How Is the Economic Order Quantity Model Used in Inventory Management?

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June 7, 2024
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Economic Order Quantity (EOQ)

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Economic order quantity, EOQ, is a formula used to determine inventory orders for manufacturing inputs. Manufacturers use EOQ formulas to lower their inventory ordering and carry cost, thus minimizing all costs related to inventory management.The two components of inventory cost — ordering and carrying — are interrelated. Ordering costs include shipping costs, as well as the employee cost associated with purchasing the items. Carrying costs include warehousing expenses, spoilage, and the cost of money tied up in paying for the inventory items. These two components counterbalance one another. For instance, purchasing smaller quantities more frequently could reduce carrying costs, but doing so increases ordering costs. Managers use the EOQ formula to find the optimum level of inventory to order that minimizes both the ordering and carrying costs.The EOQ formula is:EOQ = the square root of 2SD/PIWhere S equals set up costs, D equals demand rate, P equals production cost, and I equals the interest rate. Note that the interest rate represents an opportunity cost number, so the risk-free rate can be used as the interest rate.Purchasing managers can modify the formula to calculate the optimal levels of inventory to keep on hand, and to time when new orders should be generated.

Reviewed by David KindnessFact checked by Kirsten Rohrs SchmittReviewed by David KindnessFact checked by Kirsten Rohrs Schmitt

The economic order quantity (EOQ) refers to the ideal order quantity a company should purchase in order to minimize its inventory costs, such as holding costs, shortage costs, and order costs. EOQ is necessarily used in inventory management, which is the oversight of the ordering, storing, and use of a company’s inventory. Inventory management is tasked with calculating the number of units a company should add to its inventory with each batch order to reduce the total costs of its inventory.

The EOQ model seeks to ensure that the right amount of inventory is ordered per batch so a company does not have to make orders too frequently and there is not an excess of inventory sitting on hand. It assumes that there is a trade-off between inventory holding costs and inventory setup costs, and total inventory costs are minimized when both setup costs and holding costs are minimized.

Key Takeaways

The economic order quantity (EOQ) refers to the ideal order quantity a company should purchase in order to minimize its inventory costs.
A company’s inventory costs may include holding costs, shortage costs, and order costs.
The economic order quantity model seeks to ensure that the right amount of inventory is ordered per batch.
This is so a company does not have to make orders too frequently and there is not an excess of inventory sitting on hand.
EOQ is used in inventory management, which is the oversight of the ordering, storing, and use of a company’s inventory.

Formula for Economic Order Quantity

The formula for Economic Order Quantity is:

begin{aligned} &EOQ= sqrt{frac{2times Stimes D}{H}}\ &textbf{where:}\ &S = text{Setup costs (per order, generally including}\ &text{shipping and handling)}\ &D = text{Demand rate (quantity sold per year)}\ &H = text{Holding costs (per year, per unit)} end{aligned}

$EOQ = \frac{2 \times S \times D}{H} where: S = Setup costs (per order, generally including shipping and handling) D = Demand rate (quantity sold per year) H = Holding costs (per year, per unit)$

How to Use Economic Order Quantity

To calculate the EOQ for inventory you must know the setup costs, demand rate, and holding costs.

Setup costs refer to all of the costs associated with actually ordering the inventory, such as the costs of packaging, delivery, shipping, and handling. Demand rate is the amount of inventory a company sells each year.

Holding costs refer to all the costs associated with holding additional inventory on hand. Those costs include warehousing and logistical costs, insurance costs, material handling costs, inventory write-offs, and depreciation.

Ordering a large amount of inventory increases a company’s holding costs while ordering smaller amounts of inventory more frequently increases a company’s setup costs. The EOQ model finds the quantity that minimizes both types of costs.

Example of Economic Order Quantity

EOQ considers the timing of reordering, the cost incurred to place an order, and the costs to store merchandise. If a company is constantly placing small orders to maintain a specific inventory level, the ordering costs are higher, along with the need for additional storage space.

For example, consider a retail clothing shop that carries a line of men’s shirts. The shop sells 1,000 shirts each year. It costs the company $5 per year to hold a single shirt in inventory, and the fixed cost to place an order is $2.

The EOQ formula is the square root of (2 x 1,000 shirts 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 shirts.

Important

Despite its limitations, the EOQ model is still an important cash flow tool to help streamline inventories and reduce associated costs.

Disadvantages of Using Economic Order Quantity

The basis for the EOQ formula assumes that consumer demand is constant. The calculation also assumes that both ordering and holding costs remain constant. These assumptions make it difficult, if not impossible, to account for unpredictable business events, such as changing consumer demand, seasonal changes in inventory costs, lost sales revenue due to inventory shortages, or purchase discounts a company might get for buying inventory in larger quantities.

What Is Economic Order Quantity?

Economic order quantity (EOQ) is the theoretically ideal quantity of goods that a firm should purchase that minimizes its inventory costs.

What Are the Basic Assumptions of the EOQ Model?

EOQ assumes that demand, ordering, and holding costs all remain constant over time.

What Are the Limitations of the EOQ Model?

Critics have argued that the assumptions of constant demand and fixed cost levels are a limitation of the EOQ model. Seasonal changes in demand, for instance, are known to occur for many businesses, and costs can vary over time.

The Bottom Line

For companies involved in manufacturing or consumer sales, inventory management is key to controlling operating costs. The economic order quantity model allows companies to find the right balance between storing unused products and making new orders, allowing them to minimize inventory costs.

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