The ELS model calculates Total Cost per unit over a range of batches. The lot size having the lowest unit cost is the Economic Lot Size (ELS) or Economic Order Quantity (EOQ). There are three components of cost in the ELS model: Setup Cost, Carrying Cost, and Direct Cost. When graphed, Total Cost typically forms a rounded check mark shape as shown in figure 1.
Setup costs can be significant in CPG andFood plants. Setup Cost includes the labor and material required to prepare forproduction. There may be costs for charging the production line with productand increased scrap until the line is dialed in. If the line is at or near capacity, overheadcosts should be included as representation of lost opportunity for production whileline is being changed over. Setup cost is averaged over the entire batch toderive the Setup Cost per unit. Setup cost per unit is high when batches aresmall and rapidly decreases with increasing lot size.
Carrying cost is the cost associated with holdinga unit for the average time it will be in inventory. Carrying cost includesactual storage costs, cost of capital for the value tied up in working capital,and shrinkage for Warehouse damage and obsolescence. In traditional ELS calculations, CarryingCost per piece is assumed to vary directly with lot size.
Direct costs are generally directlyproportional to the amount produced, such as materials and direct labor. Since directcost per piece is typically unaffected by lot size, it does not actually affectthe calculation of ELS.
ELS assumes demand to be linear, as shown in Figure 2. The demand is each day is the same. When inventory drops to zero, it is immediately replenished by the ELS quantity.
In reality, demand tends to be lumpy and irregular as shown in Figure 3. ELS is still valid for this situation, as long as average demand can be predicted accurately, and as long as the risk of obsolescence does not increase for larger batch quantities.
Shive Supply Chain Solutions LLC is available to help you determine applicability of EOQ or ELS to your situation. For more information, contact us at info@shivesupplychainsolutions.com.
