Feb 23 2015
The “Plan for Every Food” in my household involves different policies for buying coffee beans and fresh raspberries. These simple examples show that thinking in terms of Economic Order Quantity (EOQ) isn’t always wrong, and Just-In-Time (JIT) isn’t always right. You need to set appropriate policies for screws, steel bars, engines, microchips, and all other items you may need, and review these policies periodically as circumstances change.
As a family of heavy coffee drinkers, we go through a 5-lb bag of beans every month, which I order on line directly from our favorite grower in Kona, HI. Just based on shipping costs, the following table shows that, the more bags I buy at once, the less I pay per pound:
|Number of Bags||Price/bag||Shipping||Total Cost||Cost/lb|
Kept in the freezer, the beans do not deteriorate in three months, and unused space in the freezer is available. The only holding cost is therefore the return that alternative uses of the money tied up in coffee inventory would have brought. I have, on the average, half an order on hand in the freezer, or about $80. If my investments yield an average of 8%/year, buying 3 bags at a time makes me forego $80×8%/year=$6.4/year, for 12×5=60 lbs, or $0.11/lb. This brings my cost/lb to $10.91, which is still 6% cheaper by the pound than if I order it one bag at a time. Economic Order Quantity (EOQ) thinking is that, as you increase the number of bags per order, you reach a point where the increase in inventory holding cost exceeds what you save in shipping costs. It is applicable here.
Fresh raspberries, on the other hand, spoil in 24 hours at room temperature. And you don’t want to refrigerate them because it alters their taste. In other words the inventory holding cost of raspberries reaches 100% of the price in 24 hours, when you throw them away. The cheapest way to enjoy raspberries is to buy them just before you eat them, in just the quantity you are going to eat, in other words, just-in-time (JIT). And there is no marginal cost of going to the store to buy the raspberries, because you don’t make a special trip for this purpose. It is just one more item on your shopping list.
For each item, you need to think whether it is more like coffee beans or fresh raspberries. You need to consider what each order actually costs you in terms of additional administration, shipping, and handling, and you need to account for all the components of inventory holding costs:
- The cost of capital of the money tied up in inventory.
- Storage, retrieval and in-house transportation.
- Quality losses due to delays in detecting defects, handling damage, and deterioration in place.
- Obsolescence, due to engineering changes.
For coffee beans in my household, the only relevant component of inventory holding cost is the cost of capital; for raspberries, it’s quality. For items in your manufacturing warehouse, you need to consider all factors, and you need to change them as the numbers evolve while you and your suppliers improve operations.