more costly than previously believed. Increasing
the slope of the holding cost line increases the level of total costs of any order quantity, but
more significantly, shifts the minimum cost point substantially to the left, in favour of a lower
economic order quantity. In other words, the less willing an operation is to hold stock on the
grounds of cost, the more it should move towards smaller, more frequent ordering.
Using EOQ models as prescriptions
Perhaps the most fundamental criticism of the EOQ approach again comes from the
Japanese-inspired ‘lean’ and JIT philosophies. The EOQ tries to optimize order decisions.
Implicitly the costs involved are taken as fixed, in the sense that the task of operations
managers is to find out what are the true costs rather than to change them in any way. EOQ
is essentially a reactive approach. Some critics would argue that it fails to ask the right
question. Rather than asking the EOQ question of ‘What is the optimum order quantity?’,
operations managers should really be asking, ‘How can I change the operation in some way
so as to reduce the overall level of inventory I need to hold?’ The EOQ approach may be a
reasonable description of stock-holding costs but should not necessarily be taken as a strict
prescription over what decisions to take. For example, many organizations have made considerable
efforts to reduce the effective cost of placing an order. Often they have done this
by working to reduce changeover times on machines. This means that less time is taken
changing over from one product to the other, and therefore less operating capacity is lost,
which in turn reduces the cost of the changeover. Under these circumstances, the order
cost curve in the EOQ formula reduces and, in turn, reduces the effective economic order
quantity. Figure 12.9 shows the EOQ formula represented graphically with increased holding
costs (see the previous discussion) and reduced order costs. The net effect of this is to
significantly reduce the value of the EOQ.
Should the cost of inventory be minimized?
Many organizations (such as supermarkets and wholesalers) make most of their revenue
and profits simply by holding and supplying inventory. Because their main investment is
in the inventory it is critical that they make a good return on this capital, by ensuring that
it has the highest possible ‘stock turn’ (defined later in this chapter) and/or gross profit
margin. Alternatively, they may also be concerned to maximize the use of space by seeking
to maximize the profit earned per square metre. The EOQ model does not address these
objectives. Similarly for products that deteriorate or go out of fashion, the EOQ model can
result in excess inventory of slower-moving items. In fact, the EOQ model is rarely used in
such organizations, and there is more likely to be a system of periodic review (described later)
for regular ordering of replenishment inventory. For example, a typical builders’ supply
merchant might carry around 50,000 different items of stock (SKUs – stock-keeping units).
However, most of these cluster into larger families of items such as paints, sanitaryware or
metal fixings. Single orders are placed at regular intervals for all the required replenishments
in the supplier’s range, and these are then delivered together at one time. For example,
if such deliveries were made weekly, then on average, the individual item order quantities
will be for only one week’s usage. Less popular items, or ones with erratic demand patterns,
can be individually ordered at the same time, or (when urgent) can be delivered the next
day by carrier.