Economic Order Quantity (EOQ): Definition, Formula, and Guide
One of the biggest problems that affect the profitability of a business is balancing its inventory orders with the demand for the inventory in the marketplace.
When a business orders more inventory than it has demand for, it leads to high ordering costs as the company spends more of its cash flow on inventory. Also, it leads to high holding costs as the inventory tends to spend a long time in the warehouse since the supply exceeds demand for the product.
When a business orders less inventory than its customers demand, it can easily lose out on customers who will go elsewhere for the product.
The Economic Order Quantity (EOQ) is an inventory management system that ensures a company orders the right amount of inventory that meets the demand for the product. Businesses use it as a valuable tool to make decisions about the number of inventory to order and keep, and how often to reorder to attract the lowest possible costs.
Our guide will show you everything you need to know about Economic Order Quantity (EOQ) from its importance to its limitations to its calculation.
Let’s get started.
What is Economic Order Quantity (EOQ)?
Economic Order Quantity (EOQ) gives the perfect standard quantity used by a company to calculate the inventory. It also helps in minimizing the total costs of inventory such as the overall ordering costs, shortage costs, and holding costs.
EOQ is part of inventory management that ensures the inventory is always monitored. It ensures that a company orders a fixed quantity every time the inventory attains a specific reorder point.
Economic Order Quantity (EOC) is the quantity required to avoid running out of stocks. It limits the risk of understocking or overstocking of products. The EOQ reduces stock and production issues.
This key metric can also be defined as the most economical and cost-effective inventory quantity level a company, industry, or small business orders for the sake of reducing the cost of inventory. It addresses the issue of how much stock a business should order at a time.
Economic Order Quantity also provides an ideal method of calculating the appropriate reorder point and the optimal reorder quantity to prevent shortages in inventory by replenishing the inventory instantly.
The EOQ assumes demand is constant and inventory is reduced at a fixed rate until it reaches zero. EOQ ensures that a company witnesses no shortage of inventory with no additional cost.
This scheme was invented by Ford W. Harris in 1913 and has undergone various reviews since then.
Why Use EOQ?
Economic Order Quantity (EOQ) is an essential key metric for businesses that work with the inventory. There are various reasons why businesses use EOQ. They include decision making, cost reduction, tracking orders, shows the availability of stocks
1. Decision Making
Economic Order Quantity is valuable to both small and big business owners. It assists managers in taking decisions on the number of times they make orders on a particular item, how often they reorder to get low possible costs and how much inventory they have.
Economic Order Quantity shows business owners if current order quantities are reasonable or not. It helps to indicate if an action should or should not be carried out.
For example, a business owner becomes aware of the risk of over-stocking if he or she decides to order a certain amount of new stocks at a particular time.
2. Cost Reduction
Economic Order Quantity reduces the high cost of inventory storage. The amount of money spent on inventory storage becomes lesser and more affordable.
3. Tracking Orders
Once you start using Economic Order Quantity, it makes keeping track of the increment or decrement in the rate of ordering easier.
Proper use of EOQ assists in monitoring orders. It keeps the rate of order at a normalized level that will be beneficial to the business. The renewal of the inventory becomes faster, efficient, and accurate.
4. Shows Availability of Stocks
Using EOC helps the company stay ahead of demands and not run out of stocks. Stocks are available in abundance and deadlines are easily met when you use the Economic Order Quantity to perfection. This results in keeping long-term customers and clients, and lower customer acquisition costs (CAC).
5. Easy Running of the Business
Businesses operate better when they are aware of their ideal Economic Order Quantity. Economic Order Quantity helps a business time its orders for inventory to avoid low stocks and dead stocks situations.
Formula and Calculation of Economic Order Quantity
The formula for determining the Economic Order Quantity (EOQ) is:
In situations where the Holding Cost ($) is not given, you multiply the Holding Cost (%) to get the Cost Per Unit ($).
