Retailers lose $1.1 trillion globally in revenue due to overstock and out-of-stock situations. So if you still don't believe ordering the wrong amount of inventory for your business can be extremely costly, you should think again. On one hand, ordering too much inventory results in obsolete inventory and high storage space cost. On the other hand, if you have too little stock, you run the risk of stockouts occurring and letting your customers go elsewhere. What metric can you use to assist you in determining the ideal quantity of goods your business should order?
We’ve got the answer for you: economic order quantity.
What is Economic Order Quantity?
The definition of economic order quantity, or EOQ in short, is the optimum quantity of goods that a company should purchase at a single time to minimize their total inventory cost to the lowest level.
How does using EOQ help your business?
1. Reduce your storage and holding costs
It is a common misconception that accounting for inventory ends after its purchase. Other than the cost of production, you still have to take into account the ordering cost and cost of holding your product inventory in stock. While technology has helped to make inventory management more efficient, “days inventory outstanding” (which is the number of amount of inventory on hand based on average sales a day) has risen at a pace of 8.3% over the past five years. This begs the questions, how do you lower your inventory cost?
The EOQ model considers these factors. Using the EOQ model, you can find the ideal quantity of goods to purchase in one order that is the most economically profitable. If you order too few products at one time, you might find yourself having higher inventory cost due to a higher total ordering cost. The higher ordering cost consists of the cost incurred due to ordering, handling and shipping cost of that particular order. Other times, you might not be saving money when you buy in bulk quantities due to higher storage cost. Only when you order at your EOQ value are you able to achieve the lowest possible inventory cost possible.
2. Satisfy your customer’s need
Ensuring that you have enough products to meet your customer’s demand is often a difficult task. However, by using the EOQ formula, you can determine how much stock to maintain, when do you need to re-order inventory and the number of goods to order. With this information, you can ensure that you will have enough product stock to keep orders fulfilled and your customers satisfied.
Limitations of EOQ
While EOQ is useful for your business, there are some limitations that you will need to take note of when using this value for ordering products to your inventory.
Here are the assumptions for the EOQ model.
- There is a constant demand for the product.
- You must have the ability to restock your product immediately. There is no delay for the re-ordering of the stock and the quantity delivered is the exact quantity demanded.
- Your business is not seasonal and does not fluctuate throughout the year. Note: The standard EOQ model does not factor in seasonality or economic fluctuations. In order to account for seasonal variations in your product, you can use a shorter time period for your EOQ calculations during which the demand is relatively constant for the particular time frame.
- The formula is used to calculate the optimal amount for individual products and, if applicable, product variants. I.e., not for product categories in aggregate, or for a product with multiple variants.
Economic Order Quantity Formula: How To Calculate It?
To determine your product’s EOQ, you will first have to get the following information:
- Annual Demand: the expected demand of your product for the year.
- Ordering Cost: This is typically the cost of ordering, shipping, and handling of an order. This is not the cost of goods.
- Holding/Carrying Cost: A product’s holding cost will typically include:
- Cost of storage space
- Cost of labor
- Cost of insurance
- Cost of goods damaged or spoiled
With these 3 data, you can calculate your products EOQ using the following formula:
Q= Economic order quantity (in units)
D= Annual demand (in units)
S= Ordering cost (per order)
H= Carrying cost/holding cost (per unit)
Allow us to show you an example to illustrate how it works.
Don Sports Store sells Basketballs. The business expects to sell 4500 basketball a year. The unit holding cost per year for the basketball is $0.20. The ordering cost per order is $20 per order.
D (Annual Demand) = 4500
H (Holding Cost) = 0.2
S (Ordering Cost) = 20
Using the EOQ formula,
The economic order quantity calculated for the basketball is 949.
Thus, Don Sports Store should order 949 basketballs per order to minimize its inventory costs.
We hope this article helps you understand how using economic order quantity can lower your inventory costs.