What is the Economic Order Quantity (EOQ)?
- What the Economic Order Quantity (EOQ) is
- Why retailers use the EOQ
- How the EOQ can change
- How to calculate the EOQ
How do retailers establish the best performing quantity of goods to buy, according to ordering and carrying costs? What is the ideal amount of inventory that retailers need to order every time so that cost is at a bare minimum? The answer is the Economic Order Quantity (EOQ).
What is the Economic Order Quantity?
The Economic Order Quantity (EOQ) is how replenishment managers and buyers calculate a reduction in inventory expenses while maximizing profits. RMs and buyers can use this calculation to find out precisely the best time to place an order and how much to order, thus enabling regular production and a reduction in inventory costs.
To put it mathematically, the EOQ is the point at which both the ordering and holding costs are equal. According to the following graph, the annual ordering costs and holding costs change as the reorder quantity rises:
Graph of Annual Cost versus Order Quantity
The EOQ is the lowest point of the Total Cost curve.
Why should retailers use the EOQ?
Inventory comes at a high cost. It is costly to produce or acquire stock, and it is also expensive to have it in the store. Whether it’s raw materials, Work in Progress (WIP), or final products, retailers can use the benefits of the EOQ as a proficient ordering benchmark to avoid problems and prevent the need to maintain surplus stock.
Order quantity is a critical matter — if a retailer orders too many items, it will raise holding costs. On the other hand, if a retailer orders inadequate amounts, an out-of-stock situation may arise. Both have their disadvantages for every business, and retailers and suppliers should avoid them to retain the feasibility of their business operations.
The EOQ is usually among several approaches to manage inventory that retailers can use within an inventory control or ERP solution. Other methods comprise Reorder Points, Period of Supply, and others.
Additionally, the EOQ serves to keep storage and holding costs to a minimum, benefits the company in minimizing wastage, and allows for cash flow planning by keeping the cost of inventory at a bare minimum. It also helps figure out the precise reordering level, i.e., the level that is just appropriate to place an order for more inventory.
Related Reading: Replenishment 101: What is Replenishment?
Considerations when Calculating EOQ
According to most demand planners or supply chain managers, getting the optimum EOQ for every item in stock seems to be the ideal way to administer inventory. However, retailers need to consider several factors before beginning to define the EOQ for each product.
Let us assume that the EOQ establishes that a warehouse would be placing orders for toys at an annual frequency of 17 times – more than once a month. Though this number may be ideal for keeping costs at a minimum, do stores and the workforce have the capacity to manage the high frequency of orders and supplies? Can retailers place more frequent orders with suppliers? Will it cause clashes in the supply chain? Practicability is a challenge with the EOQ.
On-hand and in-pipe
It could be that the supplier’s demand has fluctuated, or perhaps the need for a specific product is different for every store. In any case, reordering items based on the EOQ alone without giving careful thought might result in a poor distribution of resources if the products are already “in-pipe.”
This is a scenario where redistributing those products to the store with the most demand is a more lucrative way to use resources instead of reordering. It also removes those products from shelves where they are not in much demand, making room for higher value items.
Lower demand versus capacity loss
Placing orders for the EOQ for every product in a supplier’s warehouse, irrespective of their value to sales, can cause a deficiency in higher-value products. Is valuable space being squandered on goods that do not always have to be in stock? Giving priority to higher demand and higher-valued products can ensure that customer service levels are superior. ABC analysis makes it possible to define the highest-value items and to prioritize SKUs. Additionally, suppliers should assess the optimal warehouse set-up to keep high-demand products within reach of packers and collectors.
Minimum order quantity
With more frequent smaller batch orders, inventory managers get higher flexibility to match purchasing behavior with actual customer demand. However, many suppliers must have a minimum order quantity (MOQ) before shipping an order. In case of the receipt of orders without a MOQ, the suppliers’ profit margins per unit dip low, and shipping costs increase.
Even though this isn’t a comprehensive list of what to take into account while deciding EOQ and placing orders with suppliers, these points indicate that to manage inventory accurately, EOQ alone is insufficient.
Changes in the EOQ
In a scenario where both the cost per commodity and the demand for each commodity are constant, and the number of commodities is small, it would be effortless to find and maintain the EOQ.
However, while the commodities traverse the product lifecycle and demand changes, calculating the EOQ can encompass hundreds of SKUs. In this case, finding and managing the EOQ becomes a very tedious task.
As demand per year is an essential part of the EOQ, it becomes even more challenging to calculate the EOQ with fluctuating products’ market. The EOQ for each item must be re-established consistently to absorb alterations.
To account for this situation, it is not likely that the demand for a product is constant for the entire year. Retailers and RMs also need to take seasonal demand into account. Likewise, the market for an item may go down during other parts of the year. If a large number of these items in stock during times of low demand, the holding costs increase, and low-demand products take up valuable inventory space.
Related Reading: Demand Planning
Economic Order Quantity techniques
To have the right amount of inventory in stores, retailers must receive the optimum quantity at the designated time to properly maintain stock, corresponding to the product’s depreciation and costs with the EOQ. The EOQ formula calculates the optimal number of units to order to make the transaction the most economical and keep the number of units ideal.
