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.
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How to Calculate Economic Order Quantity
Economic order quantity formula: √(2SD/H).
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.
The amount of money that you would need to spend on setup costs is denoted by the character S when calculating economic order quantity. This is also sometimes referred to as ‘order cost’. This includes all the costs of packaging, shipping, and handling throughout its journey to you.
Calculating the setup or ordering cost is very easy as it is usually a fixed cost and is not very prone to fluctuation. You might want to invest in setup funds as they might help you buy stock for a cheaper price in a turbulent market that is likely to shift.
The character D is used to represent the demand in units. Usually, the demand is calculated for a year but you can choose to modify it to figure out monthly economic order quantity. This is also the part where the equation comes into question as demand is subject to change.
While there is no foolproof way to accurately predict annual demand, your sales from the previous year can be an indicator of sales in the current year. Consider calculating an overall average to estimate how much stock you need to meet the customer demand.
The character H denotes the holding costs in this equation. Much like setup costs, calculating holding costs is pretty easy to figure out. Holding costs are all the costs associated with the holding of stock till the date that they are sold and delivered to the customer.
Your annual holding cost will consist of all the costs associated with handling and storing your stock. So to get your own annual holding cost, you must add employee cost + opportunity cost + depreciation costs + storage costs and the total value of your stock together. Of these costs that comprise and create the holding cost, labor costs are by far the most expensive for companies.
Decoding the 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)
Why Calculating EOQ is Important?
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. Minimized inventory costs
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. Easier inventory management process
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. High Chances of meeting customer demands
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.
What difficulties Faced While Calculating EOQ?
1. Does not account for abnormal demand
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. Inaccurate data sets
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. Possibility of running out of stock
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.
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The formula for economic order quantity was created by Ford W. Harris in 1913. This makes the formula quite recent when compared to other economic formulas. The EOQ model has seen extensive use in stock-keeping areas and for good reason as it does give companies a clearer vision and greater cash flow.
There is no generic number for the ideal EOQ number as it is simply a number that tells you the amount of annual quantity demanded of stock that you need to meet consumer demand. Some fulfillment services that have a big consumer base like to keep stock higher than their EOQ number to be on the safe side even if it means dealing with a higher holding cost.
Economic order quantity (EOQ) gives you the optimal amount of stock needed to fulfill the product demand to minimize inventory costs, while minimum order quantity (MOQ) tells you the minimum amount of stock required to make a profit. While both are geared to generate more profit, they are indeed different.
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 30 days free trial.