The economic order quantity model with compounding

Abstract

The standard Economic Order Quantity (EOQ) model is a cornerstone of inventory management. It is one of the oldest and highly recognized models in business and operations research. In the EOQ model, the inventory holding cost consists of two parts: a financial cost that represents the opportunity cost of capital tied up in the inventory and a warehousing cost. In the classical model, the inventory holding cost is expressed as a percentage of the monetary value of the physical inventory, like an interest rate. The classical model assumes simple interest accrual, which is not realistic because compound interest is used in practice; and it is the rule rather than an exception. In this research, we extend the classical model to account for compound interest and develop an intuitive closed form equation for the optimal order quantity.