Inventory Management, also known as stock management, is a crucial part of working capital management. EOQ is one of the most prominent models used widely for effective inventory management. EOQ calculates the ordering quantity for a particular inventory item using inputs such as carrying cost, ordering cost, and annual usage of that inventory item.
Working Capital Management is an important specialized function of financial management. Every component of working capital such as inventory, debtors or receivables, cash, creditors or payables, short-term debts, etc needs effort to manage. Inventory comprises a major part of working capital. This makes its management critical, compared to other working capital components.
Two important questions of inventory management are ‘how much inventory should be ordered?’ and ‘when should it be ordered?’ In manufacturing and merchandising companies, inventory management is overemphasized. It is because the inventory covers the major part of the asset pie. Inventory is a part of current assets and it occupies a major share of working capital and hence it is necessary to ensure that it does not block too much of finance.
While we are planning for inventory management, the first thing that should be evaluated is the type of costs associated with it. However, there is a general presumption that inventory cost means the cost price of product stored as inventory. Practically, there are other costs as well, which are associated with inventory like ordering cost, carrying cost etc.
Various tools have been recommended for inventory management and new studies have added some innovative methods like just in time (JIT) management, total quality management (TQM). However, one of the proven, adopted and efficient models is economic order quantity (EOQ). This helps to answer a major question i.e. “What quantity should be ordered?” The quantity to be ordered should be optimum which optimizes everything whether it is the space required or the money blocked in the inventory. At the same time, quantity ordered should be sufficient to meet the needs. Insufficient inventory can lead to stoppage of production.
How to calculate EOQ?
To determine the quantity to be ordered EOQ uses following inputs like annual usage or demand, cost per order, carrying cost etc.
It is the annual usage of that particular raw material.
Ordering cost is the cost associated with placing an order. It varies inversely with quantity ordered. More the quantity ordered, less is the number of order to be placed and therefore ordering cost incurred is less.
Carrying cost is the cost associated with storing and maintaining the inventory. The carrying cost varies directly with the order size. More the quantity ordered, more is the cost incurred in relation to storing and maintaining such inventory.
Since both the cost behaves in an opposite manner there is the need to find out an optimum quantity to be ordered that can maintain a tradeoff between ordering & carrying cost.
The total of ordering and carrying cost is minimized when optimum quantity or economic quantity “Q” is ordered.
Formula for EOQ
“Q” or “EOQ” is calculated using following Formula:
EOQ = ∑ (2 * ACPO * AUU) / (UC * CCP)
ACPO = Acquisition Cost Per Order
UC = Per Unit Cost
AUU = Annual Usage of Units
CCP = Percentage of Carrying Cost
Drawbacks of the EOQ Model
Though EOQ gives an answer to how much inventory should be ordered, it does not give an answer to when should it be ordered. EOQ model assumes in an instantaneous procurement of material. However, in practicality, procurement of material needs some time. This is known as “lead time”. So, ordering level for the material is generally defined as: “Lead Time in days * Average Daily Usage”.
Thus, EOQ can be an effective tool in inventory management to find optimum quantity to be ordered. But, it cannot be adopted as one stop solution for total inventory management. Therefore, other techniques and methods need to be considered and adopted along with EOQ.