Importance Of Economic Order Quantity Formula in Inventory Management
When reordering products, most businesses place orders according to their present business needs rather than determining the reorder quantity method. By optimizing Economic Order Quantity Formula, one can determine their reordering way and pay for the exact products.
EOQ denotes the exact order amount a company needs to purchase to minimize its 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.
What is the Economic Order quantity?
Economic order quantity 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 the EOQ formula. 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.
Economic Order Quantity Formula:
The Economic Order Quantity Formula 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 calculating 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: it 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
Example of Economic Order Quantity:
An example is the best way to understand how to how would you compute EOQ. Here is an example for better understanding:
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.
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.
Advantages of determining EOQ:
Calculating the EOQ for your company offers several advantages 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 to using the EOQ formula, such as;
Reduce inventory costs:
Storing extra products in inventory can increase your storage costs. It also depends on how you order, how many damaged products, and what products you should never sell. Continuously Ordering low-velocity products can increase your cost. EOQ helps you to determine the number of orders you need in a period.
Improve efficiency:
EOQ helps 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.
Minimize stockouts:
Economic order quantity 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:
The EOQ method increases your 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.
Disadvantages of determining EOQ:
- The formula of EOQ assumes that customer demand is constant. The calculation assumes that maintenance and ordering costs remain constant.
- It does not make it convenient for seasonal and economic fluctuations.
- It is for one product business; it doesn’t allow for multiple products in the same order.
Factors you need to analyze EOQ:
The economic Order Quantity Formula 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 sell 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 EOQ model helps you find the actual quantity that reduces both the costs.
EOQ formula calculator:
No, you have to manually deal with it using the EOQ method, although it’s possible if it doesn’t require a lot of calculations.
Small business owners generally prefer to use 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 of the sellers manually check inventory levels for reordering products, which is a lengthy process. 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.
Final Words:
Using the economic order quantity formula, you can expand your inventory management method. When you order the actual inventory units, you not only reduce costs but also prevent stockouts so that you can operate your supply chain smoothly.
Frequently Asked Questions:
Q. How to calculate EOQ?
Answer: 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)
Q. Why is EOQ important?
Answer: EOQ is important because it helps you determine the amount of inventory you need so that there will not be any overstocks or understocks. It also helps you to reduce your inventory costs.
Q. How does EOQ work?
Answer: By calculating setup costs, holding costs, and demand rates, you can get EOQ. And you will purchase only that number of products. It reduces your inventory costs and maximizes your profit.
Q. What are the components of EOQ?
Answer: There are three components: setup costs, holding costs, and demand rate.