Economic Order Quantity vs. Just-in-time Inventory Models Bettina Bradshaw Susan Day Tameka S. Levy Accounting April 20, 2011 There are several models that have been developed to deal with the trade-off between ordering and carrying costs of inventory. The two that will be discussed is the Economic Order Quantity (EOQ) model and the Just-in-time (JIT) model. First, the history and definition of the theories will be discussed. Secondly, there will be a comparison of these two models presented.
Thirdly, organizations that employ the EOQ and JIT model will be discussed and an explanation will be given on how each organization benefited in their operations from using these particular models. The EOQ model is a mathematical model that minimizes the total of short-term ordering costs plus short-term carrying cost for the period. In addition, it specifies the size of order to place every time inventory is ordered (Ainsworth & Deines, 2011). The EOQ model was developed by F. W. Harris in 1913, but R. H.
Wilson, a consultant who applied it broadly, is given credit for his early thorough analysis of it (Hax, 1984). The JIT inventory model is a long-run model based on the principle that inventory should arrive just as needed for production in the quantities needed (Ainsworth & Deines, 2011). JIT is a Japanese management philosophy which has been applied in practice since the early 1970s in many Japanese manufacturing organizations. It was first developed and perfected within the Toyota manufacturing plants by Taiichi Ohno as a means of meeting consumer demands with minimum delays.
Taiichi Ohno is frequently referred to as the father of JIT (Monden, 1993). There are many differences between the EOQ and JIT model. The EOQ model reflects only short-term carrying and order costs. The EOQ model assumes that inventory ordering and inventory usage transpire in uniform cycles throughout the period. However, the JIT is a long-term model based on the principle that inventory should arrive just as needed for production in the quantities needed (Ainsworth & Deines, 2011). Furthermore, EOQ is a mathematical model that regulates the optimal order size.
JIT, on the other hand, is a visual or electronic model that uses a kanban system to determine the need for inventory. A kanban system is a pull system that uses cards to visually signal the need for inventory (Ainsworth & Deines, 2011). In this model, production is determined by customer demand and the need for raw materials is determined by production. The EOQ system considers batch-related ordering costs and unit-related carrying costs. JIT deliberates all levels of cost and focuses on reducing or eliminating nonvalue-added costs (Ainsworth & Deines, 2011).
Effective inventory management is essential in the operation of any business. The Economic Order Quantity (EOQ) model can be used by a restaurant to minimize the total ordering costs plus short-term carrying costs. The EOQ model is based on certain assumptions: (Ainsworth & Deines, 2011) * Demand is essentially uniform throughout the year * Lead time is constant * The entire order is received at the same time * No quantity discounts – assumes inventory costs are the same regardless of the size of order * Inventory size is not limited – orders of any size are possible * Storage costs are irrelevant
The above graph illustrates the variation of the inventory level over time for the classic EOQ model. The downward sloping curve shows inventory level is being reduced at a constant rate over consumption time. Inventory level is shown as Q when a new order is received. The inventory is gradually depleted until it reaches zero just as the new order is received. The average inventory (Q/2) is equal to 1/2 within the same period. The object of effective inventory control is to purchase materials in the amount that will prevent an interruption in supplies at the least costs.
Once the size of order is determined, next you must determine the reorder point or the inventory level that indicates it is time for additional inventory. In order to do this, you must determine the daily demand and lead time. Daily lead time is calculated by dividing the annual inventory demand by the number of business days. The reorder point is figured by multiplying the daily demand by the lead time, which is the number of days from when the order is placed until it is delivered. (Ainsworth & Deines, 2011) My nephew’s fish restaurant uses 1569 cases of fish a year. Deliveries are made with a two day lead time.
The restaurant operates 363 days a year. We will estimate the ordering cost is $5 per order and the carrying cost is $10 per case in inventory per year. Q = v (2 x 1569 x $5)/10 = 40 cases 1569/363 = 4. 3 cases – Daily demand 4. 3 x 2 = 8. 6 cases – Reorder point This equation shows he should order 40 cases each time he places an order. He should place another order when inventory reaches 8. 6 cases. He would rather have some safety stock of 2 cases so the inventory does not reach 0 at delivery time. We add 2 cases to the reorder point to make a new reorder point of 10. cases. Harley Davidson is known to be the king of the road, but in 1985 the respected firm was hours from bankruptcy. A recession, Japanese competition and a combination of management errors was about to do-in the last American manufacturer of motorcycles. The company was rescued at the last minute by a caring investor and a well-executed version of Lean Manufacturing. Harley Davidson had to make some changes. Harley Davidson put together a Lean manufacturing strategy that emphasized employee involvement, Just-In-Time delivery and Statistical Process Control.
The plan was well-thought-out, well-executed and successful. They call their plan, MAN, meaning, Material As Needed. Traditionally, Harley Davidson facilitated bikes in large batches. MAN stabilized schedules and conditioned suppliers to deliver more frequently. Harley Davidson had previously held four weeks of stock at a cost of $25 million a year. Now, it carries no safety stock. If there is a problem and parts are short, production halts. In April 1998, Harley Davidson announced record sales and earnings for 32 consecutive quarters of growth.
As of 2007, Harley Davidson continues to run neck and neck with Honda in unit sales, thus surviving their past mistakes and proving yet that they are here to stay (Strategos). Another company using the Just-In-Time inventory strategy is Dell Computers. For instance, one of the main benefits Dell seen with Just-In-Time is that it will eliminate waste and make the company more efficient. Dell is one company that has implemented Just-In-Time systems. When a customer goes to the Dell website they will choose what options they want for their computer. The computer is then made to order.
Dell has become very successful as one of the leading computer manufacturers. Dell is more efficient because it does not have computers that are waiting to be sold and becoming obsolete as technology advances (eHow). In conclusion, EOQ and JIT are two very distinct inventory models. Depending on your organization either one may be beneficial. However, by viewing the differences an organization should be able to determine which model would work best for their organization. It has been proven that both models are used and have benefited organizations in the end. References Ainsworth, P. nd Deines, D (2011). Introduction to accounting: an integrated approach, 6th ed. New York, NY: McGraw-Hill/Irwin. Hax, A. (1984). Production and inventory management. Englewood cliffs, eHow. Pros and Cons of the Just In Time Inventory System. Retrieved from http://www. ehow. com/about_5099120_pro-just-time-inventory-system. html NJ: Prentice-Hall Monden, Y. (1993) Toyota production system: an integrated approach to Just-In Time. Norcross, Georgia, Industrial Engineering and Management Press Strategos. Lean in Hard Times-Harley Davidson. Retrieved from http://www. strategosinc. com/
