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Economic Order Quantity (EOQ): Definition and Formula

Economic Order Quantity

Economic order quantity (EOQ) is a production-scheduling model that finds the ideal inventory amount a business should have in stock. The quantity of stock should allow the business to meet customer demand and minimize costs at the same time. 

The EOQ formula is an important factor in inventory management, as it reduces the amount spent on storage or holding costs while helping inventory managers maximize cost optimization. In other words, calculating the EOQ will assist in only spending on what your customers want, reducing unnecessary business costs.

Key Takeaways

  • The economic order quantity formula is used to optimize a company’s order quantity, meeting demands while being able to minimize inventory costs and avoid shortages.
  • The EOQ works for companies of any size that carry inventory.
  • The EOQ model assumes perfect conditions, but may not be right for fast-growing companies.
  • Using the economic order quantity calculation can help ensure you don’t run out of stock, without overspending on storage or tying up too much of your cash flow.

Table of Contents

What Is EOQ?

EOQ uses a formula to determine the most advantageous amount of stock for a business to order. With this calculation, companies can maximize their cash flow by reducing inventory levels and holding costs, without running out of product. 

It’s important to keep enough stock on hand to ensure customer satisfaction, and finding the optimal order quantity can minimize inventory costs, allowing the business more cash on hand to invest, or use for another purpose.

Any company needs to find the correct inventory ordering balance. If they run out of stock on a popular item, they lose money. If they have too much unsold inventory, they’re wasting usable funds and tying up cash flow in a product that’s not selling, while spending money on costs related to storage and maintenance.

Calculating the EOQ on each item will give you the optimal reorder point, meaning when the item’s inventory falls to a specific number, it’s time to reorder. As different vendors have unique production and shipping times, each item may have a different reorder point. As your business grows, you may consider implementing an automated inventory management system to keep track of stock levels, inventory costs, and order dates.

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EOQ Formula 

The economic order quantity formula is:

EOQ = √(2DK/H)

In this formula, there are several variables. Here’s what each one means:

D = The annual demand for a product (the number of product units purchased in a year)

K = The ordering costs on each purchase order

H = The holding costs, or storage costs for storing inventory, per unit

How To Calculate EOQ With an Example

While the above formula may look complex, calculating economic order quantity is straightforward. If you want to calculate EOQ, find the square root of 2 times the annual demand (in units) multiplied by the order cost per purchase order, divided by the annual carrying cost or holding cost per unit. 

Let’s look at an example to better understand how to calculate economic order quantity.

Let’s say you run a small clothing store that carries a popular baseball cap, and you sell 400 caps each year. It costs your company $3 per year to hold each hat in inventory, and the average order cost is $900. 

To plug these numbers into the EOQ equation, it will look something like this:

EOQ = √(2DK/H)

So,

EOQ = √[2 x (400 x $900)] / $3

EOQ = √[2 x 360000] / $3

EOQ = √720000 / $3

EOQ = √240000

EOQ = 489.9

In this example, assuming demand remains constant over time, the optimal quantity of hats to minimize your order costs while meeting demand would be approximately 490 units. 

Why Is Economic Order Quantity Important For Business? 

The EOQ model is important for several reasons:

1. Reduces Over-ordering

Using the EOQ for inventory planning can help you meet demand while maintaining a reasonable inventory balance. While at first glance over-ordering may seem like a safer move, you may be tying up too much of your cash in physical stock during periods of low demand. This can result in missed business and investment opportunities.

2. Lower Storage Costs

Calculating EOQ for each item in stock will help you determine the right amount that meets demand, with fewer products in your store. This is important, as holding inventory on-site results in additional real estate costs, security fees, utility bills, insurance premiums, and other related costs.

3. Plan Bulk Orders

Many vendors offer purchase discounts or large quantity discounts when you order items in bulk. You can also save money on shipping and handling fees when you order more than a few items at once. By using your EOQ calculations, you’ll be better able to take advantage of these perks.

