What Is Economic Order Quantity: Calculation and Benefits

Introduction

Effective inventory management is critical for any business’s success and profitability. Unfortunately, many businesses struggle with ordering the right amount of inventory. They either order less, leading to unmet customer demand and lost sales, or they overstock, tying up working capital that could have been utilized to meet other urgent business needs, while incurring increased holding and carrying costs. 

This is where the economic order quantity comes into play. EOQ refers to the process of determining the accurate order size for inventory purchase. It involves comparing the costs of holding and selling stock with yearly customer demand. By using EOQ, businesses can determine how frequently they should order, bringing down their overall inventory spending. 

This blog will discuss everything you need to know about the economic order quantity, including its meaning, formula, example, benefits and its limitations.

What Is Economic Order Quantity?

The economic order quantity (EOQ) helps businesses calculate the ideal quantity of units to purchase to minimize inventory costs. EOQ is crucial for inventory management as it helps the business determine the number of units it must add to each batch order in order to prevent stockouts or overstocking. 

Inventory management often comes with a lot of ambiguity. Businesses either have too much inventory, tying up their working capital, or they have too little, resulting in lost customers due to unmet demands. To remove such elements of guesswork when ordering stock, businesses need to implement the EOQ model for effective inventory management. 

By ordering the right amount of stock in every batch, businesses can avoid making orders too frequently or holding excessive stocks. Introduced in 1913 by Ford W. Harris, the EOQ model helps to establish order quantities that best fit businesses’ inventory needs and improve cash flows. 

Factors affecting EOQ

Numerous factors impact the EOQ in the supply chain. Demand variability, lead time, and price discounts, are some of them.

1. Fluctuations in demand 

One of the key factors impacting the EOQ results is changes in demand. If the demand for a product is constant and predictable, businesses would be able to calculate the EOQ with more accuracy. But if the demand fluctuates, it can lead to higher inventory costs and large order batches. 

2. Holding and setup costs 

Ordering a large amount of stock increases a business’s holding costs, while ordering in small quantities more frequently increases setup costs. Implementing an EOQ model helps businesses find the ideal quantity that minimizes inventory costs. 

3. Lead time 

Lead time refers to the duration between placing an order and receiving the inventory. Longer lead times call for bigger EOQs so businesses can have an uninterrupted supply of stock, and vice versa. 

4. Price discounts 

Discounts provided by suppliers or vendors also play a significant role in determining the EOQ in the supply chain. If vendors offer discounts for large order quantities, businesses should consider these discounts to reduce overall cost per unit. 

Formula For Calculating Economic Order Quantity (EOQ)

EOQ allows businesses to identify the optimal order quantity. The EOQ formula involves multiplying the demand rate (D) by ordering costs (S), multiplying the product by two and then dividing by the holding costs (H). Finally we take the square root of the resultant. 

Annual demand, carrying costs, and cost per purchase order, also called ordering costs or set-up costs, make up the EOQ formula. 

EOQ formula is as follows:

Where,

D = Annual demand rate or the number of units sold per year

S = Set up costs or order costs

H = Holding costs or carrying costs (also referred to as the cost of holding one inventory item in a year) 

Assumptions used in the EOQ formula

This EOQ formula is based on numerous assumptions, such as constant demand, no change in ordering or holding costs throughout the year, the absence of discounts, and more. 

• Constant demand: The EOQ formula assumes that the annual demand for inventory is accurately and easily predictable and will stay constant throughout the year. It does not consider any seasonal changes or variances in demand.
• Zero inventory residuals: The formula does not include any inventory residuals. So, when analyzing reorders, the stock is considered to be zero, fully exhausted or sold. 
• Consistent costs: Any increase in costs, like changes in logistics costs, a change in payroll amounts, or rising warehouse rents, will impact your costs and directly affect the EOQ calculations. However, EOQ does not include these holding or ordering costs that are constant throughout the year. 
• Does not consider lead time: Stock replenishment is assumed to happen instantaneously when the business reorders, and lead times are not included. 
• Excludes economies of scale: Businesses need to omit any economies of buying in scale and any discounts from vendors. 

EOQ Calculation Explained

EOQ is more about maximizing and minimizing problems. The goal is to increase the stock ordered while reducing the order and holding costs. For EOQ calculation, businesses must know how to derive the two inventory costs – setup costs, rate of annual demand, and holding costs. 

How the EOQ calculation works

A business has to determine the units consumed during a year. It is the quantity of stock that a business anticipates using or selling to customers in a year. 

