Economic Order Quantity: Assumptions and formula
16 Sep 2021
Economic Order Quantity, also known as EOQ, is a production-scheduling model, which was first developed by an American production engineer Ford Whitman Harris in 1913. The purpose of EOQ is to determine the perfect order quantity that a company should choose for inventory purchases, which will minimize inventory handling and ordering costs.
What is Economic Order Quantity?
This formula aims to identify the maximum number of units so that an organization can minimize its costs in terms of storing, taking delivery, and buying the units. The formula is easily modified to gather information about varying production levels.
It has become a cash flow tool that can minimize the amount of cash and the inventory cost integrated into the inventory balance. The formula also calculates the inventory reorder point of an organization.
This helps the company as it avoids running out of inventory to fulfill all the orders promptly.
What does the Economic Order Quantity tell you?
The Economic Order Quantity (EOQ) aims to determine the optimal quantity of products to be ordered. As a result, ordering and handling costs are minimized.
EOQ is also a crucial tool when it comes to cash flow management. Businesses can use it to manage the financial resources tied up to the inventory balance. Because for many companies, inventory is one of the most significant assets. So, those businesses need to minimize inventory volumes to the level where it still meets the market needs but does not create unnecessary costs. Thus, by optimizing inventory levels, businesses can invest cash savings for other activities or assets.
Assumptions under the EOQ method
The Economic Order Quantity model holds certain assumptions on inventory practices and norms.
First of all, the EOQ model assumes that there is a demand certainty regarding that specific product. So, it ignores potential seasonal fluctuations and behavioral changes that can affect the annual market demand.
The second assumption is about the invariability of ordering and holding costs. The model supposes that the costs such as transportation expenses and warehouse rent either do not change or do not affect the ordering and handling costs, which is not entirely realistic.
The third assumption relates to the absence of potential discounts. The Economic Order Quantity model does not consider that a business can receive discounts, for example, when ordering in larger quantities.
Economic Order Quantity formula and example
Q=2 x D x S / H
Q = EOQ (units)
D = Demand (units)
S = Ordering costs (per order)
H = Holding costs (per unit, annual)
Let’s further understand the main elements of the formula.
As the name suggests, ordering costs occur every time the company places an order with its supplier. Ordering costs are charged for each order, so the more times the orders are made, the higher the annual ordering cost. General ordering costs may include delivery fees, telephone charges, expenses related to the payment process, and inventory verifications.
Holding costs are otherwise referred to as carrying costs. These costs occur while the company owns the inventory in a warehouse, storage, or store. The larger are the ordered product volumes; the higher are the holding costs. Holding costs generally include storage rent, storage utilities, property tax, insurance, and other expenses.
EOQ formula in a practical example.
The company XYZ is a retail company operating in wine retail. Its forecasts tell that the market demand in a month is 10,000 bottles. The company has also calculated that the cost for one order is $1000, including all costs and expenses associated with it, such as transportation and labor expenses. The holding cost for a bottle of wine is $10, including insurance and storage costs.
The logistics manager has to determine the ideal quantity for an order to minimize the ordering and holding costs.
So, the economic order quantity formula is the following:
Q=2 x D x S / H
D, which is the annual demand, will equal the monthly demand multiplied by 12.
D = 10,000 x 12 = 120,000 bottles.
S is the setup costs, which in problem was referred to as ordering costs. It is $1,000.
Lastly, the H is the holding cost per unit, which is $10.
Inputting these data into the formula the manager will get the following:
Q=2 x 120,000 x 1,000 / 10= 4,899
So, the perfect quantity for an order, which will minimize inventory costs, is 4,899 units.
Advantages of the EOQ model
- Because the model helps determine the perfect quantity for an order, the company will not hold extremely high inventory levels. As a result, it will have lower holding costs and save money on rent and other expenses.
- The company will also get its ordering prices reduced. It will reduce the frequency of the orders to the optimal level. As a result, there will be no need for ordering too often.
- The EOQ improves the overall inventory management due to the reduction of operational expenses and increases in profits.
Disadvantages of the EOQ model
- There are assumptions under the model, which might not always be practical in real-life business scenarios. For example, the EOQ model assumes that the demand is fixed and does not consider its seasonal effects.
- Sometimes, the supplier might not fulfill the orders because of a lack of materials, for example. As a result, the company may face losses or supply chain challenges.