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    Economic Order Quantity: What is EOQ + Formula

    Learn how the EOQ (economic order quantity) formula can help you find the right order quantity to help minimize inventory storage costs.

    Economic Order Quantity: How Can EOQ Help You Minimize Costs & Save Space

    By Shannon Callarman February 26, 2020

    When reordering products, many businesses place orders based on what they need at the exact moment rather than using a reorder quantity formula. Instead, they should optimize the way they order and pay for product by using the Economic Order Quantity formula (EOQ).

    The EOQ formula helps calculate the optimal order quantity to save money on logistics and ecommerce warehousing costs. By calculating EOQ, you’re able to make better decisions on how much product to order in a given period of time.

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    Table of contents:

    What is economic order quantity (EOQ)

    Why you should be calculating EOQ

    3 factors you’ll need to calculate EOQ

    The economic order quantity formula

    Other factors that can optimize inventory

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    What is economic order quantity (EOQ)

    Economic order quantity is a calculation companies use to figure out the optimal order quantity with the goal to minimize the logistics costs, warehousing space, stockouts, and overstock costs. The goal of the EOQ model is to determine the ideal order quantity you should have.

    Why you should be calculating EOQ

    EOQ calculations for your business offer several benefits that impact your bottom line. It’s a great way to grasp how much product needs to be purchased to maintain an efficient ecommerce supply chain while keeping costs down.

    Here are the top benefits of calculating EOQ.

    Minimize inventory costs

    Having extra items in your inventory can quickly increase storage costs. Inventory costs can also go up depending on how you order, what gets damaged, and what products never sell. If you’re constantly re-ordering products that have low velocity, EOQ can help determine how much to order in a certain time period.

    Minimize stockouts

    EOQ can help you better understand how much you need to re-order and how often. By calculating how much you need based on how much you sell in a given period of time, you can avoid stockouts without having too much inventory on hand for too long. You may be surprised that ordering in smaller quantities may be more cost-effective for your business, or it could be the opposite — calculating EOQ can help determine this.

    Improve overall efficiency

    Overall, calculating EOQ can help you make a better decision when it comes to storing and managing inventory. The truth is that many ecommerce business place orders based on a “gut feeling” of how much to order, instead of actually ordering how much product is actually needed. Calculating EOQ is a smart way to better quantify how much you need based on important cost variables.

    3 factors you’ll need to calculate EOQ

    The EOQ formula is made up of three variables: holding costs, demand, and order cost. We break down each variable below.

    1. Holding costs (H)

    Holding cost (also known as carrying costs) refers to the total cost of holding inventory. Minimizing inventory costs is an important retail supply chain management strategy. How much do you spend on holding and storing inventory, per unit, per year? In order to properly calculate EOQ, you’ll first need to determine your holding cost. To do so, you can refer to the simply formula below:

    (Storage Costs + Employee Salaries + Opportunity Costs + Depreciation Costs) / Total Value of Annual Inventory = Inventory Carrying/Holding Cost 

    2. Annual demand (D)

    How much demand do you get for a product each year? By looking into historical order data, you can determine the number of units you sell year over year.

    3. Order cost (S)

    Also referred to as ‘setup cost,’ how much does an order cost per purchase? This is done on a per-order basis and includes both the shipping and handling costs.

    The economic order quantity formula

    The formula for economic order quantity is:

    EOQ = square root of: [2SD] / HS = Setup costs (per order, generally including shipping and handling)D = Demand rate (quantity sold per year)H = Holding costs (per year, per unit)

    An EOQ example

    If you haven’t used EOQ before, here’s an example of how to calculate it:

    Let’s say you have these variables:

    $0.75 in holding costs per unit = H

    Demand rate of 10,000 per year = D

    Setup cost of $500 = S

    You’d get this formula: EOQ =  square root of (2)(500)(10,000)/.75) = 3,652 units per order.

    Your optimal order quantity is 3,652 units for that specific product.

    Other factors that can optimize inventory

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    Economic Order Quantity (EOQ) Defined

    Economic order quantity (EOQ) is a formula to determine the optimal order size to minimize costs and maximize profits — and our free EOQ template will help you get started.

    Economic Order Quantity (EOQ) Defined

    Austin Caldwell | Senior Product Marketing Manager

    May 11, 2021

    For any business that buys and holds inventory, it's essential to place orders in the amounts that best fit your needs. That's where economic order quantity (EOQ) comes in.

    If your orders are too large, you could have too much money tied up in inventory and storage expenses. If you order too little, you won’t be able to meet your customers’ needs. Economic order quantity helps you find the sweet spot where your business makes the ideal order size and maximizes profitability.

    What Is Economic Order Quantity (EOQ)?

    Economic order quantity (EOQ) is a calculation companies perform that represents their ideal order size, allowing them to meet demand without overspending. Inventory managers calculate EOQ to minimize holding costs and excess inventory.

    It doesn’t matter if your business sells jelly beans, appliances, furniture or airplanes. Finding the economic order quantity for every product you purchase is almost certain to impact the bottom line. Every business that manages inventory can benefit from measuring and following the EOQ.

    Key Takeaways

    Economic order quantity is a metric that represents the ideal order size to minimize costs for the business.

    Economic order quantity is a useful formula for businesses of all sizes and types that order and hold inventory.

    Inventory management systems and ERP systems can automate economic order quantity calculations, so your business makes the best, most informed decisions regarding orders and inventory management.

    Economic Order Quantity (EOQ) Explained

    Economic order quantity is a useful metric for businesses that buy and hold inventory for manufacturing, resale, internal use or any other purpose. Businesses that follow EOQ look at all costs related to purchasing and delivery while also factoring in demand for the product, purchase discounts and holding costs.

