A Beginner’s Guide to the Economic Order Quantity Model

Finances are always tight when you’re running a business, and you’re always on the lookout for ways to cut costs.

One costly part of running a business is inventory. Those products don’t look expensive just sitting there on a shelf, but every second they are costing you money in storage fees, employee salary, and other miscellaneous overhead costs.

What if you could have just enough inventory on hand to fill customer orders, with almost no excess inventory — meaning you’re operating at peak efficiency and aren’t spending a penny more on inventory than absolutely necessary? It would save you a lot of money.

Fortunately, you can do this, by using the economic order quantity (EOQ) model. Many businesses use this tried-and-true method to keep inventory costs at a minimum.

Let’s dive into what this model is all about, how to calculate it, and see if it makes sense for your business.

Overview: What is economic order quantity (EOQ)?

Economic order quantity (EOQ) helps a company have the most efficient number of products on hand — minimizing inventory costs as much as possible while also ensuring the company has enough inventory to meet demand.

EOQ supply chain management generally only works if demand for a product remains constant over a long period. Constant fluctuations in demand make achieving EOQ difficult, meaning you would often have too much or too little product on hand.

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EOQ is an important part of a systemic inventory management system. Under this model, you order a fixed amount of inventory each time inventory reaches a predetermined reorder figure.

What does the economic order quantity model tell you?

An EOQ model helps an inventory manager determine when products should be reordered, restocking inventory only when it drops to a certain point. It determines the optimal quantity of EOQ inventory to reorder, and it reduces the risk of shortages or excess inventory.

It also helps determine the operating cash flow necessary to keep the business running. This model is valuable for a small business owner since it can reduce overhead costs.

How to calculate costs with the economic order quantity formula

Calculating economic order quantity is relatively straightforward and involves a simple EOQ formula. Once you’ve arrived at your figure, you’ll know how much product to order when restocking.

1. Calculate demand in units

First, determine annual unit demand. For this EOQ example, if you sell 10,000 widgets per year, that’s your base number of units, and we will use it as the foundation for this formula.

2. Calculate the order cost

Next, calculate the order cost, which is the incremental cost to process, set up, and order the unit. For this example, let’s say the cost is $150 per widget.

3. Calculate the holding cost

Calculate the holding cost — also called carrying cost — which is the cost to hold one widget in your inventory. Let’s say it’s $25 per widget in this example.

4. Double the demand figure

With these numbers in hand, we can calculate your EOQ. First, double the demand figure:

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2 x 10,000 = 20,000

5. Multiply the result by the order cost

Next, multiply the doubled demand figure by the order cost:

20,000 x 150 = 3,000,000

6. Divide the result by the holding cost

Take this new figure and divide it by the holding cost:

3,000,0000 / 25 = 120,000

7. Calculate the square root of the result

Take the square of the result from Step 6 to get your final EOQ:

Square root of 120,000 = 346

So, the company should order 346 widgets to achieve optimal inventory levels, according to the EOQ equation.

3 benefits of the economic order quantity model

The EOQ model doesn’t work for every business model, but it has key benefits every company should consider. It can make your company run more efficiently and cut costs.

1. Reduces holding costs

With a properly calculated EOQ, a business knows exactly how much product it should have on hand to meet customer demand. The company doesn’t order more than necessary, and therefore, doesn’t pay to hold excess inventory. This also saves staff time and frees up capital for other purposes. Companies can also better leverage discount bulk buying to achieve further savings.

2. Minimizes inventory space

The EOQ model minimizes inventory space taken up by this product, which can be used for other purposes. For example, a company could decrease inventory space for products that aren’t selling while increasing inventory space for products that are. A company can optimize the costs related to the space and maximize staff efficiency.

3. Helps a business run better

When you run your inventory at maximum efficiency, your business runs better as a whole. You’re able to meet customer demand more efficiently, determine better when to reorder, and know how much inventory to hold. All of which enables you to offer enhanced customer service.

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Limitations of the economic order quantity model

The EOQ model doesn’t work for all businesses, however. Businesses must be equipped to gather the data to make an accurate calculation. Getting the EOQ formula wrong because you don’t have the right data on holding or order costs means you have the wrong amount of inventory, which could cost you big if you run out of a product or stock way too much of it.

Also, EOQ assumes continuous demand. If your product demand fluctuates greatly, it will be impossible to accurately calculate your EOQ. This can be a problem for startups and seasonal businesses.

Finally, EOQ assumes fixed costs. In some businesses, those costs may change because of many factors. So even if your order quantity is constant, fluctuating costs may still make your EOQ calculation inaccurate.

Software can help with the data

Calculating EOQ is impossible without the proper data, so the first step in implementing the EOQ model, or at least exploring it as a possibility, is to use software that can gather that information.

Inventory management software will track how much inventory you’re moving per day, week, month, or year, and indicate your order and holding costs. Once you have this data, you can run it through the formula above to determine your EOQ.

Inventory software offers other features and tools you can combine with the EOQ to further cut costs, such as implementing more efficient order picking methods, cutting supplier lead time, and setting up automatic reorders. These efforts will help your business operate as a well-oiled machine and keep you from spending money on things you don’t have to, freeing up capital to expand your business rather than just tread water.

View more information: https://www.fool.com/the-blueprint/economic-order-quantity/

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