LGT5015 Chap.2 Inventory Policy and Economic Order Quantity
Inventory Policy and Economic Order Quantity
Stock types before formulas
Inventory supports routine replenishment, protects service against uncertainty and bridges time or distance. This chapter separates cycle stock from safety, transit, seasonal and speculative stock before calculating EOQ, average inventory and turnover.
It treats EOQ as a baseline with explicit assumptions and connects reorder timing to expected lead-time demand and protection stock.
Cycle stock answers how much
When stock falls evenly from an order quantity Q to zero, average cycle inventory is Q divided by two.
A larger Q reduces how often orders are placed, so annual ordering cost falls, but it increases the units held on average, so annual holding cost rises. EOQ finds the minimum of their sum. At the continuous optimum, the two cost arms are equal, which provides a powerful check on the arithmetic.
Safety stock answers uncertainty
Safety stock is not the unused remainder of an order.
It is deliberate protection against variation in demand or replenishment time at a chosen service level. Reorder policy combines expected demand during lead time with that protection. A persistent increase in expected lead time should change the expected-demand part; random variation changes the protection part.
Keeping those roles separate prevents a process delay from being hidden inside an arbitrary buffer.
Units carry the calculation
Annual demand D is measured in units per year, K in dollars per order and h in dollars per unit-year. When the source provides a carrying percentage, multiply it by unit cost before treating it as h.
Keep the square-root calculation unrounded until the final operational quantity, then verify that annual ordering and holding costs are close. A mismatch usually points to a unit error or premature rounding.
Policy continues after EOQ
EOQ rests on stable demand, constant lead time, instantaneous replenishment, identical units and no shortages.
Real policy may add safety stock, price breaks, constrained storage or uncertain supply. Average total inventory adds protection stock to half the cycle quantity, and turnover divides annual usage by that average. Interpret each number narrowly: EOQ sets a baseline quantity, the reorder point sets timing, safety stock protects service and turnover describes how intensively inventory is used.
What this chapter covers
- 01
Cycle and safety stock
- 02
Ordering and holding cost
- 03
Economic order quantity
- 04
Average inventory
- 05
Inventory turnover
- 06
Reorder point and service
Worked example · free
Calculate EOQ with a carrying rate
- 2Convert carrying rate to h.
- 3Substitute into EOQ.
- 3Check both cost arms.
Key terms
- Cycle Stock
- Inventory created by routine replenishment quantities.
- Safety Stock
- Additional inventory protecting service against uncertainty.
- Economic Order Quantity
- The quantity balancing annual ordering and holding cost.
- Inventory Turnover
- Annual sales or usage divided by average inventory.
- Reorder Point
- The inventory position that triggers replenishment.
Inventory Policy and Economic Order Quantity FAQ
What does EOQ decide?
EOQ decides how much to order under its assumptions. It does not independently decide when to order, how much safety stock to hold or whether quantity discounts and uncertain lead times change total cost. Use reorder logic for timing, a service-based uncertainty model for protection and complete feasible cost comparisons when the unit price changes.
Why should ordering and holding costs match?
At the continuous EOQ solution, annual ordering cost and cycle-stock holding cost are equal. Their near equality is a useful verification step and often exposes a wrong unit for h or an early rounding error. The check applies before operational rounding and policy extensions.
How does safety stock affect turnover?
Safety stock raises average inventory without increasing annual demand, so turnover falls. The policy may still be justified if the added protection supports the required service level under uncertainty. Compare the service gain with carrying cost and check that the buffer responds to genuine variation rather than a persistent process delay.
Exam move
Write D, K and h with units before using EOQ. Recompute until the two relevant annual costs agree, then add safety stock and interpret turnover separately. Build a four-line calculation routine: convert the carrying rate into dollars per unit-year, compute EOQ without early rounding, calculate annual ordering and holding cost, and explain the result.
On a separate line, write average inventory as half the cycle quantity plus safety stock. This separation prevents protection inventory from entering the EOQ balance incorrectly. Practise one example with a stable lead time and another in which expected lead-time demand changes. For every policy, label the stock type being changed and state the service effect.
Use a blank table to compare smaller Q, more safety stock, faster replenishment and centralisation across cost, turnover, availability and risk. End every numerical practice with the decision the number supports and the assumptions that limit it. If quantity discounts appear, compare complete feasible total costs instead of assuming the unconstrained EOQ automatically wins.
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