Why Economic Order Quantity May Be Right (Or Wrong) for You

Economic Order Quantity can take the guesswork out of reordering stock, find out how.

Would you like to know exactly when you need to reorder stock and how much you need to reorder?

Then you need to calculate your economic order quantity (EOQ).

EOQ – much like a reorder point formula – helps you take the guesswork out of stocking your warehouse and keeping up with customer demand.

We’ll show you how to use an EOQ formula, it’s advantages and disadvantages, and the one tool you need to optimize your use of EOQ and any other inventory formulas.

What is Economic Order Quantity?

Economic order quantity is the lowest amount of inventory you must order to meet peak customer demand without going out of stock and without producing obsolete inventory.

That’s the ideal use of EOQ.

Its purpose is to reduce inventory as much as possible to keep the cost of inventory as low as possible.

The EOQ model assumes that demand is constant and that inventory is depleted at a predictable rate. While this isn’t the case for many businesses, the model still helps companies better approximate when they need to replenish their inventory and how much they should order.

How Do You Calculate Economic Order Quantity?

To help you calculate EOQ, here is the formula from Kenneth Boyd, author of Cost Accounting for Dummies:

Economic order quantity uses three variables: demand, relevant ordering cost, and relevant carrying cost. Use them to set up an EOQ formula:

• Demand: The demand, in units, for the product for a specific time period.
• Relevant ordering cost: Ordering cost per purchase order.
• Relevant carrying cost: Carrying costs for one unit. Assume the unit is in stock for the time period used for demand.

Note that the ordering cost is calculated per order. The carrying costs are calculated per unit. Here’s the formula for economic order quantity:

Economic order quantity = square root of [(2 x demand x ordering costs) ÷ carrying costs]

That’s easier to visualize as a regular formula:

Q is the economic order quantity (units). D is demand (units, often annual), S is ordering cost (per purchase order), and H is carrying cost per unit.

What are the Advantages of EOQ?

Economic order quantity has been successfully used for decades by businesses of all types, so it certainly has a few advantages.

Here are some of them:

Helps Lower Inventory Costs

The primary purpose of EOQ is to help keep inventory carrying costs as low as possible.

The more inventory you have on hand, the more you have to pay for insurance, taxes, security, etc.

Accurately calculating how much inventory you need will help you maintain a budget you can afford.

Makes Restocking Easy

Economic order quantity can help you understand how often you should be ordering. You may discover that ordering small quantities more often is better for your bottom line or vice versa.

By calculating how much you need in proportion to how much you sell over a given period of time, you can ensure you always have enough stock to satisfy your customers.

Helps You Find the Best Deal

Many vendors advertise deals throughout the year to entice you to buy more of their inventory which usually ends up increasing your cost of inventory even if you received a discounted price.

The EOQ model helps you purchase only what you’re going to use.

It’ll help you take advantage of a vendor deal if, after plugging the numbers into your EOQ formula, you find out you’re not overpurchasing but getting the right amount at a lower price.

What are the Disadvantages of EOQ?

While economic order quantity has some benefits and a long history of use, it’s not without its shortcomings.

Here are a couple of them:

Requires Numerous Assumptions

The largest complaint about EOQ is that it requires numerous assumptions.

The model assumes that there’s steady demand, steady sales, and fixed costs.

Plus, the basic EOQ model assumes you have a one-product business. If you sell multiple products, you’ll have to calculate and track each one separately.

Doesn’t Account for Fluctuations During Seasons

The biggest problem with assumptions of steady demand and steady sales in the EOQ model is that it doesn’t allow you to account for fluctuations in demand during holidays or particular seasons.

If your sales yo-yo throughout the year, then EOQ won’t be able to keep up.

How to Make EOQ Work for You

Realistically, you’re unlikely (and not lucky enough) to operate a business with fixed rates and steady sales that almost never fluctuate.

If you run a business similar to the rest of ours, then you’re constantly dealing with uncertainties in your reorder point and customer demand forecasts.

EOQ can still help you make more informed guesses about when and how much inventory should be ordered, but to make EOQ calculations work properly, you’re going to need a way to monitor and track your order quantities, reorder points, safety stock levels, etc.

With the right inventory management system, you could even forget about EOQ altogether and use more up-to-date formulas that automate reordering for all of your products.

Interested in such a system?

Then we can help…