Economic Order Quantity: Definition, Calculation and Benefits
Also known as optimum lot size, economic order quantity is a formula designed to find the optimal order quantity for businesses. In this way, companies can minimize their logistics, warehousing, and stock costs to a reasonable level. Business owners or partners are aware of the strong impact of the correct EOQ calculation to grow and manage companies’ profitability. So, they make significant investments in this department by acquiring related software or headcount. On the other side, the economic order quantity model requires a constant and continuous rate for demand. Without demand, it is impossible to calculate EOQ and optimize inventory. Because the EOQ model is meant to define the ideal order quantity a company should purchase for stock. Right here, it is helpful to say that the EOQ is not a reorder point. The calculation shows us how much to order products, not when to collect them. Shortly, the economic order quantity model gathers the costs related to a product, including production cost, demand rate, holding cost, ordering cost, and shortage cost. Combining these factors help balance all ordering costs ideally.
In our economic order quantity guide, we’ll help you understand:
- Objectives of the EOQ Calculation Factors
- Reducing Stock Costs
- Preventing Stockouts
- Maintaining Efficiency
- Saving Money
- Factors Needed to Calculate the EOQ
- Holding/Carrying Cost
- Order/Setup Cost
- How to Calculate the EOQ
- Pros Cons of Economic Order Calculation
- EOQ vs MOQ: What Is the Difference?
Objectives of the EOQ Calculation Factors
After giving a detailed economic order quantity definition, now it is time to list the objectives of the EOQ calculation. Calculating EOQ gives your business a positive effect since it means an efficient e-commerce supply chain with reduced costs. By calculating with a proper economic order quantity formula, you can benefit your company in several ways. Here are some of them:
Reducing Stock Costs
A Business’s inventory status says a lot about its profitability. Storing additional products in your warehouse can quickly increase your storage costs. In time, products start to get damaged for different reasons or pile up since they are not sold. If you are continuously reordering products with low velocity, you need an urgent EOQ calculation that will help you determine the ordering quantities.
You may be interested in; Safety stock is essential for every business. Calculating the safety stock formula helps companies avoid stock-outs and customer dissatisfaction. You can check our safety stock formula article to learn more about it.
How to find economic order quantity can help you better understand how much and how often you need to reorder. For example, it is better to order a particular amount depending on how much you sell in a given period. In this way, you can easily avoid stockouts by having the ideal amount of inventory on hold. After seeing the magical impact of the EOQ calculation on your cost-effectiveness, you’ll have a positive habit of calculating the economic order quantity for all your businesses.
Unlike many e-commerce businesses, instead of gut feelings, you need to order due to actual needs. Overall, when it comes to storing inventory, calculating EOQ can help you make better decisions. It is an intelligent way to quantify how much a product is needed on several cost variables.
By calculating economic order quantity to maintain ideal inventory management, you also have better profitability figures as a whole. It gives you a good hand in investing your money in your business’s other element and developing your company on its path.
Factors Needed to Calculate the EOQ
Businesses need three factors to apply the EOQ formula for their operations. Holding/Carrying Costs, Demand, and Order/Setup Costs are these factors that are necessary while calculating the EOQ. Let’s break down every one of them below as follows:
It is your total cost of holding stock. It is significant to reduce inventory costs to a minimum level for better supply chain management in the retail world. If you want to calculate the EOQ correctly, you need to know how much you spend on holding and storing cost per unit. The formula is simple:
(Storage Costs + Employee Salaries + Opportunity Costs + Depreciation Costs) / Total Value of Annual Inventory = Inventory Carrying/Holding Cost
Searching the historical order data, you can easily define how much demand you get for a product each year. And this number is necessary for you to calculate the EOQ.
It includes both the shipping and handling costs, and the calculation is done depending on the order. Setup Cost is the answer to “How much does an order cost per purchase?”.
