What Is Economic Order Quantity and How Do I Calculate EOQ?
September 19, 2022
Calculating economic order quantity or EOQ helps companies optimize their inventory orders and reduce overall total inventory costs. This leads to a healthier cash flow, better inventory management, and little to no unnecessary expenses.
If you source your inventory from manufacturers and distributors, EOQ is a crucial metric for your business.
This guide digs deep into how economic order quantity is defined, how to calculate it for your business, its limitations as a metric, and more. Keep reading to learn how to successfully incorporate EOQ into your business operations and reap its benefits.
What Is Economic Order Quantity?
Economic order quantity (EOQ) refers to the optimum order quantity that a company must place to run its business efficiently.
The EOQ model was first developed by American production engineer Ford W. Harris in 1913 as a production-scheduling model. After going unnoticed for a good 75 years, the model finally got its due in 1988 and has since been used and developed to refine it to the EOQ formula we know.
Today, all types of businesses, from large corporations like McDonald’s to small mom-and-pop stores, use the EOQ to make sound purchasing decisions and maintain efficient operations.
EOQ is unique to every business and is calculated based on multiple factors and costs at any given time. Hence, this metric is represented as a formula that business owners and managers can use to estimate reorder points, minimize inventory costs, and plan cash flow.
What Happens When EOQ Is Not Considered When Ordering?
If EOQ is not considered or even calculated, there is a great risk for excessive stockouts and prohibitively high holding costs. Both involve miscalculating the number of inventory units necessary per order.
If your business orders inventory without EOQ, you may be wasting a lot of money without realizing it. You may also be keeping your business from optimizing its capital, labor, and other resources.
The Importance of EOQ for Your Business
Ordering inventory, receiving it, and holding it—there are many elements to account for when calculating inventory costs. Calculating EOQ and implementing it can help your business minimize the total costs poured into your inventory.
Here’s a breakdown of some ways in which EOQ can do this:
Improve Inventory Ordering and Minimize Costs
Every time a company orders units, it invests capital in transport, handling, and receiving the inventory. These expenses include the time spent by inventory teams sorting through the orders.
Economic order quantity tells the company the ideal number of units it needs to order and when to minimize additional expenditures and time spent on them.
While businesses can reduce ordering costs by simply ordering less inventory at once, this also increases the transport, offloading, and handling costs. It also increases the chances of stockouts and other related expenses.
Reduce Stockouts and Shortage-Related Costs
When a business can’t maintain stock levels to satisfy customer demand, it must spend extra to compensate for the shortage. For example, they will be forced to order an overnight shipment and pay expedited shipping fees just to bring in much-needed units. These extra expenses are not sustainable.
The company also loses its customers to competitors in the time it takes to replenish inventory. Each lost customer can be a tremendous blow to revenue and profit, and it will cost even more money to entice them back.
Many companies try to resolve stockout issues by simply ordering more units for their inventory. This is also supported by the economies of scale theory, which suggests increasing production scale to reduce costs.
But this isn’t a well-thought decision, either. This is because a large inventory requires a large storage capacity, thus increasing expenses. There’s also a higher risk of damage and loss if the stock isn’t handled well or doesn’t clear off the shelves in time.
Optimize Storage and Reduce Holding Costs
Storage and holding costs are accrued as long as the business remains in possession of units between ordering and delivery.
Some expenses (like storage) can be minimized, and other costs (like damaged goods) can be eliminated entirely with EOQ.
Customer Satisfaction and Increased Cash Flow
With EOQ, businesses know just how many units they must order to stay on top of demand while optimizing their storage and handling capabilities. EOQ also helps reduce labor and offloading costs.
With streamlined operations, companies can deliver top-notch customer service and products to their consumers. Additionally, reduced expenses clear up a portion of capital that can be invested in scaling and other development-related activities.
The main reason EOQ is so efficient and widely adopted is that it considers all related costs. It ensures your business runs its operations at optimum capacity, benefits from economies of scale, and generates minimum losses.
To truly understand the concept and deployment of the EOQ model, it’s best to implement it yourself. Here’s the complete step-by-step process for incorporating the EOQ formula into your business operations:
The EOQ Formula
The EOQ model is represented by the following formula:
EOQ = √ 2DS / H
Where variables EOQ, D, S, and H represent:
EOQ = Units of economic order quantity
D = Rate of consumer demand (unit quantity sold per year)
S = Cost of setting up or ordering inventory (calculated per order)
H = Holding cost for a single unit of inventory (calculated per unit per year)
This formula applies to businesses that do not produce but rather order their inventory.
If you manufacture your own products, check out the EPQ formula instead.
How to Calculate EOQ
First, calculate the exact values for these variables: setup costs, holding costs, and demand rate.
Here’s a breakdown of what these values entail and how to calculate them:
This refers to all costs accrued when ordering and setting up a single order of inventory. It includes costs of packaging, shipping, handling, sales tax, and any interest incurred by the company for credit purchases.
