Economic Order Quantity (EOQ): Components and Benefits

Definition

Economic Order Quantity is a formula-based inventory management technique that calculates the optimal order quantity to minimize total inventory costs. It considers factors such as carrying cost, ordering cost, and demand to determine the most cost-efficient quantity to order.

The Components Of Economic Order Quantity

In general, there is no single formula that applies in every case as every situation is different, and which of the above components you use depends on your case.

Some example components of calculating the Economic Order Quantity for your products include the demand rate (and resulting order frequency), ordering costs and carrying costs, the lead time, and the reorder point, to name a few.

Here’s what these mean:

Annual Demand: is factor represents the number of units expected to be sold per year.
Order Cost per Purchase Order: This factor includes expenses associated with shipping and handling for each purchase order. It represents the costs incurred by the business for each individual unit sold.
Annual Holding Costs: Also known as carrying costs, this factor encompasses various expenses related to holding inventory. It includes capital costs, inventory service costs, inventory storage costs, and inventory risk costs, for example.
Lead Time: The time it takes for a product to reach your business from your supplier.
Reorder Point: At which stock level should the purchase order should be issued.

Although there are simplified versions of formulas to calculate EOQ (for example for uniform yearly sales), picking the wrong approach can be very inaccurate and costly (for example if your cycle is even slightly seasonal).

A simple way to calculate the Economic Order Quantity (EOQ):

Let’s say a company sells a particular product with an annual average demand (D) of 1,000 units. For the sake of the example, we can assume the order cost per purchase order (S) is $50, including shipping and handling expenses. Also, we can say the annual holding costs (H) have been measured to be $2 per unit if we can somehow take into account capital costs, inventory service costs, inventory storage costs, and inventory risk costs.

To calculate the EOQ, you can use the following formula:

EOQ = √((2DS) / H)

Plugging in the values from our example:

EOQ = √((2 * 1,000 * $50) / $2)

EOQ = √((100,000) / $2)

EOQ = √50,000

EOQ ≈ 223.61 units

Therefore, the EOQ for this product would be approximately 224 units. This means that the company should place an order for approximately 224 units each time they need to replenish their inventory. Since they will need to buy 1000/224 ≈ 4.5 times in a year, this means they will need to buy 224 units every 2.6 months (the order frequency) to minimize costs associated with ordering and carrying inventory.

Benefits Of Implementing EOQ

Adopting the EOQ concept is a method used in inventory management to determine the optimal order quantity that minimizes the total cost of inventory. The benefits of using EOQ include:

Cost savings through optimal order quantities: EOQ helps determine the most cost-effective order quantity, minimizing ordering costs. This potentially leads to direct cost savings for the business.
Reduction in inventory holding costs: By optimizing order quantities, EOQ helps prevent overstocking, which in turn reduces inventory holding costs, such as warehousing, insurance, and depreciation expenses.
Minimization of stockouts and backorders: EOQ ensures that inventory is replenished at the right time, reducing the likelihood of stockouts and backorders. This helps maintain customer satisfaction and avoids potential sales losses.
Improved cash flow management: With EOQ, businesses can better manage their cash flow by aligning the timing of inventory orders with customer demand. This prevents tying up excess capital in inventory and allows for efficient use of financial resources.

Implementing EOQ as part of inventory management practices can lead to cost savings, improved efficiency, and better customer service.