How to Calculate the EOQ
Companies should plan their ideal order quantity smartly to minimize holding costs, shortage costs, and order costs. The economic order quantity is necessary for a company as it gives you the ideal number of orders you need to purchase at the end of the day. To decrease the perfect inventory cost, you need to know how to calculate the number of units to add to your list. The EOQ tries to guarantee that the no-more-no-less amount of inventory is ordered per batch. This way, companies do not have to reorder nor handle the excess inventory sitting on hand.
As mentioned above, you need to be aware of the setup, demand, and order costs to calculate the economic order quantity. For example, you cannot see your total setup cost without the information on packaging, delivery, shipping, and handling costs. On the other hand, warehousing, logistics, insurance, handling, and depreciation costs give you the total holding costs associated with storing additional inventory in the warehouse. In short, if you order significant amounts of stock, your holding costs will inevitably arise. Vice versa, if you contain smaller amounts of inventory more frequently, your setup/order costs will increase. The economic order quantity model is the balancer in between to minimize both types of expenses. The formula is as follows:
EOQ= The root of (2×S×D/H)
- S= Setup cost including shipping & handling
- D= demand (quantity sold per year)
- H= Holding Cost per unit & per year
Let’s explain EOQ calculation with an example. Say that you have a retail clothing shop that carries women’s skirts. You sell 1000 skirts per year. Your holding cost for a single dress in inventory is $5 per year and the fixed cost to place an order is $2. The EOQ formula here is the square root of (2 x 1000 skirts x $2 order cost) / $5 holding cost. The result is 28,3. It means that your ideal order size to minimize costs and meet demand is slightly more than 28 skirts. With the EOQ model, you will have a clearer idea about your perfect order, and holding amounts to manage your inventory better and sustainably maintain your profitability.
Pros & Cons of Economic Order Calculation
Every business, small or large, requires an efficient inventory system to maximize profit. Since inventory means ordering products and holding them in a suitable place, related costs should handle adequately. The economic order quantity model helps you organize your orders according to your annual selling figures and carries you to your primary target through shortcuts. Let’s have a look at economic order quantity benefits closer.
Minimize Storage Cost
One of the main advantages of the EOQ model is the customized recommendations provided related to the most economical number of units per year. For example, the model may suggest that you buy a larger quantity of fewer products to take advantage of the discount. On the other hand, it may point to more orders of fewer items to reduce holding costs.
Keeping enough inventory levels to meet the demand is a balancing act for many small businesses. The EOQ model provides you with specific numbers in a particular industry, how much stock to hold when to reorder it, and how many items to order. Since this makes the inventory available whenever needed, the re-stocking process will be smoother than before, and the customer service results will be better.
Avoid Excess Inventory
The EOQ model gives you the chance to have control over your products hold in the warehouse. Like how much to order, you also have an idea regarding how much you can keep your inventory for a specific time. It gives you a solid hand to prevent excess inventory along with deadstock.
After stating some main benefits of the EOQ model, let’s take a look at its disadvantages.
For those lacking math skills, it can be challenging to calculate the EOQ. Additionally, effective EOQ models require detailed data to calculate several figures. That’s why acquiring an EOQ software will be logical to avoid human error and complicated calculations.
On the market, there are always economic or seasonal fluctuations. Since the EOQ model assumes constant demand of a product and instant availability of items to be re-stocked, the result is again an assumption of fixed costs of inventory units, ordering charges, and holding costs. Also, the primary economic order quantity model may be ineffective and limited mainly by the assumption of a one-product business.
EOQ vs MOQ: What Is the Difference?
The terms EOQ and MOQ are both supplier-related. To better understand the difference between MOQ and EOQ, one should explain their definitions first. MOQ, Minimum Order Quantity, refers to the minimum amount that can order from a supplier. For example, if a supplier defines a MOQ of 1000 units of a specific product, you must buy at least 1000 units to deal with that supplier. By the way, do not forget to take a look at our blog post “Learn How to Earn More Setting Up Your Minimum Order Quantity!” if you are interested in growing your business and earn more!
On the other hand, the EOQ, that Economic Order Quantity, refers to the supplier’s costs associated with purchasing goods. In other words, it is the calculation to find the optimal order amount for businesses to reduce logistics costs, warehousing space, stockouts and overstock charges.
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