EOQ Formula: Complete Guide to Economic Order Quantity Calculation 2024

The Economic order quantity (EOQ) formula is required by any business looking to understand the amount of stock they need in order to satisfy demand. Excess inventory usually ends up as waste for the companies that overspend, making it important to minimize inventory costs.

According to Bloomberg, around $163 billion worth of inventory is trashed each and every year. Seeing such brutal wastage of inventory, it is no wonder why businesses are looking into the EOQ formula, as it can truly alleviate most of the cost issues with stock-keeping estimation.

This basic formula can save businesses thousands of dollars as it prevents you from overspending on inventory costs. The economic order quantity formula takes into account multiple factors to bring down total costs and gives you insights into managing inventory.

Understanding EOQ Formula Fundamentals

What is Economic Order Quantity?

Economic Order Quantity (EOQ) is a key inventory management metric. It helps businesses determine the optimal order quantity to minimize total costs related to ordering and holding inventory. The formula is designed to balance the cost of replenishing stock with the expense of storing it.

Here:

• S: Setup cost
• D: Demand (in units)
• H: Holding cost

If that looks complex and confusing, then you are not alone. When an equation is vaguely introduced it can be hard to understand its meaning and utility. Let us understand how each character in the economic order quantity equation functions to give you the optimal order quantity to meet customer demand.

Key components of EOQ formula

Setup cost breakdown

Setup cost, represented by S, includes the expenses related to preparing and placing an order. This is sometimes referred to as the “order cost” and covers costs such as:

• Packaging
• Shipping
• Handling

Setup costs are generally fixed and do not vary much over time, making them easy to calculate. Understanding your setup cost helps you anticipate expenses and even plan bulk orders to mitigate market fluctuations.

Demand analysis

The demand, denoted as DD, is the number of units required over a specific period, typically one year. Calculating demand can be challenging due to its variability. However, past sales data serves as a useful benchmark.

For the best results:

• Use historical sales data.
• Calculate an average to estimate future demand.

This step ensures your stock levels are aligned with customer needs while minimizing excess inventory.

Holding cost calculations

Holding costs, represented by H, include all expenses incurred to store and maintain inventory until it is sold. These costs often consist of:

• Employee wages
• Opportunity costs
• Depreciation costs
• Storage expenses

Of these, labor costs are often the highest. Calculating the annual holding cost is straightforward. Add up all relevant expenses, and you’ll have an accurate figure to use in the EOQ formula.

Decoding the EOQ formula

Armed with the meaning behind the characters, we can move on to working out the equation to fully learn how to calculate your EOQ. Follow the steps given to understand how the equation works and how you can use it on your own.

1. Multiply the Setup cost by 2 (2 x S)
2. Multiply the Setup cost by the Demand (2 x S x D)
3. Divide the sum by the Holding cost (2 x S x D / H)
4. The square root of the final number is your EOQ  (EOQ = √2 S x D / H)

By following these steps, you can calculate the EOQ for your business and optimize inventory management. Let’s discuss these steps in detail in the next section.

Step-by-Step EOQ Calculation Guide

Formula components and variables

As we have already discussed, before diving into calculations, it’s important to understand the variables used in the EOQ formula:

• Setup Cost (S): The fixed cost of placing an order, including packaging, shipping, and handling.
• Demand (D): The total number of units required, typically measured annually.
• Holding Cost (H): The cost of storing one unit of inventory for a year, including labor, storage, and depreciation.

With these components, the EOQ formula helps find the optimal order quantity to minimize overall inventory costs.

Practical calculation examples

Basic EOQ calculation

Let’s calculate EOQ for a simple scenario:

• Setup Cost (S): $50 per order
• Annual Demand (D): 1,000 units
• Holding Cost (H): $5 per unit per year

1. Multiply the setup cost by 2: 2×S = 2×50 = 100
2. Multiply this result by demand: 100×D = 100×1,000 = 100,000
3. Divide by the holding cost: 100,000/H = 100,000/5 = 20,000
4. Take the square root of the result: EOQ= √20,000 ​≈ 141

So, the optimal order quantity is 141 units.

Advanced scenarios

In more complex situations, other factors may need to be considered, such as fluctuating demand or seasonal variations. Here’s an example:

• Setup Cost (S): $40 per order
• Demand (D): 1,200 units, with higher demand during peak months
• Holding Cost (H): $6 per unit per year

Steps:

1. Multiply setup cost by 2: 2×S = 2×40 = 80
2. Multiply by demand: 80×1,200 = 96,000
3. Divide by the holding cost: 96,000/6 = 16,000
4. Find the square root: EOQ = √16,000​ = 126

In this case, the optimal order quantity is 126 units.

