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Economic Order Quantity: What Does It Mean and Who Is It Important For?

November 8, 2022
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Businesses involved with purchasing and holding inventories know that purchasing too little or too many resources is equally bad for the overall business operation. When the order is too large, this equals to wasted money sitting in inventory that means having too much money sitting in inventories while more investment  money is spent just to accommodate the extra supply those orders. On the other hand, purchasing too little resources will lead to an under-supply in the end  order product order product.

To avoid these scenarios happening to businesses, a scheduling model known as economic order quantity (EOQ) comes in. What is it, and why is it important?

Definition of Economic Order Quantity (EOQ)

Essentially, an economic order quantity (EOQ) is a production-scheduling model first introduced in 1913 by Ford W. Harris. According to Investopedia, EOQ is the ideal quantity for a purchase taken to minimize inventory costs. These costs include holding costs, shortage costs, and order costs.

As the name suggests, EOQ is used to avoid unnecessary costs and excess inventory. With a properly calculated EOQ, you won’t have purchased products piling high in your warehouse. A proper EOQ also ensures that the ones that pile up in the warehouse won’t be there for long.

However, like other human creations, EOQ comes with its own limitations. The formula assumes that the demand, order costs, and holding costs remain constant. Because of thisit, it is ’s next to impossible to calculate business events like demand surges during a certain period, increasing inventory costs, or purchase discounts.

How to Measure Economic Order Quantity (EOQ)

Economic order quantity is calculated as a means to identify the most optimal number or quantity of product units to order. Typically, this calculation is used for high volume or expensive purchases by a company.

The variables comprising the formula consist of demand in units, order cost per purchase, and annual holding costs per unit. The formula for calculating EOQ is: Q = √ [2DS/H]

  1. D = Demand in units (annual)
  2. S = Order cost
  3. H = Holding costs (per unit, per year)

Where:

Q = EOQ units

D = demand in units

S = order cost per purchase

H = annual holding costs per unit

The formula is adjustable to accommodate different product levels or purchase intervals. Larger corporations with equally larger supply chains and inventories might use computer software to calculate their EOQ. This is to eliminate human error during calculation due to the enormous amount of order cost and annual holding cost.

The formula generates not only the EOQ units but also reorder points. Reorder point is a point in which the EOQ triggers the need to place an order for a new batch of product. A determined reorder point will help your business avoid running out of inventory and continue meeting the customer’s demand.

It’s worth noting that the formula assumes the annual demand to be relatively flat, meaning that new EOQs should be calculated with every purchase. However, once you have done the math, you’ll end up with the ideal order size and the optimal number of purchases for a time period.

Economic Order Quantity and Why It Is Important

Economic order quantity was formulated to reduce holding costs and minimize the risk of unused products going bad before being used in the manufacturing process. With that said, the ones that benefit most from EOQ are actually the business owners and managers. They are the ones responsible for managing the business operations, including purchasing products.

If we’re talking about the importance of EOQ for business operations, the most obvious discourse is how it can help companies efficiently manage their inventory. Since inventory is a type of working capital, it represents business assets required in regular day-to-day operations. However, a poorly managed working capital will end up eating your profits and represents a big opportunity cost your company has to bear.

Calculating EOQ is quite hard, especially if your inventory consists of dozens of products. That’s why most established companies resorted to algorithms that automatically calculate the EOQ units of each purchase. In this case, the algorithm is usually developed by their own internal team.

However, smaller businesses can also take EOQ into account calculate EOQ using third-party services. One such service is Nimbly Technologies. With a simple mobile app and powerful dashboard, Nimbly helps business owners digitalize and automate business operations and boost their company’s performance. Click here to learn more about what Nimbly has to offer.

Benefits of Economic Order Quantity (EOQ)

The main benefit of using EOQ is improved profitability. Here’s a list of benefits that all add up to savings and improvements for your business:

  • Improved Order Fulfillment: When you need a certain item or something for a customer order, optimal EOQ ensures the product is on hand, allowing you to get the order out on time and keep the customer happy. This should improve the customer experience and may lead to increased sales.
  • Less Overordering: An accurate forecast of what you need and when will help you avoid overordering and tying up too much cash in inventory.
  • Less Waste: More optimized order schedules should cut down on obsolete inventory, particularly for businesses that hold perishable inventories that can result in dead stock.
  • Lower Storage Costs: When your ordering matches your demand, you should have less products to store. This can lower real estate, utility, security, insurance and other related costs.
  • Quantity Discounts: Planning and timing your orders well allows you to take advantage of the best bulk order or quantity discounts offered by your vendors.

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