The Crucial Role of Economic Order Quantity Formula in Streamlining Inventory Management

February 16, 2024 The staff is managing inventory specifically according to economic order quantity inventory management strategy in a warehouse.

When reordering products, most businesses place orders according to their present business needs rather than determining the reorder quantity method. 

By optimizing the Economic Order Quantity model, one can determine their reordering way and pay for the exact products. 

The major Advantages of economic order quantity is to minimize inventory costs, including holding costs, order costs, and shortage costs. 

It is essentially used in inventory management. It is denoted by optimizing the number of products a business should include in its inventory with every order to diminish total inventory costs. 

This article will help you through the Advantages of Economic Order Quantity and how to calculate Economic Order Quantity so that you can maximize your profit. 

What is the Economic Order quantity?

The economic order quantity model is worked in cost accounting to determine the number of optimum inventory stages of an item that should be kept to prevent overstocking and understocking. Overstocking increases total costs and wastage, while understocking denotes losing sales. 

In simple words, we can say that EOQ is a formula that a company uses to calculate the optimum inventory to reduce logistic costs, stockouts, overstock costs, and warehousing space. 

There are several certain assumptions when we calculate economic order quantity. 

  • The first assumes customer demand, carrying cost, purchase order time, and cost for a single order. The second one is you will purchase the same amount for every reorder. 
  • The third one is you will never face zero stock; thus, your stockout cost will always be zero. 
  • The last one is that your cost for every size of the order will remain the same as determined by per unit bases. 

Definition of Economic Order Quantity:

The definition of Economic Order Quantity is:

EOQ= √2DS/H

Where D denotes as demand rate (amount sold/year)

S denotes setup costs (per amount, including handling and shipping)

H denotes Holding costs (per unit/year)

Before calculate Economic Order Quantity, you should know its components, such as;

Holding cost: the cost of holding inventory is called holding cost. It has to be determined to get the best store inventory where demand is constant.

H = i*C

H denotes holding cost

i denotes carrying cost

C denotes the Unit cost

Ordering cost: the expense of placing an order is called the Ordering cost. You will get the total number of orders by dividing the annual quantity demanded and volume per order. 

Number of orders = D/Q

D denotes the annual quantity demanded

Q denotes volume per order

The multiplication between ordering costs and the number of orders is called the annual ordering cost.

Annual Ordering cost = [D * S] / Q

Annual Holding Cost is the sum of holding cost and volume per order.

Annual Holding cost = [ Q*H] /2

Total cost: sum of holding cost and ordering cost is called total cost.

Annual Total Cost = (D*S)/Q + (Q/H)/2

EOQ = DTC/DQ

Or, EOQ = √2DS/H

Economic Order Quantity formula example:

Economic Order Quantity (EOQ) formula is used in inventory management to calculate the optimal quantity of goods to order at a given time

An example is the best way to understand how to determine Economic Order Quantity. Here is an Economic Order Quantity formula example for better understanding:

Economic Order Quantity formula example 1:

The variables are:

The holding costs per unit (H) is $0.75

The demand rate per year (D) is 10000

The setup cost (S) is $500

So EOQ= √2DS/H = square root (2* 500* 10000/ 0.75)= 3652 units/order

That means you should place 3652 units of order. 

Economic Order Quantity formula example 2:

Suppose the annual demand for a bottle manufacturing farm is 400, the holding cost is $4, ordering cost is $2. Now find out the EOQ.

Here,

Holding cost (H) = $4

Ordering cost (S) = $2

Demand (D) = 400

EOQ = √2DS/H

Or, EOQ = 20

That means you should place 20 units of order. 

You can also use this formula to find out how many muzzles, leashes, chews, and treats you need to keep to avoid overstocking and understocking. 

Method 1: Here’s a formula to calculate EOQ:
EOQ = √ [2SD / H]
S is the setup cost (per order, which includes shipping and handling) D is the demand rate (product quantity sold in a year) H is the holding cost (per unit, per year)
EOQ Example:
Let’s say a business expects a demand of 20,000 units with an average order cost of $10000 and a holding cost of $5 per unit in a year.
The EOQ formula becomes:
EOQ = √ [2 x D x S / H] = √ [ (2 x 20,000 x $10000) / $5] = √ [80000000] = 8,944 units

 

Method 2: Here’s another formula to calculate EOQ:
EOQ = Total Ordering Cost / (Ordering Cost per Unit) + (Minimum Handling Cost per Order)
EOQ Example:
For example, suppose you want to buy 1000 devices from a supplier. Each device costs $10, and the handling cost per order is $1. You want to find out how many units you should order at one time to minimize your total ordering costs.
The EOQ formula becomes:
EOQ = ($10 x 1000)/(10 + 1) + (1 x 10) = $9,990/11 + 10 = 873 units
So, in this case, we would order 873 units at one time to minimize our total ordering costs.

