Economic Order Quantity (EOQ) is a measurement used in Operations and Supply Management. As a company grows, along with the size of its inventory, the cost of holding the inventory rises, and it becomes critical to find efficient stock management and ordering systems for when stocks begin to deplete. The EOQ formula is an important cash flow tool for inventory management and efficiency, as it calculates the ideal order quantity for a company to keep inventory costs to a minimum.
Applying EOQ to Your Business
Once calculated, the EOQ formula can determine your company’s inventory reorder point. If applied to your company’s business processes, this streamlines inventory management. The formula raises the alert for a new order to be placed when a certain stock level is reached. The formula has also already calculated the ideal number of units to order. The application of this formula avoids situations whereby inventory is allowed to go out of stock, and customer orders are forced to be put on hold.
Calculating Your EOQ – The Economic Order Quantity Formula
If your company uses an ERP, these calculations may be handled for you. If not, you can simply locate the below variables from your inventory management system and enter the numbers into the below formula.
Economic Order Quantity = √(2SD/H)
What are the components of the EOQ Formula?
D: Annual Quantity Demanded
Q: Volume per Order
S: Ordering Cost (Fixed Cost)
C: Unit Cost (Variable Cost)
H: Holding Cost (Variable Cost)
i: Carrying Cost (Interest Rate)
Try out this spreadsheet template to calculate EOQ for specific products:
Free Economic Order Quantity (EOQ) Template
Calculating the Ordering Cost
The number of annual orders for a company can be obtained by dividing the annual demand by the volume per order.
Number of Orders =D÷Q
A company may have orders with fixed costs, which are independent of the number of units (S). We can calculate this annual ordering cost with the below equation:
Annual Ordering Cost =(D÷Q) x S
How to Work Out Your Holding Cost
Inventory costs may arise from direct storage costs, but the holding cost can also be expressed as an ‘opportunity cost’: costs which are incurred by holding inventory instead of investing those funds elsewhere.
This is why we can present the holding cost per unit within the following equation:
H=iC
Here, the holding cost per unit is multiplied by the interest rate.
If we assume that demand for units is constant, and therefore stock depletes at a constant rate throughout the year, we can find the holding cost of the inventory by calculating the sum product of the inventory at any instant and the holding cost per unit.
Annual Holding Cost=Q ÷2X H
Economic Order Quantity Formula – Example
For company X, annual ordering costs are £20000.
The annual quantity demanded is 2000 and the holding cost is £4000.
Economic Order Quantity is Calculated as:
- Economic Order Quantity = √(2SD/H)
- EOQ = √2(20000)(2000)/4000
- EOQ = √14142.14
- EOQ = 118.92
Therefore for this company, the ideal order quantity for efficient inventory management would be 118.92 units, which we can round up to 119 units.
The Advantages of Knowing and Applying Your EOQ
Without an inventory management technique such as EOQ, companies tend to have an imbalance of inventory, whether that is holding too few units during times of high demand, or an excessive number during a time of low demand. A company with efficient inventory tracking maximises their profit and space, creating new opportunities for funds to be placed in other areas of the business.
As a business grows and managing the inventory of high volume or expensive units becomes a priority, calculating a company’s EOQ becomes more important, and the formula’s application has a greater value to maximise profit margins.
As all businesses look to reduce waste, applying an EOQ formula will cut down on obsolete inventory. This is particularly crucial for companies which hold perishable stock.
Are There Any Limitations Of EOQ?
The EOQ formula assumes that demand for units is constant throughout the year. It also assumes that holding costs and ordering costs remain consistent. Therefore, the formula is fallible to business changes such as seasonal fluctuations in inventory costs or changes in consumer demand. The EOQ may be best, then, for an established business with reliable order units year on year.
Key Takeaways: Why Is It Important To Know Your Company’s EOQ?
- Knowing your inventory reorder point leads to a better understanding of when stock needs to be ordered.
- Stock management systems implemented from an EOQ formula lead to improvements in customer service, ensuring that stock is always available.
- Holding an accurate calculation of units sold in a given time period ensures excessive units of inventory are not held in storage, avoiding unnecessary holding costs.
With over 50 years of experience in distribution and warehousing, here at Breakwells, we are the haulage and storage experts in the West Midlands. At our modern storage facility in Kidderminster, you can benefit from both 24/7 CCTV monitoring and the expertise of knowledgeable and professional warehouse staff. Whether you are looking to store individual items or full container loads at affordable prices, get in touch today.