What is Economic Batch Quantity (EBQ)?

“Beware of little expenses; a small leak will sink a great ship.”

~ Benjamin Franklin

 

This quote by Benjamin Franklin with ship metaphors, is a great piece of advice for all the manufacturing units and cost accountants. It talks about the importance of making budgets and sticking to them, in order to accomplish the financial goals.

 

A manager needs to keep in check all the expenses because you never know when the petty expenses become enormous that you cannot manage the daily needs. Production should be done in a standardized way such that no abnormal expenses arise.

 

In order to find out how many components, pieces, goods have to be produced, cost accountants can adopt different techniques. One such technique is Economic Batch Quantity in short EBQ. In this blog, you will learn about Economic Batch Quantity.

 

Also Read | Cost-benefit Analysis

 

Concept of Economic Batch Quantity

 

It is the duty of the production managers to decide in what quantities the output should be produced. It can be manufactured in batches, lots, order-based or any form that is suitable.

 

If the products are made in lots/batches then often the quantity manufactured is more than what can be sold in the market i.e. the rate of production is more than the rate of demand. 

 

Such extra production creates many implications such as excessive wastage, more costs, high labor payout and more storage space requirements. In order to prevent such issues the concept of Economic Batch Quantity is used. 

 

Economic Batch Quantity or EBQ is the quantity produced in 1 batch that is economical to manufacture with no wastes. In short EBQ is that quantity at which your cost of production will be minimum.

 

Here we are continuously using the term Batch production. What is Batch production? Batch production is a method in which you distribute your entire production for the day or month or any timespan in lots or small batches.

 

Instead of producing in a single go i.e. mass production, you prefer producing in smaller quantities. In many cases smaller production is vital. It is because there are certain types of manufacturing units that need to replenish and replace the machines in order to start production again.

 

Or if you produce perishable items then you cannot produce all the goods in one go. You may have to divide the output so that the shelf life remains good. Apart from it, there are multiple uses of doing a batch productions like:

 

It minimizes the risk of obsolescence. Any small or minute change can be easily made in the next batch. Or any mistake can be corrected without having to waste the entire production. 

 

You must have heard of a brand named Ikea. It is one of the best and the most famous brands that uses Batch Production method. It produces furniture and home items in bulk in batches.

 

Apart from it, a very popular Chocolate Brand in New Zealand called Whittakers also uses Batch production method. They make chocolate in batches. They add a variety of different flavors and essence to make some limited editions batches as well.

 

We can apply the concept of Batch Quantity in products like: 

 

• Furniture

 

• Tools

 

• Fabrics

 

• Watches

 

• Food items like cookies, cakes, pastries etc.

 

 

Factors affecting the Economic Batch Size

 

Given below are the factors that affect the economic batch size:

 

1. Usage Rate

 

The rate at which production is done should match with the rate at which these parts are used and assembled in the line.

 

2. Manufacturing cost

 

The higher the batch size, its per unit cost will be lower. Set-up costs like machine, paperwork will be lower. But the carrying costs like- handling of goods, storage will increase with the increase in batch size.

 

3. Cost of Obsolescence

 

The higher the size of the lot, higher will be the possibility of deterioration or obsolescence. Deterioration is related to the shelf life. Whereas change in technology or no-demand or even outdated products are related to obsolescence.

 

Before we take the decision of producing in lots, we have to check the availability of raw materials as well as the production capacity of the plant.  Whatever quantity is the economic lot size needs to be verified properly.

 

Also Read | Opportunity Cost

 

Economic Order Quantity vs Economic Batch Quantity

 

Multiple terms are used in relation to optimum quantity production like Economic Batch Quantity, Economic Order Quantity or Economic Manufacturing Quantity. People often get confused as to which term is relevant. 

 

Economic Order Quantity (EOQ) is used to calculate the optimum size when goods, parts and finished goods have to be delivered to an external supplier or outsourced when an order is placed. However, Economic Batch Quantity (EBQ) is used to find out the batch size for a production run when manufacturing is internal.

 

As said by Charles T. Horngren- “EBQ is an inventory-related equation that determines the optimum order quantity that a company should hold in its inventory given a set cost of production, demand rate, and other variables.”

 

Both EOQ and EBQ are similar in the sense that we calculate the size of the optimum quantity. Economic Batch Quantity is an example of a technique used to control costs of materials as well as cost of production.

