What is Economic Batch Quantity? With Example
Economic batch quantity (EBQ) is a crucial concept that determines the most cost-effective quantity of units to produce in a single batch or production run.
By optimizing the batch size, businesses can minimize their overall production costs, considering factors such as ordering, setup, carrying, and unit costs.
Understanding EBQ and Its Significance
Economic Batch Quantity achieves a balance between the two significant costs of producing: ordering costs and carrying costs. With every new production run ordered, ordering costs involve setup charges, labor, and clerical work. Being a holding cost, carrying costs represent storage, insurance, as well as risks of obsolescence.
Overproduction leads to high carrying costs due to the level of inventory. Producing low quantities leads to a higher order cycle count, which inflates the cost of orders. EBQ seeks to find the right size of batches that will minimize both conditions by efficiently optimizing the production and usage of resources.
Ordering costs are the costs associated with placing an order, such as the cost of preparing the order, shipping the order, and inspecting the goods. These costs are typically fixed, meaning that they do not vary with the order quantity.
Carrying costs are the costs associated with holding inventory, such as the cost of storage, insurance, and obsolescence. These costs are typically variable, meaning that they increase with the order quantity.
Calculating EBQ: The Formula and Assumptions
The formula for calculating EBQ is derived from the economic order quantity (EOQ) model, considering the production rate (R) in addition to demand (D), setup cost (S), carrying cost per unit (C), and ordering cost per order (I). The formula is:
EBQ = √(2DS/IC)
This formula assumes that demand is constant and known over a specific period, production time is constant, setup costs are fixed, and unit costs remain constant.
Example of Economic Batch Quantity (EBQ)
A company produces widgets at a constant rate of 100 widgets per hour. The annual demand for widgets is 10,000 units. The setup cost per batch is $50, and the carrying cost per unit per year is $1.
Using the EBQ formula, we can calculate the economic batch quantity to be 200 widgets. This means that the company should produce widgets in batches of 200 units in order to minimize the total average cost of production.
Conclusion
In cost accounting, EBQ determines the most economic way of producing a product. Producing in batches can save the number of setups through which it has to pass and the exposure time that a product remains in inventory, thus resulting in substantial savings.