What is Economic Order Quantity (EOQ)?
Economic Order Quantity is the optimum quantity of an item that should be ordered at a point in time. The main motive of finding out this quantity is to avoid over-spending in an item, minimize the ordering and the holding costs associated with the item. It helps to ascertain the frequency as well as the volume of the order by taking into account factors such as demand, holding cost, ordering cost, the interest cost, etc. In other words, by finding out the EOQ, the main aim is to minimize the total cost (from ordering to holding) for every order.
Put, EOQ is the quantity of an item we should order so that we do not run out of stock on the one hand, and the overhead costs related to the inventory are minimized too on the other side. Thus, it reduces the risk of over-stocking or deadstock, while ensuring we do not face a stockout and production issues.
- What is Economic Order Quantity (EOQ)?
- How to Calculate Economic Order Quantity?
- Importance of Economic order quantity (EOQ)
- Limitations of Economic Order Quantity
How to Calculate Economic Order Quantity?
Any order has two components: the cost of the order and the cost of holding inventory. These two components, along with the quantity or volume ordered, are used to find out the EOQ.
There is a fixed cost incurred with every order that goes. It is generally independent of the number of units ordered or the volume of the order. This cost is known as the ordering cost of an order and includes packing and forwarding charges, freight, etc.
Holding inventory, too, has costs of its own. It can be in the form of godown space or rentals for the storage area, electricity bills, and repairs and maintenance. Then there would be the cost of human resources to look after the stock. Also, if the company had not invested in the product under consideration, the same could have been put to an alternative use. It is the opportunity cost of holding a particular product. Similarly, there may be interest cost, too, that is associated with the inventory if the money was invested elsewhere. The holding costs also include the costs incurred due to perishability, leakage, or theft of goods and inventory insurance.
The calculation for annual holding cost is done as:
Order quantity/2 x Holding cost per unit of the product
Calculation of EOQ
The formula for calculation of the EOQ is:
EOQ- Square root of (2xDxS/ H).
Here, D= Annual demand in units of a product.
S= Ordering cost per order
H= Holding cost per unit of the product.
Let us suppose that Mr.X deals in bicycles and has an annual sale of 6000 units. The ordering cost per order is US$ 300, and the holding cost per unit of the bicycle is US$50. His Economic order quantity calculation will be as below:
EOQ= Square root of (2x 6000x 300/ 50)
= Square root of 72000
=268 units (rounded off)
Therefore, the economic order quantity for Mr.X is 268 units of bicycles, where he will minimize the risk of running into a shortage of stock and keep control of his holding cost as well.
Let us take three different scenarios to get to our point.
Case 1: Mr.X decides to order in lots of 200 bicycles.
Total number of orders per year: 6000 units /200= 30 orders
Total ordering cost per year= 30 x 300= US$ 9000
Annual holding cost= 200/2 x 50= US$ 5000
His Annual Total Cost= US$ 9000+ US$5000= US$14000.
Case 2: Mr.X decides to order in lots of 300 bicycles.
Thus, the total number of orders per year: 6000 units /300= 20 orders.
Total ordering cost per year= 20 x 300= US$ 6000
Annual holding cost= 300/2 x 50= US$ 7500
His Annual Total Cost= US$ 6000+ US$7500= US$13500.
Case 3: Mr.X decides to order in lots of 268 bicycles, our economic order quantity.
Thus, the total number of orders per year: 6000 units /268= 22.39 orders.
Total ordering cost per year= 22.39 x 300= US$ 6717
Annual holding cost= 268/2 x 50= US$ 6700
His Annual Total Cost= US$ 6717+ US$6700= US$13417.
Therefore, we can see that his annual total cost is minimum in case 3, the one with our economic order quantity derived earlier.
Importance of Economic order quantity (EOQ)
Minimizes Wastages and Stockouts
The concept of Economic order quantity helps companies to minimize blocking excess money in inventory. At the same time, it indicates when to reorder to avoid any shortage and disruptions in the production or other processes.
Helpful in Case of Multiple Products
It is easy to keep a tab on inventory when the number of products is less. But for bigger companies and multinationals, there are thousands of items to be taken care of in the inventory. EOQ is of great importance in such cases and solves the problem of order to an extent.
Limitations of Economic Order Quantity
The concept of EOQ has its limitations as well.
Assumption of Constant Values
This concept is based on the assumption that demand for the product will be constant all year-round. It is not the case in the real world.
Also, it assumes that the ordering cost, as well as the holding cost per unit of the product, do not change year-round. Some of these costs are not controllable and may vary around the year as per different situations. Packing and transportation charges may differ for every order delivered. Similarly, rentals and other overhead expenses may increase and affect the holding cost.
Delivery Time of Order may Vary
The concept assumes that inventory will be restocked in one go each time all the year-round. It is also not the case in the real world. Moreover, order replenishments take time, and delivery periods may vary. Because there could be seasonal and weather-related issues that can change the delivery lead time. Hence, depending solely on the EOQ for reordering may result in stock getting overdue or delay in supply of the product.