Eye on Inventory: Moving Beyond Economic Order Quantity

11/12/2024

Maintenance and engineering managers using economic order quantity (EOQ) to manage their departments’ ordering and inventory should stop. EOQ was never intended to be used in spare parts storerooms. 

I’ve witnessed a parts room filled with materials that have not been issued or used for years. Based on consulting, assessments and interviews with close to 250 organizations, I estimate that 58 percent of the items in a typical storeroom have not been issued in over three years. Of the remaining 42 percent of active inventory, 60 percent is overstocked. 

These figures mean many managers have rooms full of potentially obsolete items that are tying up cash. I worked with a large university a couple years ago that was carrying over $1 million in toilet paper in stock. 

Why is this happening? In theory, EOQ is the ideal quantity of units a manager should order to meet demand while minimizing inventory costs, such as storage and ordering. This production-scheduling model was developed in 1913 by Ford W. Harris while working at Westinghouse. The clear objective is to enable the ordering of goods that are periodically held in the warehouse and to define the quantity and date on which orders must be placed with suppliers. 

Although this system is commonly used to structure the purchase of raw materials, it is applicable to optimizing the purchase of any product required by an organization, provided purchasing costs can be determined in terms of item cost, ordering cost, known usage rate and carrying costs. 

Managers need to know the following basic conditions, or they cannot make accurate calculations: 

• The item’s known usage rate stays consistent during the year. 
• The unit cost of the item must be fixed throughout the year. 
• Carrying costs are known and depend on the level of stock. 
• The supplier’s lead times are constant and known. 

Inventory costs: A closer look 

Why do I recommend that managers not use EOQ for ordering maintenance, repair and operations (MRO) materials? Let’s look at the three main calculations used to determine optimal order and holding costs: 

Known usage. Outside of the items used for any preventive maintenance (PM) replacement schedule, what other spare parts have a yearly known usage rate? Without this figure, managers might order too many or too few products. Either way, managers are either carrying too much inventory or not enough and, as a result, ordering more often. 

Item costs. According to the formula, the unit cost must be locked in for a year. With everyone trying to “lean out” the supply logistics chain, the item cost can fluctuate every time the item is ordered. Inflation is also another consideration. A product’s price in January might not be its price in October. 

Carry costs. Has anyone ever calculated the true cost of carrying inventory? The carry cost is the amount a business spends on holding inventory over a period. It is the costs involved in owning, storing and keeping items in inventory. These costs include warehouse expenses — utilities, office supplies, software and hardware— taxes, insurance, employees’ salaries, loss and shrinkage, spoilage, depreciation, obsolescence and opportunity costs — interest rates. 

Now consider lead times. Regardless of where I go in the world, I hear the same two complaints about the lack of skilled technicians and supplier lead times. As mentioned above, everyone is trying to lean out inventory because inventory ties up cash flow. Therefore, it is very expensive for organizations upstream or downstream to hold inventory. 

It’s all about inventory turns. Like a server in a restaurant, how many times can a table turn so they can make more money on tips? I’ve witnessed organizations add buffer or safety stock to inventory as a just-in-case tactic. I’ll never agree to adding more inventory without first understanding the issues. 

Understanding EOQ 

Below are several scenarios that demonstrate the reasons that the numbers used to calculate EOQ are critical. Let’s say there is an annual demand for 100 widgets. The EOQ ordering would fluctuate based on the following: 

• Scenario 1: The cost to place an order is $50 with 25 percent carry cost, which equals EOQ ordering 200 items. This means carrying two years’ worth of inventory. 
• Scenario 2: The cost to place an order is $25 with 25 percent carry cost, which equals EOQ ordering 140 items. This means carrying roughly four months of inventory. 
• Scenario 3: The cost to place an order is $5 with 25 percent carry cost, which equals EOQ ordering 60 items. Ordering twice a year means carrying two-plus months of inventory. 

As you can see, the numbers and percentages used can cause significant harm to the cash flow, lead to bloated inventories and even cause managers to order too many times. 

Some operations carry overstocked mobile equipment PM items, such as oil, filters, belts and lights. But why? Typical mobile equipment PMs are based on hours of operation or mileage, and managers can generally predict when the PMs are due. Why not have the supplier kit the items required for that 200-hour or 10,000-mile PM? 

Why does EOQ remain popular? Some managers like to have excess inventory as a just-in-case scenario, or they want to carry minimal inventory to keep the cash. Some organizations use EOQ to determine the lowest acquisition cost to carry the inventory. But as I said, they could be causing more harm than good by tying up cash in excess inventory. 

The best-performing facility storerooms ensure front-line technicians have the right parts at the right time while holding the right inventory levels. Managers do not need to carry $1 million worth of toilet paper in stock if they can easily have it delivered within a day or two. 

Beyond EOQ 

How can we managers control MRO spare parts without using EOQ? Here are my suggestions: 

Accurate min/max levels. These are determined by the average consumption rate. Minimum levels are established by knowing the average consumption rate during the lead-time period. That is the point of reordering. Maximum levels can be determined by a number of factors, such as minimum order quantities from suppliers, or cases, pounds, gallons, etc. 

Blanket purchase orders. Managers looking for volume discounts and buying in bulk should consider placing a blanket purchase order (PO) for those items. This tactic allows managers to release items when required, managing cash flow while the supplier holds the inventory. Managers still can benefit from the volume discounts, and the supplier still will sell the product eventually, ensuring income cash flow for them. 

Supplier agreements. Understanding that a supplier is in the business to make money is a start. Managers should never try to nickel and dime suppliers. That will only go so far before they come back to tell you to go pound sand. Look into vendor managed inventory or consignment programs. I strongly recommend: MRO vending machines; stocking programs as an alternative; blanket POs or strategic procurement where volume discounts are offered; or buying groups for the most common MRO items that other organizations are purchasing from in order to leverage buying power. 

EOQ was never intended to be used for spare parts ordering. In fact, the practice actually can cause more issues than it solves. Managers have a range of options to help them optimize their inventories without using EOQ. 

Andrew Gager is CEO of AMG International Consulting. He is a professional consultant and facilitator with more than 20 years of partnering with organizations to achieve strategic objectives and goals.