What is Economic Order Quantity and How to Calculate

Have you ever struggled with ordering too much for your business needs and not having the space to store your inventory? Or have you ever ordered too little to meet your customers' demand? If this is a struggle you regularly face, you might need to consider your need to understand EOQ.

So, what is EOQ, you ask? Well, Economic Order Quantity (EOQ) is that phenomenon that will help you make the right decision to order the right quantity of inventory and also multiply your profit margin.

This blog entails answering what is EOQ in a broader sense by discussing the benefits and limitations of EOQ and how to optimize EOQ in inventory control. Let's begin!  

What is Economic Order Quantity (EOQ)?

The Economic Order Quantity (EOQ) is the appropriate order amount a corporation should acquire to reduce inventory expenditures such as holding charges, shortage, and order costs.

In other words, it is a measurement applied to supply, logistics, and operations management. EOQ is essentially a technique for calculating the volume and frequency of orders needed to meet a specific level of demand while lowering the cost per order.

Economic order quantity is a relevant statistic for companies that purchase and maintain inventory for manufacture, resale, internal usage, or other reasons. Businesses that adhere to EOQ consider the demand for the goods, buy discounts, and hold costs in addition to all costs associated with purchasing and delivery.

Benefits of Economic Order Quantity

Economic Order Quantity (EOQ) calculations are beneficial to understanding how much product needs to be bought to keep a cost-effective supply chain for E-commerce and in your business planning process. If you are to launch a new product, you may need to consider the benefits of EOQ.

Here are some of the benefits of EOQ:

Improve Order Fulfillment

A clever technique to define how much you require depending on significant cost variables is to use the EOQ formula. You can now fulfill your orders more efficiently and streamline the purchasing process. Knowing your EOQ can help you store and manage your inventory more effectively.

Less Overordering

EOQ can assist you in determining how much and how frequently you need to place new orders. You may prevent overordering without keeping an excessive amount of inventory on hand for an extended period by figuring out how much you need based on how much you sell in a specific amount of time. You might be shocked to learn that placing smaller orders could result in lower costs for your company.

Less Waste

With less overordering, you are automatically reducing the wastage of resources. You can divert those funds to invest in other aspects of your business. You can purchase necessary equipment like printers, office chairs, etc., to meet your office needs.

Lower Storage Costs

Small business owners could find it pricey to store merchandise. The tailored recommendations for the most affordable quantity of units per purchase are the Economic Order Quantity (EOQ) model's key benefit. To benefit from bulk purchasing discounts and reduce purchase costs, the model can advise purchasing a larger quantity in fewer orders. If holding costs are high and ordering costs are low, it can indicate placing more orders for fewer things.

Quantity Discounts

You can benefit from your vendors' most satisfactory quantity or bulk order discounts if you plan and time your orders correctly. Amazon Business is an online vendor providing attractive bulk discounts on bulk purchases for your diverse business needs.

Importance of Calculating EOQ

Economic Order Quantity (EOQ) is crucial since it aids businesses in effectively managing their inventories. Here's why calculating the economic order quantity is important:

Reduce Stockouts

Selling out of a well-liked item may result in lost sales and customers, who will go to a different store to find the thing they want. One of the most effective strategies to ensure you'll have enough stock is determining economic order quantity (EOQ). The EOQ establishes the reordering point for your company. When used correctly, your EOQ formula initiates an order for additional units when the stock falls below a specific threshold. By doing this, you may keep filling orders without worrying about running out of stock.

Avoid Overstocking

It would be best to streamline your inventory procedures because storage costs are increasing yearly. The holding charges you incur will increase the longer you own the stock. However, EOQ establishes the optimal level of inventory to maintain between overstocking and understocking. You'll be aware of the exact amount of the merchandise.

Improve Cashflow

EOQ improves cash flow for your company while also assisting you in better planning inventory purchases. Other than labor, inventory is a retail business's most significant asset, and you need plenty of inventory to meet client demand. The EOQ formula directs money away from your inventory balance and toward more profitable uses. Effective cost management strategies and business decisions could also improve the cash flow.

Economic Order Quantity Formula and Factors

Understanding the three main factors of EOQ is crucial. They are mentioned below:

Holding Costs (H)

It is an essential retail supply chain management technique for reducing inventory expenses. The overall cost of maintaining inventories is referred to as the holding cost. It is also known as carrying costs. It would be best to establish your holding price to do an accurate economic order quantity (EOQ).

Annual Demand (D)

This refers to the demand you get for your products yearly. You can determine the annual demand for your products by looking at the previous years' data and determining the number of units you sell over the year.

Order Costs (S)

The Order Cost is also known as set up cost. It refers to the cost of an order per purchase. This can be calculated per order, including shipping and handling costs.

Top Aspects of EOQ

Economic Order Quantity Examples

EOQ considers the reordering timing, cost while placing an order, and the cost incurred to store the product or merchandise. Let's see an economic order example by learning how to calculate it.

Suppose you own a retail clothing shop that carries a women's clothing line. Your store sells 1000 women's shirts each year, and it costs your company $5/ year to store a single shirt in inventory, and a fixed cost of $2 is incurred while placing the order.

After applying the EOQ formula,

The EOQ comes around ~28.3. This reveals the ideal order quantity to reduce the costs and ensure consumer demand is slightly more than 28 shirts.

What Does Economic Order Quantity (EOQ) Tell Businesses? 

