Green ordering with green EOQ’s

During this period, the Service Logistics Forum (SLF) is focusing on the theme ‘Green & Resilient’. An innovation sheet has already been published earlier, about the carbon footprint. It described, among other things, that the footprint in service logistics can be reduced by decreasing the amount of purchase orders at the supplier. But how do we need to adjust our inventory parameters to influence this? Which strategies can you follow and most importantly: “how do I still ensure the lowest possible costs?”. In this article, we discuss a method to influence the number of orders with an adjustment in the order quantity calculation, the ‘green’ EOQ.

Order quantity costs
In determining the order quantity, we are weighing two types of costs.

➢ Inventory costs
Higher inventory costs will lead to lower order quantities and therefore a higher frequency of
ordering. The inventory costs have three key elements:

  • Space
    The first element is about storage costs. How much does it cost to keep your warehouse running and hold a part on stock. We need to include all costs, not only the ‘rent’ of the warehouse but also the costs of the warehouse staff.
  • Interest
    The interest rate is currently quite low, but we can also translate this aspect in ‘cash flow’. Purchased stock is representing money on the balance sheet that you can’t spend, which is a problem for most companies. For a spare part assortment, it is healthy that parts are in the warehouse for a maximum of six months on average before they are issued.
  • Risk
    Finally, we have the risk aspect, which is the most relevant for service logistics. Due to the uncertainty in demand and maintenance projects, it often happens that parts are no longer needed or become obsolete. In this case, parts need to be scrapped which means a loss in capital. The risk of obsolescence is smaller for fast moving items than for slow moving.

Order costs
On the other hand, the costs of placing an order have an increasing effect on the order quantity.
When order costs are high, we would like to order less frequently. To guarantee the same stock
availability, we need to order higher quantities at a time. The largest part of the order costs is
those for transportation, but we also need to include the internal handling costs.

  • The warehouse receives, checks and stores the incoming orders.
  • Finance reviews and approvals of invoices.
  • Planning reviews purchase requisitions, makes the orders, and monitors them during the lead time.

If you add up all these components, most companies end up around 75 – 100 euros per order line. This can be different per product type. Order costs for a relatively expensive item are higher than for cheaper items, because of the procurement process for more expensive items requires much more attention from buyers.

A greener ordering method
How do we ensure that we can make our ordering method greener, without letting the costs go out of
control? My proposal is to make an adjustment in the equation of the economic order quantity.

A ‘greener’ EOQ
An order quantity method that is used often, is the EOQ (Economic Order Quantity). In the equation we optimize the balance between the order and inventory costs. To refresh your memory, you can see the well-known equation below. At the top we have the costs of one order line (K), when these costs become larger, the EOQ will also increase. At the bottom we have the inventory costs (H), which will decrease the EOQ.

To make this equation greener, we want to increase the outcome. When the EOQ is higher, the amount of order lines that are needed are lower. We add a cost element to represent this ‘greener’ effect.

Defining these ‘green’ costs can be tricky. The easiest way is to use a fixed penalty per order. If you currently charge €100 per order, increase this value then with an additional penalty of for example €100. In this way you increase your order quantity and lower your number of order lines.

A more solid method is to use the average emission costs of transport. Suppose we determine a tax of €10 per kg CO2 emission (Ê) and we also know the amount of kg CO2 emissions per order line (c). Then we can include these new variables into our EOQ equation.

The green optimal
A green stocking decision doesn’t necessarily have to be less than optimal. With the right strategy you
can still find a balance between the different types of costs. Depending on the situation, reducing the
number of order lines can even lead to lower (order) costs. Especially when we know that in many cases
these costs are underestimated, this can be surprisingly profitable. So, take a fresh look at the settings
of your order mechanism and maybe you will turn the following order requisition into a Green Order.

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