Extensions to the EOQ Model

Thus far, we have assumed that a company will let its inventory run down to zero and then reorder. In reality, a company will wish to reorder before its inventory goes to zero, for two reasons. First, by always having at least some inventory on hand, the firm minimizes the risk of a stock-out and the resulting losses of sales and customers. Second, when a firm does reorder, there will be some time lag before the inventory arrives. Thus, to finish our discussion of the EOQ, we consider two extensions, safety stocks and reordering points.

Safety Stocks A safety stock is the minimum level of inventory that a firm keeps on hand. Inventories are reordered whenever the level of inventory falls to the safety stock level. The top of Figure 21.6 illustrates how a safety stock can be incorporated into an EOQ model. Notice that adding a safety stock simply means that the firm does not run its inventory all the way down to zero. Other than this, the situation here is identical to that described in our earlier discussion of the EOQ.

Reorder Points To allow for delivery time, a firm will place orders before inventories reach a critical level. The reorder points are the times at which the firm will actually place its inventory orders. These points are illustrated in the middle of Figure 21.6. As shown, the reorder points simply occur some fixed number of days (or weeks or months) before inventories are projected to reach zero.

One of the reasons that a firm will keep a safety stock is to allow for uncertain delivery times. We can therefore combine our reorder point and safety stock discussions in the bottom part of Figure 21.6. The result is a generalized EOQ model in which the firm orders in advance of anticipated needs and also keeps a safety stock of inventory.

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