    Experienced business owners and managers understand that purchasing and finding the ideal inventory levels can be complex. When your vendors offer volume discounts and other incentives to purchase more, EOQ can help you decide on the right place to draw the line.

    EOQ relies on the economic order quantity formula (found below). That gives you a data-driven result to help optimize business profitability.

    Why Is Economic Order Quantity (EOQ) Important?

    Economic order quantity is a key metric for your organization’s sustainability because ordering too much can lead to high holding costs and take resources away from other business activities, like marketing or R&D, that could further boost sales or reduce costs.

    Inventory is a type of working capital. Working capital represents business assets needed for regular operations. But too much working capital can eat into your profits, and it also represents a big opportunity cost.

    EOQ may not be extremely helpful when managing your office supply closet. It's most important when looking at large, high volume or expensive purchases. As your orders and inventory grow and scale, EOQ has a greater impact on profits.

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    What Does Economic Order Quantity (EOQ) Tell Businesses?

    Economic order quantity tells businesses the ideal order size for every product they buy. The EOQ formula assumes annual demand for a product is relatively flat. If you are in a growing business, EOQ may not be the best way to calculate your order size, as those numbers could change frequently.

    Once you work through EOQ, you should know the optimal number of orders per year and the ideal order size. You may adapt the EOQ model to factor in pricing discounts, backorders, defective items and more.

    With your EOQ results, you should have an optimal supply chain order schedule for the entire year.

    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.

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

    Economic order quantity (EOQ) is the order quantity a company should make for its inventory given production cost, demand rate, and other variables.

    CORPORATE FINANCE ACCOUNTING

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

    By JASON FERNANDO Updated March 16, 2022

    Reviewed by MICHAEL J BOYLE

    Fact checked by SKYLAR CLARINE

    Investopedia / Jessica Olah

    What Is Economic Order Quantity?

    Economic order quantity (EOQ) is the ideal quantity of units a company should purchase to meet demand while minimizing inventory costs such as holding costs, shortage costs, and order costs. This production-scheduling model was developed in 1913 by Ford W. Harris and has been refined over time. The economic order quantity formula assumes that demand, ordering, and holding costs all remain constant.

    KEY TAKEAWAYS

    The economic order quantity (EOQ) is a company's optimal order quantity that meets demand while minimizing its total costs related to ordering, receiving, and holding inventory.

    The EOQ formula is best applied in situations where demand, ordering, and holding costs remain constant over time.

    One of the important limitations of the economic order quantity is that it assumes the demand for the company’s products is constant over time.

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    Economic Order Quantity (EOQ)

    Formula for Calculating Economic Order Quantity (EOQ)

    The formula for EOQ is:

    \begin{aligned} &Q = \sqrt{ \frac{2DS}{H} }\\ &\textbf{where:}\\ &Q=\text{EOQ units}\\ &D=\text{Demand in units (typically on an annual basis)}\\ &S=\text{Order cost (per purchase order)}\\ &H=\text{Holding costs (per unit, per year)}\\ \end{aligned}

    ​ Q= H 2DS ​ ​ where: Q=EOQ units

    D=Demand in units (typically on an annual basis)

    S=Order cost (per purchase order)

    H=Holding costs (per unit, per year)

    What the Economic Order Quantity Can Tell You

    The goal of the EOQ formula is to identify the optimal number of product units to order. If achieved, a company can minimize its costs for buying, delivering, and storing units. The EOQ formula can be modified to determine different production levels or order intervals, and corporations with large supply chains and high variable costs use an algorithm in their computer software to determine EOQ.

    EOQ is an important cash flow tool. The formula can help a company control the amount of cash tied up in the inventory balance. For many companies, inventory is its largest asset other than its human resources, and these businesses must carry sufficient inventory to meet the needs of customers. If EOQ can help minimize the level of inventory, the cash savings can be used for some other business purpose or investment.

    The EOQ formula determines a company's inventory reorder point. When inventory falls to a certain level, the EOQ formula, if applied to business processes, triggers the need to place an order for more units. By determining a reorder point, the business avoids running out of inventory and can continue to fill customer orders. If the company runs out of inventory, there is a shortage cost, which is the revenue lost because the company has insufficient inventory to fill an order. An inventory shortage may also mean the company loses the customer or the client will order less in the future.

    Example of How to Use EOQ

    EOQ takes into account the timing of reordering, the cost incurred to place an order, and the cost to store merchandise. If a company is constantly placing small orders to maintain a specific inventory level, the ordering costs are higher, and there is a need for additional storage space.

    Assume, for example, a retail clothing shop carries a line of men’s jeans, and the shop sells 1,000 pairs of jeans each year. It costs the company $5 per year to hold a pair of jeans in inventory, and the fixed cost to place an order is $2.

    The EOQ formula is the square root of (2 x 1,000 pairs x $2 order cost) / ($5 holding cost) or 28.3 with rounding. The ideal order size to minimize costs and meet customer demand is slightly more than 28 pairs of jeans. A more complex portion of the EOQ formula provides the reorder point.

    Limitations of EOQ

    The EOQ formula assumes that consumer demand is constant. The calculation also assumes that both ordering and holding costs remain constant. This fact makes it difficult or impossible for the formula to account for business events such as changing consumer demand, seasonal changes in inventory costs, lost sales revenue due to inventory shortages, or purchase discounts a company might realize for buying inventory in larger quantities.

    Frequently Asked Questions

    How Is Economic Order Quantity Calculated?

    Economic order quantity is an inventory management technique that helps make efficient inventory management decisions. It refers to the optimal amount of inventory a company should purchase in order to meet its demand while minimizing its holding and storage costs. One of the important limitations of the economic order quantity is that it assumes the demand for the company’s products is constant over time.

    How Does Economic Order Quantity Work?

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