Advantages of Economic Order Quantity:

The Advantages of Economic Order Quantity that influence your bottom line. It’s a prodigious way to determine how many products you need to buy to keep your supply chain running efficiently while reducing costs. There are lots of Advantages of Economic Order Quantity, such as;

Minimize Storage and Reduce inventory costs:

For small business owners, storing inventory can result in significant costs. However, the key Advantages of Economic Order Quantity model lies in its ability to offer personalized suggestions concerning the most cost-effective quantity of units to order. 

The model may propose consolidating orders by purchasing larger quantities, benefiting from discounted bulk purchases, and reducing ordering expenses. Conversely, it may recommend increasing the frequency of orders but reducing the number of items per order to minimize holding costs, particularly when they are high, and ordering costs are relatively low.

Improve efficiency: 

The advantages of Economic Order Quantity allow you to understand managing and storing inventory. Most sellers did not place orders by calculating EOQ; they just ordered based on an assumption. By calculating EOQ, you can only order the amount you need. 

Business Specific: 

Small businesses often face the challenge of maintaining appropriate inventory levels to meet customer demand. However, the Economic Order Quantity model offers a notable advantage.

 It provides precise and tailored recommendations to businesses, including the optimal inventory quantities to hold, the appropriate timing for reordering, and the specific number of items to be ordered. 

By leveraging the advantages of Economic Order Quantity, businesses can streamline their restocking procedures, leading to improved customer service and satisfaction.

Minimize stockouts:

One of the major advantages of Economic Order Quantity is it reduces your stockouts. It offers you a better understanding of how many items you have to reorder so that you don’t have any overstocking and avoid stockouts. 

Increase customer satisfaction:

Another advantages of Economic Order Quantity is it increases customer satisfaction. When people see their favorite product is out of stock, they get disturbed. You make your customers happy by ensuring stock levels even in peak times. It increases consumers’ trust and loyalty. 

Enhanced Order Completion: 

By implementing the optimal Economic Order Quantity (EOQ), you can ensure the availability of required items for specific customer orders. This enables timely order fulfillment, increasing customer satisfaction and increased sales.

Quantity Discounts:

 By effectively planning and timing your orders, you can capitalize on advantageous bulk orders or quantity discounts provided by your vendors. This allows you to save on procurement costs and potentially improve overall profitability.

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Disadvantages of Economic Order Quantity:

Complex Mathematical Calculations:

One of the disadvantages of Economic Order Quantity is its reliance on intricate algebraic calculations, which can be challenging for small business owners with limited math skills. Effective implementation of the Economic Order Quantity model also necessitates comprehensive data analysis and calculation of various figures. 

However, overcoming these mathematical complexities allows businesses to determine the optimal inventory quantities per order, minimizing costs and maximizing profit margins. 

Assumptions and Limitations:

The Economic Order Quantity model is based on certain assumptions that may not always hold in real-world scenarios. It assumes a consistent demand for the business’s product and the immediate availability of items for restocking, failing to account for seasonal or economic fluctuations. 

Moreover, One of the major disadvantages of Economic Order Quantity as it assumes fixed costs for inventory units, ordering charges, and holding charges. Continuous monitoring of inventory levels is necessary for effective implementation. 

Other disadvantages of Economic Order Quantity are:

  • It does not make it convenient for seasonal and economic fluctuations. 
  • Additionally, the basic disadvantages of Economic Order Quantity is it is primarily designed for businesses dealing with a single product and does not accommodate the combination of multiple products within the same order.

Factors you need to analyze EOQ:

The economic Order Quantity model is invented with three variables: holding costs, order costs, and demand.

Holding costs (H):

It refers to every cost related to holding extra inventory in the warehouse. It includes logistical costs, material handling expenses, insurance costs, warehousing costs, depreciation, and inventory write-offs. 

Ordering costs (S):

Setup costs or ordering costs refer to every cost related to purchasing the inventory, including the cost of packaging, handling, shipping, and delivery. 

Annual demand (D):

By checking previous orders and sale data, one can find out how many sales you have done in a year.

Having an extra inventory can increase your holding cost, while purchasing a smaller amount can increase your setup costs. The Economic order quantity model helps you find the quantity that reduces both the costs. 

Calculate Economic Order Quantity:

No, you have to manually deal with the definition of Economic Order Quantity, although it’s possible if it doesn’t require a lot of calculations.

Small business owners generally prefer online calculators, which require you to input the cost of living, demand, etc. Not all calculators are created equal, and the optimal order quantity formula may vary depending on the software you are using.

 In some situations, the calculator may need more than a single type of input, which means you should prepare your expenses so the calculation doesn’t take long.

