Economic Order Quantity

What is Economic Order Quantity?

Economic Order Quantity (EOQ) is the appropriate order quantity that a company must purchase to decrease inventory expenditure, such as order costs, shortage costs, and holding costs.

This model was developed by Ford W. Harris in 1913 and has been improved over time.

EOQ Formula

It can be calculated with this EOQ formula:

Q = √2DS/H

Herein:

Q = EOQ Units D = Demand in units S = Order cost H = Holding costs

Explaining Economic Order Quantity

The objective of the EOQ formula is to comprehend the adequate number of product units that need to be ordered. If the number is achieved, the company can decrease the expenditure for purchasing, delivering and storing units.

Furthermore, this formula can also be altered to comprehend a variety of order intervals or production levels. Organizations that have massive supply chains and higher variable costs generally use an algorithm in the computer software to comprehend EOQ.

Basically, this one is an essential cash flow tool. The formula can assist a company in regulating the cash amount tied up in the balance of inventory. For several companies, inventory is the largest asset other than their human resources, and these businesses should carry enough inventory to meet the requirement of customers.

If EOQ can help decrease the inventory level; thus, the amount can be used somewhere else. On top of that, the EOQ formula helps to figure out the inventory reorder point of a company as well. When the inventory goes down to a specific formula, if the EOQ formula is applied to the business procedure, it can trigger the requirement to place the order for more units.

By comprehending a reorder point, the business can easily avert running out of inventory and continue to fill in orders.

Economic Order Quantity Example

Let’s take an economic order quantity example here. Generally, EOQ considers the reordering timing, the cost to place an order and the cost to store merchandise. In case a firm is consistently placing small orders to regulate a certain inventory level, the ordering cost will be higher, and additional storage space will be needed.

Suppose a retail clothing shop has a line of women’ jeans and they sell 1000 pairs every year. It generally costs the company Rs. 5 per year to hold one pair of jeans in the inventory. And, to place an order, the Fixed Cost is Rs. 2.

Now, applying the EOQ formula, which is the square root of (2 x 1000 pairs x Rs. 2 order cost) / (Rs. 5 holding cost) or 28.3 with rounding. The adequate order size to decrease costs and meet the demand will be a bit more than 28 pairs of jeans.