Economic order quantity (EOQ) is a term for the ideal quantity a company should purchase to minimize its inventory costs, like shortage or carrying costs. The overall goal of economic order quantity is to decrease spending; its formula is used to identify the greatest number of units needed (per order) to reduce buying.
One of the primary gains of the EOQ model is customized recommendations for your particular company. At times, EOQ may suggest investing in a larger order to take advantage of discount bulk buying and to cut down on total costs associated with multiple shipments.
Calculating Economic Order Quantity (EOQ)
Calculating economic order quantity requires some math that might seem complicated at first, however once you get the variables from your inventory management system, it’s easy to plug in the numbers and calculate EOQ. When you use a robust ERP, these calculations may all be handled for you, including order costs like inventory ordering costs, holding costs and stockout costs.
Three Variables Used to Calculate EOQ
There are several variations of the formula used to calculate EOQ. One popular EOQ formula is based on these variables, also called inputs:
- D = Annual Demand in units
- S = Order cost
- H = Holding costs (per unit, per year)
Economic Order Quantity (EOQ) Formula
EOQ = √ [2DS/H]
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Factors that affect Economic Order Quantity
- Reorder points
This is the time when you need to reorder another set of stock or replenish the existing stock. EOQ always assumes that you order the same quantity at each reorder point. - Purchase order lead time
This is the time period from placing the order until the ordering is delivered. EOQ assumes that the lead time is understood. - Purchasing cost per unit
The cost per unit never changes, over the period of time, even though the quantity of the order is changed. EOQ always assumes that you pay the same amount per product, every time. - Stockouts
There are no chances for stockouts. You have to always maintain enough inventory to avoid stockout costs. This clearly states that you always have to strictly monitor your customer demand along with your inventory levels, carefully. - Quality costs
EOQ never focuses on the quality costs, rather the carrying costs. - Demand rate
The rate of time with which your customers order more or new products. - Relevant ordering cost
The cost per purchase order. - Relevant carrying cost
The cost involved in the entire maintenance and carrying the stock, for the specific period.
Benefits of Utilizing an Economic Order Quantity Model
The main benefit of using EOQ is improved profitability. Here’s a list of opportunity costs to weigh when considering how you’ll implement EOQ or another inventory control method.
- Improved Order Fulfillment: When you need a certain item or something for a customer order, optimal EOQ ensures the product is on hand, allowing you to get the order out on time and keep the customer happy. This should improve the customer experience and may lead to increased sales.
- Less Waste: More optimized order schedules should cut down on obsolete inventory, particularly for businesses that hold perishable inventories that can result in dead stock.
- Lower Storage Costs: When your ordering matches your demand, you should have less products to store. This can lower real estate, utility, security, insurance and other related costs.
- Quantity Discounts: Planning and timing your orders well allows you to take advantage of the best bulk order or quantity discounts offered by your vendors.
The Importance of EOQ Calculations
Holding inventory can be one of the most expensive aspects of ecommerce fulfillment. It’s expensive to manufacture or procure and it is expensive to keep in stock (read more on carrying costs). Whether it is raw materials, work in process (WIP) or finished goods, companies can use EOQ as an efficient ordering guideline to prevent shortages while not maintaining excess inventories.
Economic order quantity is often one of many inventory forecasting techniques available to ensure your have the ideal order quantity on hand at any given time. Honing the inventory control method that works best for your brand requires rigorous attention. Other techniques include reorder points, period of supply, etc.
How to Use EOQ to Improve Inventory Management
When you calculate EOQ, you know the ideal order size to maximize profits for your organization. It prevents guessing, and there’s less cause for concern about overordering or running out of stock. You can follow the data and the numbers to make the best long-term decision for your business’s inventory needs.
If you run a large business, a business that requires expensive inventory, or a business with high inventory holding costs, EOQ could have a significant impact on your business, improving operational efficiency, cash flow and profits for years to come.
Bottom Line
Economic order quantity might not consider all the factors that affect business but is still a powerful tool if it sits right for you. Calculating the economic order quantity (EOQ) for your business can help you to analyze better, order better, and eventually have better profit margins.
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Tags: Calculators & Formulas
