Economic Order Quantity EOQ Definition

The model supposes that the costs such as transportation expenses and warehouse rent either do not change or do not affect the ordering and handling costs, which is not entirely realistic. The Economic Order Quantity (EOQ) aims to determine the optimal quantity of products to be ordered. It has become a cash flow tool that can minimize the amount of cash and the inventory cost integrated into the inventory balance. The formula also calculates the inventory reorder point of an organization.

How inventory software can help put EOQ into practice

As mentioned above, your safety stock is the amount of product you keep on hand, above what you believe will sell, to ensure you don’t run out between orders. Calculating EOQ for each item in stock will help you determine the right amount that meets demand, with fewer products in your store. This is important, as holding inventory on-site results in additional real estate costs, security fees, utility bills, insurance premiums, and other related costs. Having too much inventory results in higher costs that take away from profits due to the cost of maintaining inventory and sometimes having to discard old inventory. Having too little inventory means a company is losing out on sales by not meeting demand. Economic order quantity helps ensure companies manage their inventories efficiently.

Ford W. Harris, a production engineer, designed the EOQ model in 1913. First of all, the EOQ model assumes that there is a demand certainty regarding that specific product. So, it ignores potential seasonal fluctuations and behavioral changes that can affect the annual market demand. Going back to the China example, here’s how it would all play out. According to Trump’s math, the 67% tariff on Chinese products would cause prices of those products to go up by 16.75%.

EOQ Formula in Action

For more seasonal-based businesses, or businesses for which demand has fluctuated, EOQ will be minimally useful. Nonetheless, it’s still good to have a general ballpark understanding of how much inventory you should have, subject to fluctuations and seasonality. If the demand for your products fluctuates, using the EOQ will give you inaccurate results.

Assumption of cash flow

Also called optimum lot size, EOQ helps you calculate how many units to order and when. The EOQ formula gives us a fair idea of the right amount of inventory. It also assumes that both inventory ordering and holding costs remain stable. Thus, the optimum number of hats Company X should order is 400 at one time. The EOQ is the optimal amount of inventory to minimize inventory holding costs, and ordering costs. Ordering costs include things like processing fees, shipping charges, and staff time spent placing orders.

Economic Order Quantity (EOQ): Formula & how to calculate

Customers are much more likely to return to a business that is reliable, with products consistently available. If your business experiences inventory shortages and cannot meet customer demand, you will lose revenue, and the customer will be less likely to return in the future. The EOQ calculation will ensure enough product is on hand, which can lead to increased sales. The formula will determine the optimal economic number of orders that a company should operate on in order to minimize inventory costs. EOQ is an important cash flow tool for management to minimize the cost of inventory and the amount of the economic order quantity formula assumes that cash tied up in the inventory balance.

Limitations of the EOQ Model

In other words, a 67% tariff on Chinese products would reduce demand for Chinese products by … also 67%. That could be a huge problem if you’re still waiting for clients to pay their bills and you don’t have $3,000 on hand. In that case, you may have to bite the bullet and order fewer cement bags—even if it means higher inventory costs in the long run. So how do you determine the optimal number of items to order at a time?

• This formula aims to identify the maximum number of units so that an organization can minimize its costs in terms of storing, taking delivery, and buying the units.
• And ordering more units at a time would make your storage cost higher.
• Stay updated on the latest products and services anytime anywhere.
• While the EOQ calculation model assumes there will be consistent demand for your product, and pricing will remain constant, reality is not usually that simple.
• In the next section, you may input your data into the economic order quantity formula, or follow the example provided below.
• So, those businesses need to minimize inventory volumes to the level where it still meets the market needs but does not create unnecessary costs.

Economic order quantity is best used with other inventory management techniques such as reorder point and safety stock. While the EOQ specifies the lot size of each order, the reorder point is used to determine when an order must be placed for it to be fulfilled on time. Safety stock, however, is the inventory buffer kept just in case for times of unusual demand. When you use the economic order quantity model can help you cut down on dead stock and obsolete or expired products. By calculating the optimal order quantity of each item, you will be more likely to sell it well before its best-by date.

For many companies, inventory is its largest asset other than its human resources, and these businesses must carry sufficient inventory to meet the needs of customers. If your business has complex ordering needs, the EOQ model could still be an efficient way to cut costs—but we’d recommend using inventory management software to calculate your EOQ automatically. Get started by checking out our top-recommended inventory management platforms. The biggest failing of the EOQ model is it assumes production costs and storage costs for your product are constant. When it comes to replenishment, it can be tricky to balance costs.

Assumptions under the EOQ method

• Consequently, EOQ is best applied to products in your inventory that are equally desirable throughout the year.
• Customers are much more likely to return to a business that is reliable, with products consistently available.
• Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.
• Yes, carrying costs, or holding costs, is one of three metrics you need to calculate economic order quantity.

This guide covers everything you need to understand EOQ, including its definition, benefits and advantages, and a basic calculation formula. From sole traders who need simple solutions to small businesses looking to grow. Today, there are many ERP/MRP systems available that are designed specifically for small businesses. These software solutions are affordable, easy to use, and provide small businesses with functionality that was previously available only for large enterprises. Thus, any business aims to have just the right quantity of inventory. S is the setup costs, which in problem was referred to as ordering costs.

Once stock levels hit a certain threshold, your system or staff reorder. EOQ helps you avoid over-ordering, so you’re not paying more to store excess stock. You also reduce the risk of being left with damaged or unsellable items. This formula shows you should multiply the demand rate by two, then multiply that by the ordering costs and divide by the holding rate.

Using the EOQ for inventory planning can help you meet demand while maintaining a reasonable inventory balance. While at first glance over-ordering may seem like a safer move, you may be tying up too much of your cash in physical stock during periods of low demand. However, EOQ is based on some assumptions and might not consider all the factors that affect a business. One can use it together with other methods to arrive at business decisions. As the name suggests, ordering costs occur every time the company places an order with its supplier.

If the cost per item is different every time you order, then the EOQ formula’s assumption of consistent production costs can be a massive thorn in your side. By finding the EOQ, you can achieve a sweet spot where you order enough to avoid stockouts but not so much that your holding costs skyrocket. You may think of EOQ not only as a useful model to manage your inventory but also as a way to manage your company’s cash flow. There are many companies for which inventory costs significantly impact their balance sheet.

As different vendors have unique production and shipping times, each item may have a different reorder point. As your business grows, you may consider implementing an automated inventory management system to keep track of stock levels, inventory costs, and order dates. The EOQ formula is the square root of (2 x 1,000 pairs x $2 order cost) / ($5 holding cost) or 28.3 with rounding. The ideal order size to minimize costs and meet customer demand is slightly more than 28 pairs of jeans.

The economic order quantity formula assumes that demand and costs remain constant. Consequently, EOQ is best applied to products in your inventory that are equally desirable throughout the year. These products should also cost the same amount to order, receive and maintain, no matter the month. For example, a popular item that was once in constant demand may fall out of style, or a business may need to ensure they have more Halloween costumes available for purchase in October. Holding an optimum inventory level is vital for any business because there are disadvantages to overholding and underholding inventory.