Tag Archives: economic order quantity eoq

Moveable Barriers

Alejandro Serrano MIT / SC Frontiers. #42 | US

Supply Chain and Finance are usually seen as separate and conflicting disciplines. In a retailing or manufacturing company, key performance indicators (KPIs) are typically set by the COO to maintain high customer service levels by keeping inventories high. At the same time, the CFO pushes supply chain management to reduce inventory as much as possible to avoid the financial burden imposed by working capital requirements. As a result, supply chain and financial incentives become misaligned, and efforts to arrive at a compromise can be extremely frustrating for both disciplines. However, as a recent consulting engagement at a well-known multinational company underlines, it is possible to bridge this divide.

There are many examples of how supply chain and financial interests can diverge in companies. In turbulent times, for instance, finance may have stronger reasons and incentives to free up cash by reducing inventories. But in prosperous times, supply chain may advocate the need for on-time deliveries even though such a strategy elevates inventory volumes.

In recent years many companies have tried to become more efficient on a global rather than a local level by developing a more holistic view of their operations. However, even if a consensus is reached on what the efficiency goals should be, some crucial questions often remain, such as: What is the best method for assessing the appropriateness of an investment? Issues like these bring supply chain and finance into conflict again. Finance may firmly believe that supply chain’s evaluations of investments are incomplete because they miss a portion of the picture.

A specific example of this source of disagreement is the economic order quantity (EOQ) formula, which is commonly used in business to calculate order quantities. Any analyst in a financial department will tell you that the EOQ formula is really a surrogate for the right approach to determining order quantities. Finance specialists argue that the formula minimizes cost functions, whereas the correct approach is to maximize shareholder value by, for example, discounting expected cash flows at the appropriate cost of capital. This approach tends to overwhelm supply chain people, allowing finance to take a leadership position in such projects. Moreover, it is likely that the CEO will support the more involved methodology favored by the finance department.

Still, finance and supply chain can find common ground even in situations such as the one described above. Here is an example drawn from a recent consulting project at a multinational company of how the two sides can come together.

Three people from different departments in the company proposed distinct approaches to solving a manufacturing problem: defining the production batch size. The supply chain folks proposed using the EOQ formula. Project management wanted to calculate the batch size so as to maximize the net present value (NPV) of the resulting incremental cash flows. Finance offered a third approach: choosing the batch size that maximized the discounted economic value added (EVA), as was customarily done in the company. These approaches led to three different solutions, and it was impossible for the three departments to reach a consensus on which batch size to choose.

The consultant was asked to find the right method to use and to outline what assumptions, if any, would invalidate the other approaches. The initial assumption was that the EOQ formula could not give the right solution to maximize value, because it does not discount cash flows; it just minimizes some cost function. However, working through the calculations produced a surprising result: all three approaches yielded exactly the same solution. How can this be possible given the differences between minimizing cost and maximizing value already outlined? This is mainly due to the fact that the EOQ formula does indeed discount cash flows. The technical details are too complex to detail in this article. But in broad terms, the EOQ formula contains the inventory holding cost, a part of which is a financial cost, which coincides with the discount rate in any NPV approach.

The result immediately removed the misalignment between supply chain and finance. Although this is just one example, it sheds light on how barriers between departments can be removed by delving into the reasons for these divisions. The project should encourage managers to take a holistic view of their firms when making decisions and encourage researchers to keep working on ways to align the interests of finance and supply chain.

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