A Guide to Economic Order Quantity: EOQ Meaning, Formula, and Usage
Running a profitable business means managing inventory to suit the needs of the company, while meeting the demands of the market. One of the essential elements of effective inventory management used to grow and manage a business, calculating the EOQ can make a robust impact on profitability. Holding cost for over-purchased or excess inventory can deplete profit, so it may be valuable to utilize the Economic Order and Quantity Model (EOQ) to best manage an appropriate flow of product.
What Is the Economic Order Quantity (EOQ) Model?
The economic order quantity (EOQ) model assumes a continuous and constant rate for demand, and is meant to be used to discover the ideal order quantity a company should purchase for inventory. It is important to note that the EOQ is not the reorder point— the formula illustrates how much to order, not when to order it.
The EOQ model combines the costs associated with a product, including:
- Cost of production
- Demand rate
- Holding/storage cost
- Ordering cost
- Shortage cost
Combining these factors should “balance intangible inventory costs against the tangible costs of ordering” as discussed by Donal Erlenkotter in his analysis of the Economic Order Quantity Model.
So, what are the steps of calculating EOQ? The economic order quantity formula is as follows:
The formula represents:
- Q=Economic order quantity (amount ordered in units)
- D=Demand in units (usually determined on an annual basis)
- S=Order cost (cost per order)
- H=Holding costs (per unit of inventory annually)
What is the purpose of calculating EOQ? The goal of calculating the EOQ is to determine the optimum number of units to order while minimizing costs related to purchasing, delivery, and storage. Understanding the amount of needed product may release cash from being tied up in average inventory balance which, in turn, may be used for other business purposes or investments. To do this, EOQ considers the ordering cost, and storage of assets.
Demand is the willingness of the consumer to pay a specific price to make a purchase on a good or service. This term can be applied both to a specific good, or the aggregate consumer demand of the total number of goods in an economy. The tug of war between the demand and supply of a good is what determines the price, as set by the desire of the consumer. Businesses often try to determine the demand of the consumer over a given time period, to estimate and understand the supply quantity needed to sell at a reasonable price to meet equilibrium.
One component of the total inventory cost is storage. If production cost is the cost of producing a quality product or service, then holding cost (also known as carrying cost) is calculated as unsold inventory, which includes the storage space, labor, and insurance associated with storage. The price of damaged or spoiled goods may also be calculated into holding costs. When there's excess holding inventory, that might force the company to increase its storage cost.
Here's an example of EOQ calculation: The logistics of sourcing, shipping, and storing cannabis and cannabis products can be difficult. This is especially true as markets continue to expand and require more tactful and complex management solutions to transporting and tracking a variety of cannabis products.
Consider a cannabis dispensary that sells edibles. Among the sourcing difficulties, there are two major considerations for keeping operation costs down: limited warehouse space, and shelf life of the product. Perhaps the dispensary does not have the storage available to hold on to excess inventory, and also does not want to purchase order too much inventory that may spoil and increase holding costs. However, the company wants to ensure that they meet customer demand. In this case, determining the EOQ is valuable to understanding the flow of the market and the amount of product needed to meet demand. There are many EOQ calculators available online to help, but the formula may be used as follows:
The dispensary sells 5,000 edibles per year. It costs the company $2 a year to hold an edible in storage. The fixed cost of placing an order is $5.
The formula would look as such:
Q=The Square root of (2 x 5,000 edibles x $5 order cost) / $2 holding cost
Q= 158.2 (rounded up)
The optimum order amount is just over 158.
It should be noted that this number does not represent the purchase cost of the product, nor does it provide insight into reordering. It merely represents the most optimal order quantity per product. The reorder point formula is slightly more complicated and reflects the trigger of the placement of an order for additional products. The reorder point can also be manipulated to include a safety stock, which is determined by how crucial the item is to sales or production.
Benefits of the EOQ Model
Utilizing the EOQ model helps lower, and keep inventory costs as low as possible, by:
- Minimizing storage and inventory holding cost,
- Avoiding excess spending on ordering,
- Maintaining enough inventory for consumer demand,
- Maintaining and creating efficiency in the restocking process,
- Reserves funding for investment in other elements of the business.
How to Use EOQ in Your Business
Though the EOQ formula is quite simple to calculate, the calculation does require numerous assumptions including steady demand, sales, fixed costs, and readily available products to be restocked. However, it does help you purchase order the optimal quantity to meet consumer demand. The EOQ calculation can help you formulate calculations for other key figures, such as annual holding cost, shortage cost, estimated annual demand, etc.
Another difficulty that may arise is that the EOQ is based on one product. If a company sells multiple products, an EOQ will need to be calculated and tracked for each. The EOQ also does not account for seasonal or economic fluctuations, and thus must be recalculated for seasonality and changes in the market. The best way to utilize EOQ is to manage and track products and variables in the industry, and to calculate a new EOQ with each order to ensure the minimum order quantity (MOQ) is being met.