What is Economic Order Quantity?
Economic Order Quantity, also known as EOQ, is a widely used inventory management technique that helps organizations determine the optimal level of order quantity for a particular item, which minimizes the total inventory costs. The primary goal of EOQ is to provide a balance between the costs associated with ordering and holding inventory efficiently. EOQ is useful for businesses in order to reduce costs and keep adequate stock levels in order to meet customer demand while minimizing all the related costs associated with holding excess inventory. EOQ is a valuable tool for optimizing inventory management, but it is based on simplifying assumptions that may only hold in some situations.
Geeky Takeaways:
- EOQ helps in finding the balance between holding costs and ordering costs.
- The model takes into account factors such as carrying costs per unit, demand rate, and ordering costs.
- Implementing EOQ principles can lead to improved efficiency, cost savings, and better customer service by ensuring that businesses maintain optimal inventory levels.
How does Economic Order Quantity Work?
Economic Order Quantity (EOQ) is an inventory management system that works by helping the organization determine the optimal order quantity for a particular item, inventory, or raw material. EOQ helps in balancing the costs associated with ordering and holding inventory to minimize the costs for the organization. Here’s how EOQ works in practical terms,
1. Units Consumed During the Year (A): The organization has to determine the annual demand for the product. This is the anticipated quantity of the product that the business is expected to use or sell in a year.
2. Ordering Costs (O): The organization has to determine and calculate the cost incurred each time an order is placed. The major chunks of costs include administrative, transportation, and other incidental costs related to the inventory or raw material procurement process.
3. Holding Costs or Carrying Cost (C): The organization has to determine the annual holding cost per unit of inventory. This includes all incidental costs like warehousing, insurance, security, and the opportunity cost of tying up capital in inventory.
4. Unit Cost: The organization should know the cost of each unit of inventory.
Once all the factors are analyzed, EOQ will help out the organization by providing the optimum level of inventory or raw material that shall be ordered, where both the carrying and ordering costs of inventory shall be the lowest.
[Tex]EOQ=\sqrt{\frac{2DS}{H}}[/Tex]
here,
- D is the demand for the product (in units) over a given period.
- S is the ordering cost per order.
- H is the holding cost per unit per year.
Why is Economic Order Quantity Important?
1. Improved Order Fulfillment: When a business is in need of a certain item or inventory to procure an order, an optimal level of EOQ ensures the product is on hand, which in turn helps the organization get the order out on time and cater to customer needs. This helps to enrich the customer experience and lead to increased sales.
2. Less Overordering: An accurate forecast about an organization’s total consumption and when the organization will be in need of it helps the management avoid overordering and deploying too much working capital in inventory.
3. Less Waste: More optimized order schedules help an organization cut down on obsolete inventory, particularly for businesses that are engaged in holding perishable inventories, as it can result in dead stock and waste.
4. Lower Storage Costs: When the ordering matches the actual demand of the organization, it helps to process the optimal level of inventory to store, avoiding related costs like utility, security, insurance, and other related costs.
5. Quantity Discounts: When an organization properly plans and times the inventory or raw material, it allows the organization to take advantage of the best bulk orders or quantity discounts offered by the suppliers.
What Economic Order Quantity Can Tell You?
1. Ideal Order Size: Economic order quantity tells organizations the ideal order size for every raw material and inventory they should buy. This helps the management to deploy only the required funds in inventory and avoid situation of over deployment of working capital.
2. Demand Assumption: The EOQ formula makes the assumption that the annual demand for a product is relatively flat. Management has to carefully ascertain the demand of the product carefully along with the demand fluctuations.
3. Optimal Level of Quantity: EOQ provides an organization with the desired optimal quantity level of inventory and raw materials. This optimal level of quantity which should be ordered which minimizes the ordering cost and storage cost.
4. Helps in New Business: If an organization is in a growing business, the management has to adopt the changing variables carefully to outline an optimal EOQ. EOQ may be ideal for calculating the order size, as the numbers could change frequently. Once an organization has calculated EOQ, they should know the optimal number of orders per year and the ideal order size.
5. Calculation of Other Market Matrices: Organizations may also adapt the EOQ model to factor in pricing discounts, backorders, defective items, and more, which helps the management in carrying out price negotiations and plan for effective inventory management.
6. Supply Chain: EOQ also helps the organization craft a flawless supply chain for the business. Crafting a supply chain helps the management to efficiently handle and manage the inventory in the most efficient manner with reduced cost and quality control.
