The economic order quantity model is used in inventory management to support replenishment activity. But just how useful is it in reality? Can such a simple formula really be applied to today’s complex supply chains? In this post we find out more…
In inventory management, economic order quantity (EOQ) is the optimal reorder amount that minimises the total costs of ordering and carrying stock. The economic order quantity formula considers how much it costs to order inventory and how much it costs to store it. It then identifies the order quantity where both costs are at their lowest.
Calculating the economic order quantity of stock items can help you reduce inventory costs. Holding costs (otherwise known as carrying costs) are the costs to store inventory and include the storage space, rent, property tax, insurance, item deterioration and obsolescence etc. Obviously, the more inventory you order and carry, the higher the holding costs will be.
Ordering costs are the costs that arise every time you order inventory. They include the costs of creating a purchase order, processing an order, receiving and inspecting the goods etc. You’ll incur ordering costs no matter the size of the order, but the more orders you place, the higher the ordering costs will be.
The economic order quantity calculation helps find a balance between these two conflicting costs.
The economic order quantity formula allows you to calculate the point where your ordering costs and holding costs are minimised; in fact, it’s 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 the economic order quantity you need to know:
You can then plug these numbers into the Wilson Formula, otherwise known as the economic order quantity 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 of calculating EOQ:
Let’s imagine you’re a toy distributor and one of your best sellers is a spinning top. Every year, your demand for spinning tops is 15,000. The ordering costs – once you factor in the cost to create, place, validate, track, receive orders – comes to £20 per order. Finally, the holding cost for each spinning top – 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 spinning tops is approx. 1,096 units per order. With an annual demand of 15,000 units, you’ll be placing orders with your supplier approx. 14 times per year.
Whilst the economic order quantity formula is a relatively simple way to calculate your reorder points, there are several factors to consider when using it:
For more details around these assumptions read our post, the problem with the economic order quantity model.
If you decide to base your reordering processes on EOQ calculations, you need to ensure you’re constantly monitoring and updating the data you input into the formula e.g demand, cost per order and holding costs.
You also need to be sure that your internal operations and supplier network are happy to work around the number of orders stipulated from the results of the calculations.
Without software to support, you’ll find it very time-consuming to manually calculate the economic order quantity for potentially thousands of SKUs. It will also inevitably lead to errors in replenishment and consequently stockouts or excess inventory levels. You may, therefore, want to find an inventory management solution or enterprise resource planning (ERP) platform that will calculate EOQ for you.
If you’d like to overcome the limitations of using the EOQ model and investigate alternative ways of calculating your reorder points and quantities, you could consider investing in an inventory optimisation tool, such as EazyStock. EazyStock will tell you what to order and when, basing calculations on a range of supply and demand variables including:
For more information or to book a free demo, contact us today.