 

In Economic Batch Quantity,  2 basic laws are applied. One is the Law of Economies of Scale and the other one is the Law of Increasing Returns. It is common sense, that when we produce more the overall costs decrease and profits increase.

 

Also Read | Law of Diminishing Marginal Utility 

 

 

Importance of Economic Batch Quantity

 

Determination of Economic Batch Quantity has its own merits. Some of them are given below.

 

1. It makes sure that the goods produced meet the level of demand of goods in the market.

2. It will also help to maintain and reduce the quantity of output in inventory.

3. It also helps to minimize the machine set-up/get-up time.

4. The size of the optimum lot also helps to reduce the machine costs.

5. It will also minimize the clerical costs.

6. It also gives manufacturing units the advantage of economies of scale.

 

Graphical Representation of Economic Batch Quantity

 

Economic Batch Quantity (EBQ) can be graphically represented as:

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Graphical Representation of EBQ

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In the above graph we can see that EBQ is the point of intersection of Cost(a) and cost(b). Let us go in more detail.

 

The Total cost or the total product cost includes the cost of material, labor and expenses. The formula to calculate the total product cost is:

 

TC= Unit Product Cost* Demand

 

We assume that the demand remains constant therefore the total cost also remains constant. This is why the Total Cost is not relevant when we calculate the Economic Batch Quantity. In the graph, you can see a dotted line representing the Total Cost.

 

Cost(a) in the graph represents the Holding Costs. In order to calculate the Holding Costs we multiply the Average units kept in the warehouse with the cost per holding of the unit.

 

Cost(a)= Holding cost p.u*Average Inventory

 

We assumed that the demand remains constant. Therefore, the inventory levels rise from 0 and end with the quantity of batch size every time a batch is produced. So, in order to calculate the average inventory levels we use the given formula.

 

Average Inventory Level= Batch Size/2

 

Now we can rewrite the formula of Total Holding Costs as:

 

Total Holding Costs= Holding Cost p.u * Batch size/2

 

Cost(b) in the graph represents the Set-Up Costs. Just like holding costs, Set-Up costs are calculated by multiplying the Set-Up cost per Batch with the Number of batches produced.

 

Total Set-up Costs= Set-up cost p.b * Number of Batches

 

We have assumed that demand is constant therefore, the number of batches produced will be calculated as:

 

Number of batched produced= Total Annual Demand/ Size of 1 batch

 

We can rewrite the formula of Total Set-up costs as:

 

Total Set-Up Costs= Set-up cost p.b * Total Annual Demand/Size of 1 Batch

 

Now when we see the graph we can pinpoint the EBQ as the intersection of Holding costs and Set-Up costs. Both these move in opposite directions. The reason being:

 

Set-Up costs will be lower when we produce more batches and holding costs increase when more batches are produced. Therefore, they both go in the opposite directions.

 

At Economic Batch Quantity, both the holding costs and set up costs are equal. In other words, we can say that- The point where holding costs and set-up costs are the same, will be the Economic Batch Quantity.

 

Also Read | Implicit and Explicit Cost

 

Formula of Economic Batch Quantity

 

The formula to calculate the Economic Batch Quantity is:

 

Economic Batch Quantity(EBQ)=2AO/C

 

Where,

 

A= Annual Demand 

 

C= Carrying Cost, it includes storage costs, obsolescence of inventory, interest costs and depreciation.

 

O= Ordering or the setting up cost, it includes the cost of installing and setting up machinery for manufacturing. 

 

2 remains constant in the formula.

 

Also Read | Amortization vs Depreciation

 

 

Example of Economic Batch Quantity

 

ABC Ltd. company has to fulfill the demand of 10,000 kits a day. It produces 12,500 kits at once when production is done. The holding costs of kits is $1. Whereas the Set-up cost is $200. You need to find how frequently the runs have to be made.

 

Using the formula,

 

Economic Batch Quantity(EBQ)=2AO/C

 

We can substitute the values as follows:

 

EBQ= (210,000200)/0.01

 

The answer comes out to be 20,000 units. It means ABC Ltd. has to make 20,000 kits in a single run. Now in order to find out the frequency, we divide the batch size with the total demand of the kits.

 

I.e. 20,000/10,000, which is equal to 2 days. It means, production has to be done every 2 days 

 

Producing in batches has its own merits. The costs are based on the batches we produce. The size of batches can vary and so will the cost. In order to find out the point where we incur minimum costs we use the technique of Economic Batch Quantity.

 

Therefore, Economic Batch Quantity is an important tool both cost wise and production wise.