How to approach it
- Convert sales into material demand, grossing up for yield or normal loss.
- Ordering cost per order: only costs that vary with the number of orders (procurement processing, fixed charge per delivery).
- Holding cost per unit per year: costs that vary with stock held (financing on purchase price, storage charged per unit per period).
- Leave out fixed monthly charges and per-kg transport (they don't change with order size) and safety stock (it doesn't affect EOQ).
- EOQ = √(2 × annual demand × ordering cost ÷ holding cost per unit).
Key rules to apply
- EOQ balances ordering cost against holding cost; only incremental costs belong in each.
- Safety stock raises average inventory and holding cost but does not change EOQ.
Common mistakes
Drawn from the examiners' comments for this sitting (summarised in our words) and from typical errors on this topic.
- Not grossing up demand for yield (examiners' point).
- Putting per-kg transport in ordering cost, or leaving the per-consignment delivery charge out.
- Including the fixed monthly storage charge in holding cost.
Similar question with worked solution
Written by us with our own numbers; it tests the same skills as Q2 without copying it.
Original practice question
EOQ with yield and mixed costs
Budgeted output is 270,000 kg and each kg of material yields 0.9 kg of output. Material costs Rs 200/kg plus Rs 8/kg transport. Finance cost is 12% a year on the purchase price. Warehouse charges are Rs 0.50/kg per month plus a flat Rs 20,000 a month. Each order costs Rs 6,000 to process and each delivery has a fixed charge of Rs 9,000. Safety stock is 10,000 kg.
Required: Calculate the EOQ.
Worked solution
| Working | Value |
|---|---|
| Annual demand: 270,000 ÷ 0.9 | 300,000 kg |
| Ordering cost: 6,000 + 9,000 | Rs 15,000 per order |
| Holding cost: 12% × 200 + 0.50 × 12 | Rs 30 per kg per year |
| EOQ: √(2 × 300,000 × 15,000 ÷ 30) | 17,321 kg |
Excluded: transport per kg, the flat Rs 20,000 monthly charge and safety stock.
Answer: EOQ ≈ 17,321 kg.