Example of Economic Order Quantity
Example 1:
Calculate the EOQ from the available particulars,
- Consumption of material per annum: 10,000kg
- Cost of making an order: ₹25
- Cost of raw material per kg: ₹5
- Storage cost: 10% on average inventory
Solution:
D = Unit Consumed = 10,000
S = Ordering Cost = ₹25
H = Inventory Carrying Cost= 10% of 5 = ₹0.5
[Tex]EOQ=\sqrt{\frac{2DS}{H}}[/Tex]
[Tex]EOQ=\sqrt{\frac{2\times 10,000\times 25}{0.5}}[/Tex]
[Tex]EOQ=\sqrt{\frac{5,00,000}{0.5}}[/Tex]
[Tex]EOQ=\sqrt{10,00,000}[/Tex]
EOQ = 1,000
Here, the EOQ = 1000 Kg, which represent the optimum size of an order where the carrying cost and ordering cost will be minimum.
Example 2:
Compute EOQ, when a retail store sells 20,000 units of a certain product annually. The cost to place and process each order is $50, and the holding cost per unit per year is $2.
Solution:
D = 20,000 units (annual demand for the product)
S = $50 (ordering cost per order)
H = $2 (holding cost per unit per year)
[Tex]EOQ=\sqrt{\frac{2DS}{H}}[/Tex]
[Tex]EOQ=\sqrt{\frac{2\times 20,000\times 50}{2}}[/Tex]
[Tex]EOQ=\sqrt{\frac{20,00,000}{2}}[/Tex]
[Tex]EOQ=\sqrt{10,00,000}[/Tex]
EOQ = 1,000
Limitations of Economic Order Quantity
1. Poor Data: EOQ is based on the accuracy and reliability of the data; this is also one of the biggest challenges in determining EOQ. Manual or, for that matter, automated data that is inaccurate may lead to inaccurate calculations.
2. Outdated Systems: Old and outdated systems may have incomplete data and may lead to missing out on potential savings by EOQ. An effective inventory management system, or ERP, can solve this problem by reconciling inventory and analyzing demand trends.
3. Business Growth: The EOQ formula is ideal for businesses that have consistent inventory needs. In a fast-growing business, relying on EOQ can lead to inventory shortages as it is unable to project surge orders.
4. Inventory Shortages: If an organization relies on this method, it often generates smaller quantities of inventory and raw materials. If the management is too conservative with the calculations, they could wind up under-ordering.
5. Seasonal Needs: The seasonality factor can make EOQ more challenging. This is because there could be major changes in customer demand throughout the year, and the EOQ has to be carefully calculated by including the demand trends as well; otherwise, the result might not be effective.
Economic Order Quantity- FAQs
What is EOQ?
Economic Order Quantity, also known as EOQ, is a widely used inventory management technique that helps organizations determine the optimal level of order quantity for a particular item, which minimizes the total inventory costs. The primary goal of EOQ is to provide a balance between the costs associated with ordering and holding inventory efficiently.
What are the factors impacting EOQ?
- Units consumed during the year (A): The organization has to determine the annual demand for the product. This is the quantity of the product that your business expects to use or sell in a year.
- Ordering Costs (O): The organization has to determine and calculate the cost incurred each time an order is placed. This includes administrative costs, transportation costs, and other expenses related to the procurement process.
- Holding Costs or Carrying Cost (C): The organization has to determine the annual holding cost per unit of inventory. This includes all incidental costs like warehousing, insurance, security, and the opportunity cost of tying up capital in inventory.
- Unit Cost: Know the cost of each unit of inventory.
Give two limitations of EOQ.
- Poor Data: EOQ is based on the accuracy and reliability of the data; this is also one of the biggest challenges in determining EOQ. Manual or, for that matter, automated data that is inaccurate may lead to inaccurate calculations.
- Seasonal Needs: The seasonality factor can make EOQ more challenging. This is because there could be major changes in customer demand throughout the year, and the EOQ has to be carefully calculated by including the demand trends as well; otherwise, the result might not be effective.
Give two uses of EOQ.
- Improved Order Fulfillment: When a business is in need of a certain item or inventory to procure an order, an optimal level of EOQ ensures the product is on hand, which in turn helps the organization get the order out on time and cater to customer needs. This helps to enrich the customer experience and lead to increased sales.
- Less Overordering: An accurate forecast of what an organization needs and when it will need it helps to avoid overordering and tying up too much working capital in inventory.
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