Economic Order Quantity Technique

Economic Order Quantity (EOQ) is all about finding the perfect number of units to order so you can meet demand while keeping inventory costs low. These costs include holding, shortage, and order costs. 

Economic order quantity formula

EOQ = Square Root Of: [2(Setup Costs)(Demand rate)] / Holding costs.

Where:

Q = EOQ units

D = Demand Rate

S = Order Cost

H = Holding costs

Example Scenario:

  • Annual Demand (D): 5,000 units
  • Order Cost (S): $100 per order
  • Holding Cost (H): $2 per unit per year

Calculation:

  1. Multiply the demand rate (D) by the order cost (S): 2DS = 2 × 5,000 × 100 = 1,000,000
  2. Divide this product by the holding cost (H): 1,000,000 \ 2 = 500,000
  3. Take the square root of the result: EOQ= √'500,000 = 707

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What does economic order quantity tell you?

The economic order quantity formula helps you figure out the optimal number of units to order so you can minimise the costs of buying, shipping, and storing items. Big companies with complex supply chains often use computer algorithms to calculate EOQ. By adjusting the EOQ formula, companies can also determine the best production levels or order schedules.

Benefits of economic order quantity (EOQ)

Using EOQ can significantly boost your profitability. Here’s how:

  • Improved Order Fullfillment: EOQ ensures that you have products available when needed, allowing for quick shipping and happier customers, which can lead to higher sales.
  • Less Over ordering: By predicting what you need accurately, you avoid ordering too much and tying up cash in inventory.
  • Less Waste: Efficient ordering schedules reduce outdated inventory, which is especially important for perishable goods.
  • Lower Storage Costs: Ordering in line with demand means you need less storage space, cutting costs for utilities, real estate, safety, and insurance.
  • Quantity Discounts: Strategic ordering lets you take advantage of bulk purchase discounts from suppliers.

Limitations of EOQ

The EOQ formula assumes constant customer demand and steady ordering and holding costs. This can be a limitation because it doesn’t account for fluctuating demand, seasonal inventory cost changes, lost sales due to shortages, or bulk purchase discounts.

Further reading: What are tax levies?

Conclusion

Economic Order Quantity (EOQ) helps you determine the best order size to meet demand while minimising total costs. The EOQ formula is most effective when demand, ordering, and holding costs are constant. However, keep in mind that it assumes a steady demand, which may not always be the case.

By understanding and using the economic order quantity formula, you can improve your inventory management, reduce costs, and boost overall efficiency.

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