You can calculate the ordering or setup cost by dividing the total number of orders for a product in a year by the total inventory orders for that product in the same year.
Also known as carrying cost, it refers to a range of expenses spent on holding a particular product unit per year.
- Expenses for storage activities, such as rent, utilities, property taxes, and others
- Opportunity costs for tying capital in inventory instead of other money-making endeavors
- Cost of inventory insurance, security, maintenance, management, and damage risks
- Labor costs for handling, storing, and maintaining inventory
Add up all of these costs and divide the sum by the total number of product units. This should give you the holding cost of the product.
Demand rate refers to the number of units your business sells in a year.
If you have been selling inventory for more than a year, then you have complete data to calculate your demand rate. If you only have selling data for 6 to 7 months or less, you can use forecasting tools.
Here are a few forecasting tools you can use depending on the data you have:
- Trend projection
- Market research
- Sales force composite
- Delphi method
You can track this data using an inventory management platform like Nest Egg. It’s the one-stop solution to manage and organize your inventory using readily available information. You can track purchases, sales, and prices, and even use in-house tools to analyze data to gain insights for operational efficiency.
Calculating EOQ for Your Business
When calculating EOQ for your business, make sure to consider every product type separately and only use the variable values for each. These values cannot be applied widely to your entire inventory as the variables are very different depending on many factors.
To understand how to calculate EOQ for your business, check out this example:
A furniture store selling desks wants to determine the most profitable order quantity for its next purchase order. The store has determined that the ordering cost for each inventory order is $2,000 and the holding cost of a desk unit for one year is $40.
Sales predictions suggest that there will be a demand for 20,000 units of desks this year.
Here’s how the company can use the EOQ formula to determine what order to place:
EOQ = √ 2DS / H
According to the given variables for the furniture store, these variables will take the following values:
EOQ = Units of economic order quantity
D = 20,000
S = $2,000
H = $40
EOQ = √ 2 (20,000 x 2,000) / 40
EOQ = √ 2,000,000
EOQ = 1414.213 units per order
Hence, the furniture store needs approximately 1414 units for a single inventory stocking order.
Now, the total annual demand is 20,000 desk units. So, the company will have to divide annual stockings into parts. This can be calculated by dividing the total annual demand by the units ordered in a single stocking, i.e.
Number of EOQ orders for the year = Total annual demand EOQ per order
= 20,000 ÷ 1414.213
Hence, the furniture store needs to place around 14.14 orders for 1414.213 desks in that year to streamline operations and minimize inventory expenses.
Is a Small or Big EOQ Preferred?
Big and small EOQs can have benefits and drawbacks, but a higher EOQ is slightly preferable.
A big EOQ means an increase in product demand or setup costs. It also means fewer replenishment orders placed during the year. In contrast, a small EOQ suggests an increase in holding costs and multiple replenishment orders, which nets higher shipping costs.
Limitations of Using the EOQ
While the EOQ model is widely applied, its formula makes certain assumptions that do not apply to every business. These assumptions are:
- Factors such as demand, ordering cost, holding cost, and purchase order lead time remain unchanged for the accounted duration
- Order quantities remain the same for each reorder within the set period
- Inventory depletion occurs at a fixed, consistent rate
- The cost of inventory purchase for every order remains unchanged
The unpredictable nature of these factors makes EOQ calculations only partially accurate. But since these factors do not change too dramatically, the variances in the accuracy of EOQ are not so significant. Hence, it still provides the best possible estimate for optimizing inventory purchases.
When Can a Business Afford Not to Do the Math for EOQ?
There are circumstances when EOQ may not be a helpful metric. Some businesses may have too many promotional events, or seasonal spikes lined up for a certain portion of the year. Or there may be an unpredictable or especially erratic variable in the formula. In such cases, EOQ may be calculated, but reorder quantities should remain flexible to account for necessary adjustments.
For example, to bring back the previous furniture store scenario, the business owner can bump up reorder quantity for an upcoming promotional period based on a predicted increase in sales. This should increase their demand rate.
If they get a bulk order discount from their supplier, they can reduce their setup costs accordingly.
Businesses may also consider inventory management strategies such as just-in-time, lot for lot, or least unit costs, if their operations don’t support the EOQ formula.
Make EOQs Work for Your Business
EOQs are particularly useful for businesses with large inventories, high holding costs, or expensive units. With EOQ, your business can run more efficiently and undertake scaling and development plans sooner.
Here are some areas you can invest more time and money once your inventory operations are streamlined:
- Product development
- Scaling plans
- Customer service
- And more.
The Bottom Line
Economic order quantity is an irreplaceable tool for small and large businesses alike. The formula makes assumptions about many variable factors but still provides a reliable data point for efficient inventory and order management by minimizing total costs related to ordering, receiving and holding inventory.
Have more questions? GET IN TOUCH