It refers to all costs relating to ordering stock. It involves costs like packaging, shipping, delivery, handling fees, and salaries for employees working with inventory when it arrives. It is also called ordering costs but does not include the cost of purchasing the goods themselves. 

It refers to all costs relating to holding additional stock at hand, such as warehousing, logistics, insurance, material handling, inventory write-offs, and depreciation costs. It helps find out the capital that gets tied up in the inventory. To calculate the holding costs, we multiply the carrying cost (i) with the unit cost (c).

How to interpret the EOQ?

Here’s what businesses can derive from EOQ: 

• Ideal order size 

The economic order quantity helps a business find out the ideal order size for raw materials or inventory to be ordered. It also helps them allocate funds accurately to streamline stock levels and avoid erosion of working capital. 

• Anticipating demand

The EOQ calculation helps businesses make accurate predictions for the annual demand for products that are not performing well in the market. It aids the management in studying the patterns behind the changing demand and strategizing accordingly. 

• EOQ in supply chain management 

EOQ helps businesses find an optimized way of handling logistics to reduce transportation and carrying costs, which in turn brings down overall inventory costs. It helps a business control inventory quality and supply chain challenges while optimizing costs. 

• Calculation other metrics

Adopting EOQ models also helps businesses factor in discounts from suppliers, backorders, defective items, etc. This further helps the management carry out price negotiations and design robust inventory management.

• Determining the reorder points 

EOQ helps businesses determine a reorder point as this can prevent running out of stock and enable them to fulfill customer orders consistently. If a business faces stockouts, it will then have to struggle with shortage costs, which is basically the portions of revenues lost due to inadequate inventory and lost sales opportunities. 

• Solving cash flow problems 

The EOQ also addresses cash management issues by optimizing inventory levels. It helps businesses minimize both holding and ordering costs, maintain just enough inventory to fill in customer orders without excessive stock on the warehouse floor, and free up cash for operational needs. It also improve cash flows forecasting and budgeting accuracy by enabling businesses to frame a structured approach to inventory management and enhance overall financial management. To unlock more efficient and faster EOQ accounting, businesses can leverage technology to ensure seamless processing of closing inventory data. 

Example Of How To Use EOQ

Let’s take two hypothetical scenarios and find out the economic order quantity for both. 

Example 1

Suppose a company selling widgets wants to reduce their inventory costs by finding out the EOQ. 

EOQ = √2DS / H

DS = 10,000 × 50 = 500,000

EOQ = √2 x 500,000 / 2 

EOQ = √500,000

EOQ ≈707 units (rounded to the nearest whole number)

The EOQ for this company is approximately 707 units. This means that ordering 707 units per order would minimize the total inventory costs (holding costs + ordering costs) over the year.

Example 2

Let’s take an electronic company that sells electronic components and wants to find optimal order quantities for each batch.

EOQ = √2DS / H

DS = 15,000 × 60 = 900,000

H = i x C

H = $12 x 20/100

H = 2.40

EOQ = √2 x 900,000 / 2.40 

EOQ = √750,000

EOQ ≈ 866 units (rounded to the nearest whole number)

To reduce their inventory costs, the company needs to order 866 units for each batch. 

Benefits of Economic Order Quantity (EOQ)

EOQ is critical for businesses as it makes it easier to identify gaps in inventory management and prevent shortages or overstocking. Here are some benefits of economic order quantity:

• Improve order fulfillment
• Reduce excess ordering
• Reduce stock wastage
• Reduce storage costs
• Leverage quantity discounts 

1. Improve order fulfillment 

When a business needs to procure units to replenish stock for a particular order, EOQ helps ensure that the business orders only the optimal level of quantity and receives it on time to cater to customers. The timely replenishment ensures that there’s no wastage and demands are met on time. This ensures seamless customer experience and translates into increased revenues. 

2. Reduce excess ordering 

An accurate calculation of total inventory consumption and total order costs helps a business identify if they are overordering or putting too much of their working capital into stocking. 

3. Reduce waste 

EOQ helps identify more optimized order timelines that further help businesses reduce obsolete inventory. Businesses dealing with perishable items benefit the most from EOQ, as it ensures the business is not losing revenues due to dead stock or waste. 

4. Reduce storage costs 

Businesses can reduce inventory-related costs like utility, insurance, security, and loss in transit when their stock orders match the actual orders of their customers. 

5. Leverage quantity discounts 

When a business efficiently plans and effectively times the inventory or raw material orders, it allows them to negotiate discounts and other favorable payment terms with suppliers. This in turn improves cash flows while ensuring no working capital is blocked by excess stock.

