Economic order quantity (EOQ) concerns the most cost-efficient method of ordering stock. The objective is to find the order quantity that minimizes the total inventory holding costs and ordering costs.
Holding costs (otherwise known as carrying costs) are the costs to store the inventory and include the storage space, rent, deterioration, obsolescence, property tax, insurance, etc. Obviously, the more inventory ordered, the higher the holding costs will be.
Ordering costs are the costs that arise every time inventory is ordered. Ordering costs include the costs of creating a purchase order, processing an order, receiving and inspecting orders, etc. Note that the actual price of the items is not included in ordering costs. No matter what size the order is, ordering costs will be incurred with every order; the more orders placed, the higher the ordering costs will be.
The EOQ is the point where the ordering costs and holding costs are minimized; in fact, it is at the point where the costs are equivalent to one another. The graph below illustrates how the annual ordering costs and holding costs change as the reorder quantity increases; the EOQ is marked as the lowest point of the total cost line.
To calculate EOQ, you need: the demand of the item per year, the cost per order, and the cost of holding per unit of inventory. You can then plug these numbers into the Wilson Formula, otherwise known as the EOQ formula:
D = demand per year
Co = cost per order
Ch = cost of holding per unit of inventory
Let’s take a look at an example.
Say you’re a toy distributor and one of your big items is a fidget spinner. Every year, your demand for fidget spinners is 15,000. The ordering costs – once you factor in the cost to create, place, validate, track, receive, etc – comes to $20 per order. Finally, the holding cost for each fidget spinner – including rent, storage space, insurance, etc – ends up as $0.50 per unit.
D = 15,000
Co = $20
Ch = $0.50
This means that the EOQ for fidget spinners is approx. 1,096 units per order; with an annual demand of 15,000 units, this means you’ll be placing orders with your supplier approx. 14 times per year.
Many demand planners or supply chain managers think that finding the right EOQ for each item they stock is the obvious best way to manage their inventory. But there are several factors to consider before you just start determining EOQ for each item.
Can my warehouse and staff manage more frequent purchase cycles? In the example above, the EOQ determined that the warehouse would be placing orders for fidget spinners approx. 14 times per year – more than once a month. While this might be the best number to minimize costs, can your warehouse and staff manage to handle more frequent orders and deliveries? Will your supplier even allow more frequent orders? Are there conflicts with the supplier calendar? Feasibility is a concern with EOQ.
Are items slated for reordering already located in my warehouse network? Perhaps your demand has fluctuated, or maybe your demand for certain items varies from location to location where you warehouses are located within your network. Either way, mindlessly reordering items based solely on EOQ may be a waste of your resources if you are already holding items in a different stocking location. In this case, rather than reordering, redistributing those items to where they are needed within your network is a more valuable use of your resources. Redistribution will move your inventory to where it’s needed, saving you from needing to reorder. It also removes items that from the shelves where they have low demand – which frees up space for more valuable items.
Can capacity loss be offset by running lower demand parts less frequently? Ordering the EOQ for each item in your warehouse regardless of how valuable they are to your sales can lead to a shortage of your more valuable SKUs. Are you wasting valuable space on items that you don’t need to have in stock at all times? Prioritizing your higher demand and more valuable SKUs will ensure that you keep your customer service levels up. You can determine which SKUs are your most valuable with ABC analysis, and this can help you both prioritize SKUs and determine the optimal warehouse layout to keep those SKUs close at hand for your pickers and packers.
Will EOQ orders meet the minimum order quantity (MOQ) requirement of suppliers? Smaller batch orders with higher frequency gives inventory managers more flexibility to align purchasing patterns with actual customer demand. But many suppliers require a minimum order quantity (MOQ) before they send out a shipment. For orders that don’t reach MOQ, the suppliers are decreasing their profit margin per unit and increasing shipping costs. Even if your suppliers are alright with more frequent orders, they will not risk losing their profits.
While this isn’t an exhaustive list of what to consider when you’re determining EOQ and placing orders with suppliers, these questions clearly demonstrate that effectively managing your inventory requires more than just EOQ for each SKU.
Finding and maintaining EOQ would be relatively simple in an environment where the demand for each item and the cost per item were constant and if there was a relatively low number of items to calculate EOQ for. But as items move through the product lifecycle and demand shifts and you are calculating EOQ for potentially thousands of SKUs, finding and maintaining EOQ becomes a much bigger challenge.
Since annual demand is an integral component of EOQ, it becomes vastly more challenging to calculate EOQ as items change demand. EOQ for each item needs to be re-determined constantly to account for lifecycle changes. The graph below demonstrates how demand can shift according to the lifecycle stage of an item:
To add to this challenge, demand does not necessarily remain constant for an item throughout the year. Factors like seasonality need to be considered. In our example, the demand for fidget spinners was 15,000 per year, and EOQ was approx. 1,096 units per order. However, maybe the demand for fidget spinners surges around the holidays as people purchase them as gifts while the demand trails off for the rest of the year. Holding a huge amount of fidget spinners in stock throughout the months where demand is low ends up costing more in holding costs and taking up valuable space from other high-demand items in your inventory.
If you’re planning to base your reordering process based solely on EOQ, you need to ensure that are constantly monitoring and updating the EOQ of all your items, that there is no issue for your warehouse staff or suppliers with placing more frequent orders from suppliers, that you’re reaching MOQ for any orders you place and that your more valuable items are being prioritized.
Manually calculating EOQ for potentially thousands of SKUs is time-consuming and will inevitably lead to errors in replenishment. Plus, basing inventory management solely on EOQ is not the best practice. Optimizing your inventory management requires constant monitoring of order quantities and reorder points, but also of pick frequencies, demand changes, safety stock levels, supplier lead times, order schedules… the list goes on.
Inventory optimization – that is, making sure your inventory is slimmed down to free up capital and increase margins while you still maintain high service levels – is how small- and mid-sized businesses can make their mark in their industry. But keeping track of all the considerations that go into inventory optimization requires constant analysis. Fortunately, that’s a process you can automate!
EazyStock is inventory optimization software that monitors all your SKUs for you and, in return, delivers optimized inventory parameters and order proposals. With inventory optimization, you lower your inventory levels, fulfill MOQ when ordering from suppliers, reorder the correct amounts to cover your demand with lead time accounted for, deliver to your customers on time and more! Plus, you’re no longer spending hours and hours calculating EOQ for every SKU in your portfolio – so you can move on to finding new ways to grow and expand your business.