For seasonal peaks, consider adjusting demand estimates to reflect actual needs during high-demand periods to avoid stockouts or overstocking.

By following these examples, you can confidently calculate EOQ for various scenarios and refine inventory management strategies.

Benefits of Using EOQ Formula

Other than being aware of the amount of stock that you need to keep to satisfy demands, calculating EOQ has some other lesser-known benefits. These benefits range from helping you keep your stock more organized to saving you a whole bunch of money on holding cost.

1. Cost optimization

Holding inventory without the need for it is a seriously wasteful habit that businesses must avoid. This is not only because of a greater annual ordering cost but also the additional holding cost of deliveries and storage. Having too much stock can really be very taxing on any business.

When you have just the right amount of stock, you can not only save money on ordering costs but also on storage costs that arise from overstocking. Having the optimal order quantity also has a few unforeseen advantages on management for many companies.

2. Inventory management efficiency

With sufficient inventory levels, you can really make an impact on the inventory management process. The supply chain is notorious for getting cluttered quickly which is why it is best if a business can keep its inventory limited and organized.

Even if you are not worried about supply chain management, it is still a good idea to have a limited annual quantity of stock. This is due to the fact that you will be paying less when it comes to carrying costs. 

If you run your own warehouse then this is great news as you will be able to more efficiently manage it due to the lesser stock. Among the other great warehouse organization tips, having a limited amount of inventory can drastically reduce costs and efforts.

3. Customer satisfaction impact

Companies often overstock in fear of a sudden spike in consumer demand. Though this sudden spike often is not the case. Seeing how much money is spent on unused inventory, companies are starting to pay heed to their economic order quantity.

Because you can derive accurate reorder points from the economic order quantity formula, it can save you from tremendous stress. A reordering point can go a long way when trying to understand when you need to restock your inventory to meet demand.

When you have your EOQ number you can not only meet your customer demand but also minimize costs. This allows you to remedy two of the biggest concerns of any business at once. Knowing your economic order quantity can reduce your inventory costs really fast.

Common EOQ Implementation Challenges

1. Demand fluctuation management

It is often the case where customer demand, either exceeds or plummets below the estimation and this is true for almost any business out there. This is why despite the best efforts from top companies, they still either overspend on total cost or fail to meet annual demand. 

Because the economic order quantity formula assumes demand as a constant number it can be difficult to use the EOQ formula if you have widely fluctuating demand. These fluctuations put the utility of the EOQ formula under question. 

2. Data accuracy issues

Most business owners tend to underestimate their demand or inflate their setup costs when calculating their EOQ. This is a highly risky move as it can severely affect your EOQ number, leading to you either overspending on stock or not having enough to meet demand.

The EOQ formula already assumes most of its values as constants. In such a scenario it is best to always use the most accurate data available to derive your final EOQ number. Only a business that has a constant amount of regular customers can utilize the EOQ formula the best.

3. Stock-out risk mitigation

The Achilles heel of the economic order quantity formula is that it was primarily made for minimizing inventory costs. It gives you the most optimal quantity of stock that you need to meet demands and reduce costs based on the data that you provide. 

Though as previously stated, the formula does not account for variable cost or demand, leading you to recalculate EOQ. This is why businesses often buy more stock than suggested by their EOQ number to not run out of stock during higher demand periods.

How Upper can Save Time and Money on Your Delivery Trips?

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Final Derivative

The economic order quantity (EOQ) formula has been used globally by a wide range of businesses to maximize profits and minimize costs by letting you know the annual quantity demanded. It can also vanquish inventory management issues and the concern of being able to meet consumer demands without the need for dedicated inventory management software. 

While the EOQ formula does have a lot of benefits, it also has its own share of shortcomings.  Since it relies on the constant data that you provide, it is unable to adapt to the differences in demand, unit price, or holding costs. This makes the EOQ formula unreliable for some businesses when calculating the annual quantity demanded.

Though the one thing that you can rely on without a doubt is Upper’s ability to give you the finest routes in existence to reduce delivery costs heavily. The difference Upper makes to the delivery process is best seen first-hand, which is why you should try our 7 days free trial.