4. Reduce Waste

When you use the economic order quantity model can help you cut down on dead stock and obsolete or expired products. By calculating the optimal order quantity of each item, you will be more likely to sell it well before its best-by date.

5. Satisfied Customers

Customers are much more likely to return to a business that is reliable, with products consistently available. If your business experiences inventory shortages and cannot meet customer demand, you will lose revenue, and the customer will be less likely to return in the future. The EOQ calculation will ensure enough product is on hand, which can lead to increased sales. 

Limitations of the EOQ Model 

The EOQ model has certain limitations as well, such as:

1. Not accounting for business growth

This model assumes that costs like ordering and holding remain constant, whereas, especially in fast-growing businesses, inventory needs may change quickly. The EOQ could potentially lead to shortages, and may not be the best way to calculate your order size if business is booming. 

2. Requiring consistently updated data to remain accurate 

A big challenge growing businesses face when using the EOQ model is having to keep track of current sales and stock quantity data. An automatic inventory management system can help keep you up-to-date on stock numbers, sales amounts, and associated costs, as manual calculations can lead to inaccuracies. 

3. It does not account for changing needs and fluctuations in cost and demand

In many businesses, the amount of ordering can change based on the season, how much a product costs up the supply chain, whether a vendor offers a discount, whether consumer demand remains steady, and other factors. For example, a popular item that was once in constant demand may fall out of style, or a business may need to ensure they have more Halloween costumes available for purchase in October. These fluctuations make it difficult to forecast demand. 

4. It may result in inventory shortages

It can be difficult to forecast the exact optimal number of stock to have on hand at your business and may result in cautious calculations that cause you to order smaller amounts. This under-ordering may cause inventory shortages, which can lose your business money. 

How To Optimize Inventory Using EOQ 

There are several ways to optimize inventory using the EOQ model, discussed in detail below.

Reorder Point Determination

Your reorder point is a predetermined level of inventory a business is comfortable reaching before it’s time to place a new order. This number is different for every item, as each item will have a unique EOQ. 

The reorder point determination is found using the following formula:

Reorder Point = Lead Time Demand + Safety Stock

Lead time demand means the amount of demand you anticipate the product will have between now and when the delivery will arrive to replenish your stock. Safety stock is the amount of extra inventory you keep on hand to ensure you don’t run out. 

Safety Stock Assessment

As mentioned above, your safety stock is the amount of product you keep on hand, above what you believe will sell, to ensure you don’t run out between orders. A safety stock assessment involves analyzing the time it takes for the product to arrive from the vendor, the average demand for the product, your supply chain configuration, and your comfort level with running low. 

Keeping safety stock on hand is a good idea, as it can help you avoid unhappy customers if you run out of the item they want due to supplier delays, unexpected demand, or an inaccurate inventory forecast. It gives you the breathing room you need in case something is delayed or goes wrong, while increasing efficiency, improving your relationships with suppliers and retailers, and lightening the workload of your employees.

Real-Time Inventory Monitoring 

While the EOQ calculation model assumes there will be consistent demand for your product, and pricing will remain constant, reality is not usually that simple. Using EOQ supply chain calculations is only effective if you can use reliable data. 

You need to be able to track and manage your inventory levels as they change, in real time. Keeping current will allow you to restock your inventory on time, so your business continues to run smoothly and keep up with fluctuating demands and other irregularities. Automated inventory software is the easiest way to optimize inventory management, avoid stock-outs, keep customers happy, and improve workflow.

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Leveraging EOQ for Optimized Inventory Control 

When you use economic order quantity (EOQ), you eliminate the need for guesswork as you order stock, and ensure you don’t over-order or run out too quickly. The EOQ formula is data-driven, and when combined with expense and inventory management software, makes it simple to stay on top of your company’s inventory needs. 

FreshBooks expense-tracking software solutions help businesses organize their receipts and spending and automatically track and categorize inventory expenses. This gives company owners the data they need to analyze their spending and profits, with no manual entry required. Try FreshBooks free today, and see for yourself how FreshBooks can help you save time and energy while maximizing profits.

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Sandra Habiger, CPA

About the author

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.

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