Economic Order Quantity Definition, Explanation, Formula, Example and Assumptions

The two most significant inventory management costs are ordering costs and carrying costs. Ordering costs are costs incurred on placing and receiving a new shipment of inventories. These include communication costs, transportation costs, transit insurance costs, inspection costs, accounting costs, etc. These include opportunity cost of money held-up in inventories, storage costs such as warehouse rent, insurance, spoilage costs, etc.

Economic Order Quantity (EOQ) can help ensure you have enough products on hand to meet demand. Too much of one product can increase storage costs and reduce available cash flow. Too little of a product, and you’ll damage the immediate annuities explained customer experience and miss out on sales opportunities.

Examples of these costs include telephone charges, delivery charges, invoice verification expenses and payment processing expenses etc. The total ordering cost usually varies according to the frequency of placing orders. If your business has complex ordering needs, the EOQ model could still be an efficient way to cut costs—but we’d recommend using inventory management software to calculate your EOQ automatically. Get started by checking out our top-recommended inventory management platforms. Manufacturing costs can likewise fluctuate based on time of year, turnaround rate, and more.

Why is economic order quantity important in inventory management?

It will help the company to minimize the inventory cost, which includes purchasing cost, ordering cost, and holding cost.
Sortly centralizes all your inventory data into an easy dashboard view so you can quickly see how much of an item you have in stock and how much you’ve used.
Once you receive your cement bags, it costs $3 per bag per year to store your concrete.
For example, if you run out of inventory, there’s a shortage cost, which equals revenue loss because you can’t fill orders.

When you do the math, you find that ordering fewer units at a time brings your total cost down to $63,000. Malakooti (2013)10 has introduced the multi-criteria EOQ models where the criteria could be minimizing the total cost, Order quantity (inventory), and Shortages. Additionally, the economic order interval8 can be determined from the EOQ and the economic production quantity model (which determines the optimal production quantity) can be determined in a similar fashion. Perera et al. (2017)4 establish this optimality and fully characterize the (s,S) optimality within the EOQ setting under general cost structures. FreshBooks expense-tracking software solutions help businesses organize their receipts and spending and automatically track and categorize inventory expenses. This gives company owners the data they need to analyze their spending and profits, with no manual entry required.

Note that the number of times an order is placed will also affect the total cost, though this number can be determined from the other parameters. While the EOQ calculation model assumes there will be consistent demand for your product, and pricing will remain constant, reality is not usually that simple. Using EOQ supply chain calculations is only effective if you can use reliable data. If they have too much unsold inventory, they’re wasting usable funds and tying up cash flow in a product that’s not selling, while spending money on costs related to storage and maintenance.

Economic Order Quantity: What Does It Mean and Who Is It Important for?

When used properly, EOQ helps your business stock the perfect amount of inventory—enough to meet the demands of your customers. The rest of your cash can be saved for a rainy day, or injected into other areas of business, like sales, marketing, or human resources. Whatever the size of your organisation, having effective inventory management will help reduce costs and stockholding. Keeping the annual demand constant if for example the number of orders decreases, the ordering cost will also decrease but the holding cost will rise and vice versa.

Your reorder point is a predetermined level of inventory a business is comfortable reaching before it’s time to place a new order. This number is different for every item, as each item will have a unique EOQ. Using the EOQ for inventory planning can help you meet demand while maintaining a reasonable inventory balance. While at first glance over-ordering may seem like a safer move, you may be tying up too much of your cash in physical stock during periods of low demand.

Economic Order Quantity Example

The EOQ helps you strike the perfect balance, ensuring you have enough stock without becoming a hoarder. Notice that the quantity of 400 units with 6 annual orders and a combined ordering and holding cost of $120 is the most economical quantity to order. Other order quantities that result in more or less than six orders per year are not so economical. The ordering costs are the costs that are incurred every time an order for inventory is placed with the supplier.

It prevents guessing, and there’s less cause for concern about overordering or running out of stock.
Consequently, EOQ is best applied to products in your inventory that are equally desirable throughout the year.
When it comes to inventory management, knowing what you’ve got, where it is, and how much of it you have on hand is absolutely essential.
If your business doesn’t see a lot of fluctuation, the EOQ formula can be easily implemented in a manual inventory tracking system.

The good news is you can adjust your EOQ model to accommodate some of the common wrinkles that may affect your ideal order quantity. By applying EOQ principles, the restaurant can reduce food waste, ensure ingredient freshness, and keep costs under control. This illustrates that the economic order quantity is always in the best interests of the firm.

Suppliers’ Requirement

Economic order quantity (EOQ) is the ideal quantity of units a company should purchase to meet demand while minimizing inventory costs such as holding costs, shortage costs, and order costs. This production-scheduling model was developed in 1913 by Ford W. Harris and has been refined over time. The economic order quantity formula assumes that demand, ordering, and holding costs all remain constant. Economic order quantity (EOQ) is the order size that minimizes the sum of ordering and holding costs related to raw materials or merchandise inventories. In other words, it is the optimal inventory size that should be ordered with the supplier to minimize the total annual inventory cost of the business. Other names used for economic order quantity are optimal order size and optimal order quantity.

There are several ways to optimize inventory using the EOQ model, discussed in detail below. If you have more inventory than you need, you are wasting money, space, and personnel dedicated to caring for that inventory. Take your learning and productivity to the next level with our Premium Templates.

While the EOQ formula is a valuable tool, it’s important to remember that it’s a simplification. In reality, real-life factors like lead times, order discounts, and safety stock requirements can influence your optimal order quantity. Additionally, the EOQ assumes constant demand and holding costs, which may not always be true.

Hedging Inventory

There is also a cost for each unit held in storage, commonly known as holding cost, sometimes expressed as a percentage of the purchase cost of the item. Although the EOQ formulation is straightforward, factors such as transportation rates and quantity discounts factor into its real-world application. To minimize its inventory carrying costs, a company must place small orders. But small order size means that the company must place more orders which increases its total ordering costs.

It sounds simple, but we need to spend resources on prepare purchase requests, purchase orders, record into accounting use the sales tax deduction calculator system, and prepare payment to supplier. 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. EOQ can be confusing when applied to products consumers only want occasionally or under certain circumstances.

If you don’t have correct, real-time data on holding or order costs, you’ll have the wrong amount of inventory, which can quickly lead to a stockout. By precisely calculating your optimal order quantity, you ensure you have enough fixed manufacturing overhead variance analysis product on hand to meet demand consistently. This enables you to break down your inventory into much more manageable parts, which will prepare you for your analysis. The John Sports Inc. purchases tennis balls at $20 per dozen from its suppliers.