Factors to optimize inventory:

Big sales or seasonality can affect inventory accuracy. In such cases, you can follow other methods to optimize your inventory. Such as;

Reorder Points:

Most sellers manually check inventory levels for reordering products, which is lengthy. Instead, you can set reorder points that automatically order your products after hitting a certain level. Any inventory management program or 3PL like AMZ Prep makes this easier.  

Tracking of Real-time inventory:

You can easily monitor control stocks and check whether you store your products in the warehouse by real-time tracking. You can also know the number of products that will be shipped and make faster ordering decisions. 

Safely stock:

Many times sellers face a situation where demand increases, but they don’t have enough inventory. A safe stock refers to the extra inventory outside the expected needs. It is also used during peak seasons like flash sales or holidays. 

Advantages of Economic Order Quantity in Minimizing Costs:

When you calculate economic order quantity, you determine the optimal order size that maximizes profitability for your business.

Using this calculation, you can eliminate guesswork and avoid stock-outs or excessive ordering issues.

Leveraging the data and figures from the economic order quantity calculation enables you to make informed and timely decisions regarding your organization’s inventory requirements.

The economic order quantity can significantly impact your business if you operate on a large scale, incur high inventory carrying costs, or deal with expensive inventory items.

Implementing the economic order quantity can greatly enhance your operations, improving productivity, efficiency, cash flows, and long-term profitability.

Conclusion:

There are several advantages of economic order quantity for businesses seeking to optimize their inventory management. By accurately calculating the EOQ, businesses can minimize costs, enhance customer service, and efficiently allocate resources. 

Despite the advantages of economic order quantity, it is essential to recognize the assumptions and limitations of the Economic Order Quantity model to ensure its effective implementation. 

By leveraging the advantages of economic order quantity and understanding its drawbacks, businesses can make informed decisions that improve profitability and operational efficiency. When you order the actual inventory units, you reduce costs and prevent stock-outs so that you can operate your supply chain smoothly.

FAQ

Questions About
Economic Order Quantity

How to calculate EOQ?

EOQ is a formula used to determine the optimal order quantity for a product to minimize inventory holding costs and ordering costs.

 

The formula of EOQ is,

 

Economic order quantity = square root {2 (setup costs) *(demand rate)} / holding costs

 

EOQ= √2DS/H

 

Where D denotes as demand rate (amount sold/year)

 

S denotes setup costs (per amount, including handling and shipping)

 

H denotes Holding costs (per unit/year)

 

For example, let’s say that a company sells 10,000 units of a product per year, with an ordering cost of $50 per order and a holding cost of $2 per unit per year. Using the formula above, the EOQ would be:

 

EOQ = √[(2 x 10,000 x $50) / $2] = 1,581 units

Why is EOQ important?

EOQ is important because it helps you determine the amount of inventory you need so that there will not be any overstocks or understocks.

 

Here are some of the reasons why EOQ is important:

 

Reduces inventory costs: 

EOQ helps businesses to minimize their inventory holding costs. 

 

Reduces ordering costs:

 EOQ also helps businesses to minimize their ordering costs by reducing the frequency of orders and the associated costs. 

 

Improves cash flow: 

EOQ helps businesses to optimize their inventory levels and ordering schedules, which can improve cash flow by reducing the amount of capital tied up in inventory and reducing the need for frequent orders.

 

Increases efficiency: 

EOQ can also help businesses to increase their efficiency by reducing the amount of time and effort spent on ordering and receiving products.

 

Improves customer service: 

EOQ can help businesses to improve customer service and satisfaction.

How does EOQ work?

EOQ is a model that helps businesses determine the optimal order quantity for a product to minimize inventory holding costs and ordering costs. 

 

By calculating setup costs, holding costs, and demand rates, you can get EOQ. And you will purchase only that number of products. 

 

EOQ works by balancing the costs associated with holding inventory (i.e., inventory holding costs) and the costs associated with ordering inventory (i.e., ordering costs).

 

 

It’s important to note that EOQ is a model that assumes a constant demand rate, constant lead time, and no stockouts

 

What are the components of EOQ?

The components of EOQ are:

 

Annual demand: 

 

This is the total quantity of the product that is expected to be sold or used within a year. It is important to accurately estimate the annual demand to calculate the EOQ.

 

Ordering cost per order: 

 

This is the cost associated with placing and receiving an order, such as shipping, administrative costs, and labor. It includes both fixed and variable costs.

 

Holding cost per unit per year: 

 

This is the cost associated with storing the product, such as rent, utilities, insurance, and handling costs. It is the cost per unit of inventory held for one year.

 

 

EOQ = √[(2 x Annual Demand x Ordering Cost per Order) / Holding Cost per Unit per Year]

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Blair Forrest

Blair Forrest

Blair Forrest is the CMO of AMZ Prep. Blair helps provide consulting and guidance through our articles, guides, and other resources to help growing eCommerce & Amazon FBA businesses master their logistics and fulfillment.

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