The Economic Order Quantity (EOQ) is very important for a business because it discusses the appropriate order size for every purchase a company makes. According to the economic order quantity (EOQ) formula, the assumption states that the annual demand for any product is relatively flat. If you have a business that is still in its growing stages, an EOQ calculation may not be the ideal way to calculate your order size, as the numbers are bound to change often.

After working through the economic order quantity, you ought to know the optimum annual order volume and size. You can modify the economic order quantity model to consider price breaks, backorders, damaged goods, and more.

You ought to have an ideal supply chain order schedule for the entire year based on the results of your EOQ.

How to Use EOQ to Improve Inventory Management?

EOQ gives you the ideal order size to maximize profits for your company. Thus, you have an exact number instead of a guess number, which prevents you from running out of stock or overordering.

These insights can help you make the right decisions for your business in the short and long term. It provides you with the essential information for your business's inventory needs.

EOQ may substantially impact business performance if your organization works on a larger scale, requires expensive inventory, or has high inventory holding costs. EOQ can be used to significantly improve your operational efficiency, cash flows, and profits.

If you have the right handle on EOQ and the right vendors, procuring products or raw materials for your business becomes easy. [Our vendor management blog will prove effective in learning to manage vendors and inventory.]

EOQ Model of Inventory Management

The economic order quantity plays a crucial role in inventory management and optimization. An EAQ model ensures the right amount of inventory is ordered per batch preventing the company or business from ordering products frequently, resulting in excess inventory.

Knowing the setup cost, demand rate, and holding costs makes it easier to quantify the answer to the question of what is EAQ in inventory control using the EAQ formula. The holding costs increase with a large amount of inventory and set up cost increases with ordering smaller items frequently. With an EAQ model, you could find the optimum quantity to minimize both types of costs.

Other Factors that can Optimize inventory

A competitive edge can be gained by managing your inventory stock levels. Timely and accurate replenishment of your inventory is essential to run all the other activities smoothly. Hence, understanding and optimizing your inventory management process from time to time becomes important. Inventory optimization creates a balance between inventory, service, and costs.

Reorder points

A reorder point (ROP) is a specific level at which stock needs to be restocked. In simple terms, it tells you when to order new stock so that you don't run out of stock. The formula to determine ROP is (daily average usage x lead time) + safety stock. ROP is important because if you overorder your inventory, then your maintenance and holding costs increase. Whereas, if you are running low on inventory or out of stock, you might lose customers.

Safety stock measurements

As the word suggests, safety stock refers to the stock that is used in case of an emergency. It is maintained to avoid the risk of going out of stock. For example, if your delivery partner or supplier has some issues and cannot deliver the products on time, you still have your safety stock to mitigate the losses from the risk of stockout.

Real-time inventory tracking

Real-time inventory tracking or management is an automated process of using software to record sales and purchases. It provides you with accurate and real-time data about what's going on with your inventory. This is helpful in terms of dealing with problems like dead stock, storage, and shortages.

Challenges of Economic Order Quantity (EOQ)

Every coin has two sides, similarly, economic order quantity (EOQ) is beneficial for businesses, but it also has a downside. Let's have a look at some of the most common challenges of EOQ.

Poor Data

Any company using EOQ should make sure they have the right data. EOQ assumes the demand for products is consistent and that your company can replenish them immediately. Another problem is that it uses fixed costs, inventory items, order fees, and holding costs. This becomes problematic in the consumer market, where nothing remains fixed for a long period of time. This can lead to overstocking or understocking.

Outdated Systems

If your business is using outdated systems, getting fruitful results with the help of the EOQ model can be difficult, if not impossible. The factors affecting EOQ or data required for calculation should be accurate and based on real-time. There are multiple software available to keep track of it, but if the systems are outdated, it might lead to more losses than profits.

Business Growth

Some of the assumptions of the EOQ model are unrealistic. These further affect the insights derived from the formulas. This can result in further miscalculations and wrong decisions regarding inventory management. Since inventory is one of the key elements of business, poor forecasting and inventory management can hamper business growth.

Inventory Shortages

One of the most commonly faced problems of the EOQ model includes inventory shortages. This is due to the various assumptions and factors that are in play while calculating the desired figures. Many new users become conservative in their ordering process, which leads to inventory shortages.

Seasonal Needs

The market has always been volatile, trends can last for a few days, weeks, or months, and there is no guarantee regarding the same. However, the EOQ model is helpful only for products whose demand lasts all year round. As the model assumes the demand to be constant, it becomes problematic for products with seasonal demands or needs.

What are the limitations of EOQ?

There are multiple limitations to the EOQ model. These are primarily due to the various unrealistic assumptions it comes with. A few assumptions of the EOQ model are as follows:

1. The demand is relatively constant. It is known or predictable.
2. The total number of units that will be consumed during the period is certain.
3. The total ordering cost, inventory cost, and delivery cost remain constant throughout the period. It is known or predictable.
4. The item is purchased in lots or batches and not continuously.
5. The replacement of inventory occurs all at once. The orders are placed in a single batch.
6. Cash or quantity discounts are not available.
7. The lead time is constant, and the order is delivered on time with the full order quantity.

Conclusion

The Economic Order Quantity or EOQ model does not consider all of the factors affecting every business but still exists to be a useful tool in inventory management. The EOQ model is a dynamic that can be revised as per your business needs. EOQ helps in avoiding shortages, unnecessary expenses, and wastage of resources caused due to poor inventory management. Hence, if used properly with updated systems and real-time and accurate data, it can play a vital role in the overall business growth.

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