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The Economic Order Quantity (EOQ) - What It Is and How to Use It
Inventory management is one of the most challenging aspects of running a commerce business. A business must consider many variables when determining how much inventory to order. That’s where economic order quantity (EOQ) comes into play.
EOQ can be one of the most effective ways to reduce overhead expenses and manage orders in an optimal fashion. Whether you are already using EOQ to manage your inventory or are simply looking to improve your operating efficiency, this article will tell you everything you need to know about EOQ, how to calculate it, and how to use it correctly.
What is Economic Order Quantity (EOQ)
Economic order quantity or EOQ refers to the optimal amount of inventory that a company should order at a given time to minimize the cost associated with receiving and holding inventory while still satisfying demand. Simply put, it is the optimal number of inventory orders. EOQ takes into account ordering and holding costs, vendor volume incentives, and demand.
You can see from the graph below that there is an inverse relationship between holding cost and ordering cost. As order volume increases, the cost to hold it also increases, but the total ordering cost goes down. This is because vendors often offer a lower cost per unit when larger volumes of products are ordered. But as the graph indicates, there is a point of diminishing returns where the ordering cost savings is surpassed by the new costs of holding the additional inventory. EOQ is the point where these costs intersect.
Image source: Blue Cart
EOQ empowers inventory managers to make the most informed possible decisions about ordering and managing inventory. While many ERP systems will automatically calculate EOQ on your behalf, smaller businesses still calculate it themselves.
Benefits of Using EOQ
While EOQ ultimately can help improve your business's bottom line by reducing expenses, it also offers various other benefits that we have highlighted below:
- Reduces the cost of inventory by ensuring that the right amount of inventory is on hand at all times
- Ensures that businesses have the necessary inventory on hand to meet customer demand without incurring excessive carrying costs
- Helps businesses avoid stockouts by ensuring that sufficient inventory is available to meet customer demand
- Reduces storage costs by reducing the amount of inventory that needs to be stored.
- Improves the time it takes to fulfill orders
- Improves overall efficiency and accuracy by giving inventory managers a data-driven indication of how much to order
- Simplifies inventory management by reducing the number of SKUs that need to be managed
What is Included in the Economic Order Quantity
The economic order quantity formula considers three primary factors: holding costs (also referred to as carrying costs), order costs, and annual demand.
Holding Costs or Carrying Costs
Holding cost refers to the cost of holding inventory or the amount of money a merchant must pay to store unsold inventory. On its own, holding costs can tell an inventory manager how long they can keep inventory before they lose money on it. But holding costs are also a component of the EOQ formula.
The formula to calculate holding or carry costs is as follows. The final value will be expressed in the form of a percentage.
Carrying costs = (employee salaries + opportunity costs + depreciation costs + storage costs ) / Total value of annual inventory
Annual demand is the expected number of orders you can expect to receive based on product demand. To understand demand, you need to have annual sales in units. Ideally, you take into account any seasonality or initiatives that will impact this number to arrive at a forecasted number of unit sales.
The demand component proves to be a limiting component of traditional EOQ calculations because it assumes flat sales throughout the year without accounting for seasonality or any predictable fluctuations in sales throughout the year.
Order costs are the total cost associated with ordering and receiving an order. This number should account for the cost of the product as well as shipping and handling
How to Calculate Economic Order Quantity
To calculate EOQ, you will need the following items:
- Cost of placing and receiving an order (S)
- Annual sales in units (D)
- Holding costs per year per unit (H)
The formula to calculate EOQ is as follows:
EOQ = √[2 x (annual sales in units x order cost)] / (holding costs per unit per year)
Or, more simply outlined:
EOQ = √(2DS/H)
While you should be able to get all of these items from your inventory management system, there is another formula you can use if you don’t have all of these on hand.
For this alternative calculation, you will need:
- Costs of placing and receiving an order (S)
- Annual Sales in Units (D)
- Carrying costs expressed as a percentage of inventory value ©
- See above for the calculation
- Purchase price per unit (P)
This formula for economic order quantity is shown below:
EOQ = √(2 x cost of placing an order x annual sales in units)/(carrying costs x purchase price per unit)
EOQ = √ (2 X F x S) / (C x P)
Keep in mind that other factors contribute to how often purchase orders are issued outside of EOQ. When placing orders, inventory managers must also consider any lead times and MOQs (minimum order quantities) the vendor has in place, as these factors are not accounted for in the EOQ formula alone.
How to Calculate EOQ Example
To help you better wrap your head around the EOQ calculation and understand how to use it, we have put it into an example.
A water bottle manufacturer sells 10000 water bottles per year. Each cost per order is around $2 and the cost to hold each unit for a year is $5.
If we use the first formula above, we have the following information:
- Costs of placing and receiving an order (S) = $2
- Annual sales in units (D) = 1,000
- Carrying or holding costs (H) = $5
When we put that into the formula, we get:
EOQ = √(2 x 1,000 x $2) / $5 = 28.28
This means that the ideal order quantity for the water bottle manufacturer is 29 water bottles. Because they sell 1,000 throughout the course of the year, they will need to make this purchase 34 times per year, or roughly once every 11 days.
Why is EOQ important?
If you are a merchant or product-oriented business, EOQ is important because it helps you maximize your costs by reducing overhead expenses. Businesses that deal with inventory must walk the fine line between having too much inventory to hold and not having enough to meet order demands, and economic order quantity helps mitigate this challenge.
What are the Limitations of Economic Order Quantity?
While EOQ certainly helps merchants and product companies better manage their inventory, it is not a perfect model and makes assumptions that are flawed. Some disadvantages of EOQ are listed below:
Assumes constant order volume
The EOQ calculation assumes constant order volume throughout the entire year. This is especially problematic for businesses with seasonal cycles. It is also not ideal if your business undergoes cost changes or varying lead times.
One way to combat some of these challenges is by re-calculating EOQ often, for instance, on a monthly basis and using inputs that are adjusted for a given month. For instance, if you are expecting an uptick in a demand in a given month, you can include your projected sales for the month annualized (multiplied by 12) and use that to determine your EOQ at that time.
Doesn’t account for expiration dates
The EOQ formula does not account for products that must be disposed of due to expiration if you have perishable products.
Can cause inventory shortages if inputs are not forecasted properly
While rapid growth is a great problem, it can create issues with EOQ calculations if you don’t accurately forecast your annual demand. If you undershoot your annual sales, it can cause you to run out of stock and experience low inventory.
Who Should Use Economic Order Quantity?
Generally speaking, EOQ will best serve larger businesses with at least one year of clean data to go off (preferably more). You should also have a solid understanding of each of the metrics that contribute to economic order quantity.
If you have to guess how many units you will sell or you are not 100% sure what it costs to hold an order, EOQ will not deliver the value you’re looking for. If anything, you will be more likely to miscalculate your EOQ and run into an inventory shortage.
How to Manage Your Inventory More Effectively
Implementing an enterprise resource planning (ERP) tool like NetSuite can help you get a birds-eye view into the key metrics that contribute to EOQ and all other factors that influence inventory changes. These tools can track your inventory automatically and calculate EOQ on your behalf. The benefits don’t stop there. You can fulfill orders from multiple locations, automatically replenish orders, get key insights into inventory variables, and so much more. If you’re interested in implementing a new ERP system at your organization, get in touch with us today.