Understanding economic order quantity with calculation
Understanding economic order quantity (EOQ) takes calculation and reliable data about your inventory, but it’s worth doing. With EOQ for each item in your inventory, you’ll know what to order and when, minimise your ordering costs, and reduce unnecessary shipping, handling and storage costs.
This guide covers everything you need to understand EOQ, including its definition, benefits and advantages, and a basic calculation formula.
What is the economic order quantity (EOQ) model?
Economic order quantity (EOQ) is a basic model that helps determine how much of an item to order. If your business maintains inventory, EOQ can help manage your cash flow while minimising ordering and handling costs. Also called optimum lot size, EOQ helps you calculate how many units to order and when.
Why is the EOQ model important?
The EOQ model is an integral part of inventory accounting. Buying stock in bulk will save on shipping and payment fees but may add to holding costs. It also means tying your cash up in an overstocked item. EOQ helps you optimise stock control by finding a balance between minimising the costs of buying stock and having enough stock to fulfil sales orders.
How is the EOQ model useful?
EOQ is one of a few useful metrics that help you maintain optimum stock levels and minimise ordering costs. When combined with optimum stock levels, EOQ will help you understand when to reorder a product to minimise inventory days. The metric is most useful for items with consistent demand, ordering and holding costs.
Formula for calculating the EOQ model
Calculate EOQ for each item you stock. To do this, you'll need to know the order costs, the yearly demand and how much each unit costs to store, send and sell.
This is the average number (not the value) of units you sell annually.
Also known as a setup cost, ordering costs are what you spend each time you place an order with a supplier, including any delivery or payment processing fees.
Holding cost per unit
Holding or carrying costs are how much you spend to carry each item each year.
Once you’ve got these numbers, you can calculate the EOQ. In this formula D = demand, O = order costs, and H = holding costs.
Economic order quantity = √(2xDxO/H)
This formula shows you should multiply the demand rate by two, then multiply that by the ordering costs and divide by the holding rate. Your EOQ is the square root of the result.
Example of an EOQ calculation
Here's an example of an EOQ calculation for an online retailer selling ballet gear. The business sells an average of 100 pairs of basic ballet slippers annually, pays an average holding cost per pair of $1.50 and has fixed order costs of about $.75 per pair. Here's the formula for calculating the retailer's EOQ.
√(2x100 x $.75/$1.5) = 10
This tells us that the ballet company should order 10 new shoes at a time.
What are the benefits of calculating EOQ?
Calculating the EOQ for each item you stock is integral to improving how you manage your inventory, save costs and streamline operations.
Reduce inventory costs
EOQ helps you avoid over-ordering, so you're not paying more to store excess stock. You also reduce the risk of being left with damaged or unsellable items.
You can use EOQ to avoid under-stocking, ensuring you've enough inventory to meet market demand. When you've got what customers want, it improves retention and also means you don't miss a sale.
With a reliable EOQ, you can build automatic reorder triggers into your software or processes. Once stock levels hit a certain threshold, your system or staff reorder.
Improve cash flow
If you can maintain ideal stock levels, you avoid tying up too much cash in your inventory and keep more cash on hand.
What are the limitations of the EOQ model?
EOQ uses historical data to predict the future, so it has limitations.
Doesn't account for seasonal changes
If you stock items with seasonal sales spikes, like Christmas decorations, for example, the EOQ won't be as helpful.
Won't account for consumer behaviour change
If an item becomes less popular over time and demand goes down, you'll need to recalculate the EOQ.
Relies on clean data
Unless you've accurate data on yearly demand, holding costs and ordering costs for each product, your EOQ calculation will be inaccurate.
Won't factor in discounting
The EOQ won't factor in any discounts offered for ordering larger lots or at certain times.
Economic order quantity FAQs
What is the difference between EOQ and order quantity?
Order quantity describes how much of each item you order at a time. EOQ helps you understand what order quantity is most economical and efficient for your business. Minimum order quantity (MOQ) is another term again. Set by the supplier, the MOQ is the minimum number of items you must order at a time.
What is the difference between EOQ and JIT?
Just-in-time (JIT) is a way of managing inventory where you order products only when you need them. This minimises holding costs and avoids under or over-stocking. EOQ is one of the metrics required to achieve JIT inventory management.
What are the assumptions of the EOQ model?
The EOQ model assumes that each item has consistent demand and costs, suppliers aren't dealing with shortages, and there are no discounts on offer. These assumptions simplify the calculation but may mean the EOQ won't work for you.
What is the difference between EOQ and production order quantity (POQ)?
Production order quantity (POQ) is a formula to help manufacturing businesses understand how much of one item to make and when. Manufacturers may use EOQ to optimise ordering raw materials.
Do carrying costs impact EOQ?
Yes, carrying costs, or holding costs, is one of three metrics you need to calculate economic order quantity.
If you carry inventory, EOQ is one of the basic metrics to streamline operations and minimise ordering and holding costs while minimising stock outs. The EOQ model can help you improve your cash flow, reduce costs, and ultimately increase profitability as part of broader inventory management.
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