When a business buys and maintains inventory, it is crucial for them to place orders in amounts that best fit its needs and that’s where Economic Order Quantity (EOQ) plays a key role.
Consider two scenarios here.
- If the orders are extremely large, a business has to bear storage and inventory expenses.
- If the orders are small, a business won’t be able to meet its customers’ needs.
And EOQ (Economic Order Quantity) helps find that sweet spot for a business where it maintains an ideal order size while meeting customer demand and maximizing profitability.
What is Economic Order Quantity (EOQ)?
Economic Order Quantity (EOQ) is the level of inventory that allows companies to save money. It shows how much material a business should order and stock upfront to minimize inventory costs and risks.
The idea behind EOQ is to help a business buy enough stock to meet the demand plus a buffer for unforeseen events such as a spike in sales or delays in production or shipping.
In simple words, Economic order quantity (EOQ) is a mathematical equation to determine the optimal order quantity for a given demand forecast. The EOQ equation calculates the optimal number of units to order when you can accurately predict demand and inventory costs. It also considers the ordering costs and inventory carrying costs, which are functions of the total number of units ordered.
Note: EOQ is also known as Economic Order Quantity, Economic Lot Size, or Optimal Control Point.
EOQ is commonly used in manufacturing industries where it’s essential to minimize inventory carrying costs by reducing the duration products sit in storage before being sold or used. EOQ can also be used in other industries like construction, retail, and transportation, with similar concerns about carrying costs.
How EOQ (Economic Order Quantity) Works
The basic concept behind EOQ is that it takes time for inventory to arrive from suppliers and then be stocked in warehouses before you can sell it to customers — called carrying cost.
It makes sense to minimize those costs by ordering only what you need in each shipment rather than buying more than you need at once just in case there’s a sudden spike in demand (which could happen).
The reason you should care about EOQ is this — if you don’t have enough inventory on hand, your customers may not be able to find what they want when they want it — and that means lost sales. If you have too much inventory on hand, however, you’ll end up spending money unnecessarily.
EOQ (Economic Order Quantity) Formula
To ensure you are not overbuying, you must thoroughly understand the Economic Order Quantity (EOQ) formula.
The EOQ formula helps companies minimize their inventory carrying costs by buying products in large enough quantities and at a reasonable price to sell quickly without having too much on hand at any given time.
There are various ways to calculate EOQ:
|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)
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] = √  = 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)
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.
Why is Economic Order Quantity Important
The importance of economic order quantity (EOQ) can be seen in its ability to help buyers make informed decisions. Since the reduction in inventory costs outweighs any extra costs incurred through stockouts, this method provides decision-makers with a rational way to assess the profitability of stocking different amounts of inventory.
The benefits of economic order quantity are many, and these include:
- A broader selection of products: A company can offer a more comprehensive selection of products if it orders in bulk. This will help attract more customers and increase sales.
- Better inventory control: The company’s inventory can be controlled by ordering what is needed based on past sales trends. If there is any surplus after a certain period, it can be sold at a discount or donated to charity. It also helps avoid overstocking, resulting in wasted money due to spoilage or obsolescence (when an item becomes obsolete).
- Reduces the risk of running out of stock: The EOQ value tells you how many units should be ordered at one time so that there’s always enough stock on hand to meet customer demand without creating excess inventory. It reduces expediting costs associated with getting more products into your store quickly when needed.
- Helps save on cost: Minimizes carrying costs and wasted space only by ordering what’s needed for immediate sales rather than purchasing extra units just in case they sell out quickly or unexpectedly.
Limitations of Economic Order Quantity
The key limitation of EOQ is that it does not consider any costs associated with the setup of a new production run. For example, if a company has to invest in new equipment or hire extra labor to start a new production run, EOQ will not consider this.
EOQ also does not consider the cost of carrying inventory. Since the goal is to minimize total inventory costs, companies will sometimes choose to carry more inventory than they need rather than incur the setup costs associated with starting a new production run.
EOQ also assumes that demand is constant and predictable over time. If demand varies significantly, many companies will use a technique called “average cost pricing” instead of EOQ because average cost pricing takes into account these fluctuations in demand by charging more per unit when demand is higher (and less per unit when demand is lower).
Yet another limitation of economic order quantity is that it doesn’t consider other factors, such as customer demand or competitor behavior. Therefore, it may not be able to optimize your overall business results if you are also considering other factors. Another limitation is that it only works for products that are sold in large quantities at a time.
Businesses have to deal with many challenges and make tough decisions every day. One of the most critical decisions a company must make is how much to order for stock. This is because if you order too little, you may be unable to keep up with customer demand or, worse, lose customers because of a lack of stock. On the other hand, if you order too much, you end up wasting a lot of money.
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