Inventory Management, also known as stock management, is crucial for working capital management. Economic Order Quantity 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. Now, let us see the Importance of EOQ.
Working Capital Management is an essential 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 the effort to manage. Inventory comprises a significant part of working capital. This makes its management critical, compared to other working capital components.
Two crucial 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 significant 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 a 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 and total quality management (TQM). However, one proven, adopted, and efficient model is economic order quantity (EOQ). This helps answer a major question, i.e., “What quantity should be ordered?” The quantity to be ordered should be optimum, optimizing everything, whether the space required or the money blocked in the inventory. At the same time, the quantity ordered should be sufficient to meet the needs. Insufficient inventory can lead to a stoppage of production.
How to calculate EOQ?
To determine the quantity to be ordered, EOQ uses the 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 the quantity ordered. More the quantity ordered, less is the number of orders 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. The more the quantity ordered, the more the cost incurred in keeping and maintaining such inventory.
Since both the cost behaves oppositely, there is a need to find an optimum quantity to be ordered that can maintain a tradeoff between ordering & carrying cost.
The total ordering and carrying cost is minimized when the optimum quantity or economic quantity “Q” is ordered.
Formula for EOQ
“Q” or “EOQ” is calculated using the 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 answers how much inventory should be ordered, it does not answer when it should be ordered. EOQ model assumes an instantaneous procurement of material. However, in practicality, procurement of material needs some time. This is known as “lead time.” So, the 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 the optimum quantity to be ordered. But, it cannot be adopted as a one-stop solution for total inventory management. Therefore, other techniques and methods need to be considered and adopted along with EOQ.
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