The company’s reputation and profitability are always at stake if it has too much or too little inventory on hand. 43% of business owners have considered “overbuying inventory” as a challenge, whereas 36% said the same for “underbuying inventory”.
To provide a solution to this, in 1913, Ford W. Harris designed a model of “Economic Order Quantity (EOQ)” through an explanation. This was later turned to a mathematical equation by R.H. Wilson, a consultant who applied it extensively.
The Economic Order Quantity is a very good approach for efficient inventory management, though not the only step that a merchant can take, but can certainly make an impact.
T = Total annual inventory cost
P = Purchase unit price, unit production cost
Q = Order quantity
Q* = Optimal order quantity
D = Annual demand quantity
K = Fixed cost per order, setup cost
h = Annual holding cost per unit, also known to be carrying or storage cost
The single-item EOQ formula helps find the minimum point of the following cost function:
Total Cost = Purchase Cost or Production Cost + Ordering Cost + Holding Cost
To determine the minimum point of the total cost curve, calculate the derivative of the total cost with respect to Q (assume all other variables are constant) and set it equal to zero (0):
Solving for Q gives Q* (the optimal order quantity):
Can also be written as,
Let’s assume, a retail clothing shop is into men’s jeans and sells roughly around 1000 pairs of jeans every year. It takes $5 for the shop to hold a pair of jeans for the entire year, and the fixed cost to place an order is $2.
As per the EOQ formula, the calculation of the above-mentioned scenario is below:
EOQ = Sq. root [(2 * 1000 pairs * $2 order cost) / ($5 carrying cost)]
Therefore, EOQ = 28.3 pairs.
The ideal order quantity for the shop will be 28 pairs of jeans. Simple!
The Economic Order Quantity is a quantity designed to assist companies to not over- or under-stock their inventories and minimize their capital investments on the products that they are selling. The cost of ordering an inventory touches down with an increase in ordering in bulk. However, as the seller wishes to grow the size of the inventory, the carrying costs also increase.
The EOQ is exactly the point that optimizes both of these costs i.e. cost of ordering and the carrying costs which are inversely related.
Now, with this…
There are several benefits of calculating EOQ that can impact your business. It shows and lets you maintain your supply chain while keeping the costs down.
There are high chances of booming storage costs if you plan to store any extra inventory. High inventory costs depend majorly on how you order, if there is anything that is damaged, the number of products that lie there not getting sold. If you are constantly re-ordering products that have a very low velocity, EOQ can help you analyze how much to order in a certain period.
By calculating how much inventory you need on how much you are planning to sell, EOQ will help you avoid stock-outs without having too much inventory on hand for too long. It can definitely be surprising enough to see that ordering in small quantities can be way more cost-effective, but this can turn the other way as well – calculating EOQ for your products can help.