From the course: Excel Supply Chain Analysis: Solving Inventory Problems

Describe how allowing back orders affects order quantities - Microsoft Excel Tutorial

From the course: Excel Supply Chain Analysis: Solving Inventory Problems

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Describe how allowing back orders affects order quantities

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- [Narrator] If you've ever gone to a website or a store and ordered an item that wasn't in stock, then you might've been offered the chance to put in a back order. A back order means that a store or a seller is willing to run out of items that customers want. Some people will order and wait, I'm often one of them, where others will go elsewhere and cost you money. And that money might not just be from this particular sale. It could be future sales that you lose. So how do you find your total lowest cost? And for this, I'm assuming the lowest cost of ordering guarding against two expenses. The first is the cost of excess, and that is your inventory holding cost, and the second is your cost of being shored, and that's the loss of revenue by not having an item. If you want to visualize your inventory position with back orders, you can use what's called a sawtooth diagram, and I'll add a line for your zero inventory level. So the idea is that you don't place an order until your inventory position is at a particular negative level. In this case, we're assuming minus 20. That's just an assumption though, not a general rule. What you want to do is to calculate how far below zero you are willing to let your inventory go before you place your order, and that gap is referred to as b*, or back order. So how do you calculate your economic order quantity with back orders? You need to know your annual demand, the cost per order, also called setup cost, your inventory holding cost, and also the cost of a stockout. Cost of a stockout will just be an estimate. But with these four elements, you can calculate the best quantity to order every time that you request new products from your suppliers.

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