Calculating EOQ starts with the annual demand of the product, per order cost, and the cost of holding each unit of inventory. The circumstances that frame the EOQ formula are:
- constant and known lead times,
- constant and known demand for the product,
- no quantity discounts,
- no stock-outs and shortages, and
- an assumption of prompt receipt (On Time, In Full).
The ad hoc EOQ formula
There are many vital elements of the ad hoc EOQ formula: holding cost, ordering cost, annual ordering cost, annual holding cost, and total cost.
The cost of keeping inventory in storage is the holding cost. Calculate this cost to find whether a product should remain in a store’s inventory or if the store should send it to another store – under the assumption that demand is constant.
H = I * C
H = Holding cost
I = Carrying cost
C = Unit cost
In this case, demand is constant, inventory will reduce with use until it reaches zero, and the retailer will order the item again.
When a retailer places an order requesting inventory with the supplier, there is an ordering cost. To calculate the number of orders, divide the quantity demanded per year by the volume of each order.
N = D / Q
N = Number of orders
D = Quantity demanded per year
Q = Volume per order
Annual ordering cost
Annual ordering cost is the cost of ordering inventory over the course of a year. To calculate the yearly order cost, multiply the number of orders by the ordering costs.
AO = (D * S) / Q
AO = Annual ordering cost
D = Quantity demanded per year
S = Ordering cost
Q = Volume per order
Annual holding cost
Annual holding cost is the sum product of volume per order and holding cost. To calculate the annual holding cost, multiply the volume per order by the holding cost, and divide by two.
AH = (Q * H) / 2
AH = Annual holding cost
Q = Volume per order
H = Holding cost
The total of the holding costs and the ordering costs is the per year total cost of an order. Add the annual ordering cost and yearly holding cost to obtain the total cost.
Total cost = [ (D * S) / Q ] + [ (Q * H) / 2 ]
To find the ad hoc EOQ, differentiate the total cost by the volume per order:
Ad hoc EOQ formula
The principle of Wilson’s Formula
The inventor of Wilson’s Formula actually was not Mr. Wilson but Ford Whitman Harris, who framed the mathematical principle. Then came Mr. R. H. Wilson, who was an industrial consultant and a specialist in inventory management. He used and implemented this formula to optimize inventory.
Wilson’s Formula calculates the EOQ by calculating the quantity of inventory directly proportional to its cost (more the inventory, higher the expenditure).
If there is no stock, there are no holding costs. However, the more inventory there is, the higher the expenses of possessing it. At the same time, the higher the number of orders, the higher number of incurred costs. For instance, if a retailer sells 1,000 items, rather than creating 1,000 orders of the item, it will be more profitable to place one order for 1,000 items.
Wilson’s Formula has three benchmarks:
- Demand or consumption (D)
- Order placement cost (CO)
- Stock ownership cost (SC)
To calculate Wilson’s Formula, take the square root of twice the demand multiplied by order placement cost (or ordering cost) divided by the stock ownership cost (or holding cost).
Wilson’s Formula for EOQ
In the case of retail or wholesale, the ad hoc EOQ formula (above, utilizing the total cost) is the most appropriate and lucrative compared to the Wilson formula. As for manufacturers, it can depend on the situation, especially if the order calls for a new production. If so, there is a chance of substantial ordering costs (production configuration) and minimum or zero benefits in marginal unit cost subsequently. These are the circumstances when the Wilson Formula is better suited.
Methodologies for inventory management
Retailers planning to build the reordering process exclusively according to the EOQ should ascertain that:
- they are consistently tracking and upgrading the EOQ of all products,
- warehouses and suppliers can receive recurrent orders, and
- they achieve MOQ for any orders with the most profitable goods given high priority.
Manually computation of EOQ for possibly thousands of SKUs takes a great deal of time. It also is more vulnerable to refilling errors. Additionally, running inventory management completely according to EOQ can cause valuable opportunities to fall through the cracks and create stock issues. To optimize inventory management, continuously track the quantities ordered and reorder levels, as well as frequencies, demand fluctuations, emergency supply levels, supplier waiting periods, order timelines, and more.
Inventory optimization ensures that suppliers and retailers trim inventory to release capital and maximize margins while retaining superior service quality. Small and medium firms use this technique to establish themselves in their industry. However, it is crucial to monitor and analyze all factors that form inventory optimization consistently. The best way to do so is to automate this process.
Inventory optimization helps bring down inventory levels, meet MOQ at the time of placing orders with suppliers, reorder the exact quantities to fill the demand with lead time explained, and perform timely deliveries to customers, among other things.
In the end, the EOQ is the mathematics of deciding the quantity of material to order from suppliers and hold back inventory considering specific aspects such as demand, production, and inventory cost. In short, it’s the perfect quantity of an item that a company must purchase at a given date.
Written by The SupplyPike Team
About The SupplyPike Team
SupplyPike builds software to help retail suppliers fight deductions, meet compliance standards, and dig down to root cause issues in their supply chain.
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