Economic Lot Size and Flow Trade-offs

Why it matters

The economic lot size calculation balances, over the same annual period, the cost of ordering frequently against the holding cost of a large lot. A smaller lot creates less average cycle stock, but more frequent orders are needed to meet the same demand. A large lot reduces ordering frequency while keeping the material in the warehouse for longer. The economic order quantity found under these opposing effects is a starting point with explicit assumptions. It does not by itself give the best solution for the whole flow. If the material's shelf life, the line's setup capacity or the storage space is insufficient, the quantity found cannot be applied even if the calculation is correct.

In the basic model, demand is known and occurs at a constant rate, replenishment arrives in one delivery, no shortage occurs and there is a fixed cost per order. The unit purchase price does not change with the lot. The holding cost is defined per unit per year; capital tied up, space and other relevant effects are assessed within the same scope. Under these assumptions, the average of cycle stock decreasing in a sawtooth shape is half the lot. If in reality production is completed gradually or deliveries are split into parts, the same average is not used directly. When the shape of the model changes, it is not enough to renew the numbers in the formula; how the flow takes place is redefined.

The ordering cost is not the purchase amount of the material. It represents the cost per order related to opening, preparing and receiving the order. In a production lot, the setup cost can play a similar role; but whether setup time consumes bottleneck capacity must be examined separately. The holding cost is not just warehouse rent either. The items taken into the calculation must be explicit, and the same effect must not be added to both the ordering cost and the holding cost without explanation. All costs are compared over the same currency and the same period. Using a monthly holding cost directly with annual demand makes the economic lot look different from what it is. Also separate the calculated cost reduction from the reduction in cash outflow that would occur immediately. When ordering work decreases, the time of the existing team can be assigned to other work; this does not mean in every case that payments will decrease by the same amount. Similarly, freeing up space produces an economic result only under conditions of reuse or cost reduction. Set the cost definition in the model consistently with the purpose of the decision and check the realized benefit afterwards with the same definition.

From the flow point of view, a large lot has other consequences: average stock rises, problems may be seen later and responding to a product change becomes harder. A small lot, on the other hand, can increase setup frequency and the handling load. These effects may not appear fully in the basic cost formula. Two feasible options are therefore compared not only on the calculated total but also on capacity and delivery conditions. If a smaller lot is to be chosen, the additional annual cost is written visibly; the stock and flow effect in return is explained. Reducing the setup cost or the lead time can make a smaller lot possible at the same service. The decision thus turns toward improving the causes instead of covering the problem with a large lot.

Formula