Limitations of EOQ

Despite helping businesses streamline their inventory management and scale operations and sales seamlessly, EOQ comes with numerous challenges like poor data, outdated systems, inventory shortages, and ignorance of seasonal needs. 

1. Poor data 

The success of EOQ relies heavily on the accuracy and reliability of inventory data. Unfortunately, it often becomes a challenge for businesses to determine accurate stock-related costs and expenses, which further impacts the EOQ results. Moreover, manual collection and processing of data often leads to inaccurate calculations. 

2. Outdated systems 

Businesses still use legacy, outdated inventory systems that often give incomplete data and lead to misstatements in EOQ calculations. Companies need effective and robust inventory management software, or ERP, that can solve this problem by reconciling stock and giving accurate forecasts for customer demand. 

3. Inventory shortages

While EOQ is responsible for solving inventory shortages for businesses, it sometimes generates way too small quantities of stock and raw materials, resulting in understocking. If the business becomes too conservative with its EOQ calculations, it could wind up under-ordering. 

4. Dealing with seasonal needs 

One of the basic assumptions of the EOQ formula is that it does not consider any fluctuations in seasonality. This often makes it difficult for businesses to take into account the impact of seasonal changes on stock. 

For instance, if a company is selling seasonal products, say umbrellas, the demand for this product will be highest during the rainy season compared to the rest of the year. Ideally, businesses should be adjusting their EOQs to match the increased demand during that season while having just enough stock so as not to miss any sales opportunities in other months. However, the EOQ calculation rules out this scope entirely. 

How Can Automation Help Navigate EOQ Challenges?

Automation can play a crucial role in enabling businesses to handle the EOQ challenges. It goes beyond streamlining and optimizing the inventory system but also helps eliminate manual collection of inventory data through real-time data integration, highlights errors, and suggests remedial actions to unlock accurate EOQ for reduced inventory costs. 

• Real-time data integration

Automated systems help businesses integrate with various ERP systems and pull the data from inventory management systems to your custom dashboards seamlessly. Features like LiveCube also offer easy collaboration, give a controlled view of reconciliation variances, and reconcile and match inventory data to reduce the impact of EOQ assumptions. 

• Accuracy and precision 

Automated solutions like anomaly management help detect and resolve errors easily while suggesting remedial measures. It also ensures automatic posting of journal entries relating to inventory expenses to ERP, marks errors with the help of the Anomaly engine, and creates workflows for anomaly resolution. It also provides a list of potential anomalies that help in addressing issues proactively and help businesses get an ideal EOQ number for stock procurement. 

• Scalability and adaptability 

Automation helps businesses scale and adapt to better EOQ levels during fluctuations in market conditions. It allows them to handle increased inventory volumes and growing operational activities. It makes inventory management systems more agile and ensures they remain competitive in dynamic market environments. 

Use HighRadius’ Record to Report Suite To Boost Business Operations

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FAQs

1. What does EOQ stand for?

EOQ is the abbreviation for Economic Order Quantity. It helps businesses find out the ideal quantity of inventory that they should order for every batch and reduce inventory costs. It is calculated as EOQ = √ [2DS/H], where D is annual demand, S is setting cost, and H is holding cost.

2. Which two costs does the economic order quantity balance?

The economic order quantity aims to balance the two critical inventory costs – setting up costs and holding costs. Setting up costs include shipping fees, handling costs, and delivery charges. Holding costs include storage costs, depreciation, warehouse rent, security and insurance.

3. What is an EOQ model?

The economic quantity model helps companies order an accurate amount of stock for every batch so as to prevent ordering too frequently and too much in quantity. It aims to help businesses define their inventory order quantities that best fit their inventory needs and improve their cash flows.

4. What is EOQ in the supply chain?

The EOQ in the supply chain is a critical component that helps businesses streamline their supply chain management by optimizing their inventory quantities, reducing logistics costs, and improving operational efficiency. It ensures that businesses order accurate stock quantities and get them on time.

5. How to calculate annual demand in EOQ?

To find out the annual demand in EOQ, businesses need to check their income statements for the last year and calculate the average number of products they sell to customers annually. Businesses can either calculate for each product line or use the annual demand for each product for EOQ calculations.

6. How to calculate the average inventory in EOQ?

The most common method to calculate average inventory in EOQ is to consider the total stock value at the beginning and end of the periods, add the values and divide it by two. Or, we can take the total cost of goods sold (COGS) and divide it by the number of days in a particular period.