Factors Determining EOQ
Two significant factors determine the Economic Order Quantity (EOQ): the ordering costs and holding costs.
1. Ordering Costs
Ordering costs refer to all the costs incurred each time an order is placed for inventory with the company. It is also referred to as setup costs.
Examples of ordering costs include delivery charges, telephone charges, payment processing expenses, invoice verification expenses, and others. It also includes both handling and shipping costs.
The ordering costs answer the question “How much does an order cost per purchase?” It varies depending on the frequency of orders.
In most situations, if you increase the number of orders placed in a year, the total ordering costs will increase, and if you decrease the number of orders placed in a year, the total ordering costs will also decrease.
2. Holding Costs
Holding cost is the total costs a company incurs to hold inventory in a warehouse or store. The total holding costs depend on the size of the order placed for inventory. It is also referred to as carrying costs.
Minimizing the holding costs to the barest minimum is an important aspect of warehouse management. Companies use warehouse inventory management software to help keep their holding costs low.
Examples of holding costs include insurance and property tax, rent, deterioration, maintenance fees, storage space, shrinkage, obsolescence, and others.
Relationship Between Ordering and Holding Costs
The Economic Order Quantity (EOQ) is the point at which the sum of the ordering and holding costs is at the minimum level.
Ordering cost is inversely proportional to holding cost if the annual demand remains constant. As the number of orders increases, the ordering cost increases but the holding cost decreases. Also, as the number of orders decreases, the ordering cost decreases but the holding cost increases.
What the Economic Order Quantity Can Tell You
1. How To Determine the Inventory Reorder Point
The Economic Order Quantity determines the inventory reorder point of a company. By doing so, the company continues to fill orders and does not run out of inventory. Inventory shortage leads to loss of clients and customers. There is also revenue lost if the company can not fill an order due to insufficient inventory.
2. How To Identify the Optimal Number of Products
Identifying the optimal number of products to order is the main purpose of the Economic Order Quantity (EOQ).
Ordering the optimal number of products needed helps the company to keep its costs low and prevent dead stocks. The aim of calculating the Economic Order Quantity is to determine the number of inventory to be attached to each order at the lowest possible costs.
The EOQ gives specific numbers pertaining to a business. It gives the best results concerning inventory which leads to better and long-lasting patronage.
After identifying the optimal number of products, the company can minimize the costs of buying, delivering, and storing products.
3. How To Minimize Costs
Economic Order Quantity (EOQ) is the order size that minimizes the sum of ordering and holding costs related to raw materials or merchandise inventories. Keeping costs low will inflate margins and ultimately drive more revenue for the company.
The EOQ is designed to help companies or small businesses strategize to minimize their overall costs by learning the trends of their production.
4. How to Find the Optimal Order Size
The Economic Order Quantity is used by manufacturing and merchandise companies. The merchandise companies compute it to get the optimal order size of ready-to-use merchandise inventory while the manufacturing companies compute it to find the optimal order size of raw materials inventory.
5. How to Conduct Proper Planning
Economic Order Quantity helps in planning how much product to keep in stock for the number of sales made. It prevents the need to spend more and the risk of running low on stocks while demand persists. Companies use it for demand forecasting.
6. How to Better Manage Your Company’s Cash Flow
The Economic Order Quantity (EOQ) is known as a cash flow tool that helps to control cash that has been held down in a company's inventory balance. Minimizing the level of inventory means more cash for other business investments.
Examples of How to Use EOQ
How to Use EOQ – Example 1
DeMoon, a newly established small-scale glassware company, sells 250 China cups per month. The holding costs of the company per year are $5,000 and its ordering cost is $2,000 per year. Calculate its Economic Order Quantity (EOQ).
The formula to determine EOQ is:
EOQ = ( 2 x Annual Demand x Ordering Cost / Holding Cost ) 1/2
To find out the annual demand, you multiply the number of products it sells per month by 12.
Annual Demand = 250 x 12
Annual Demand = 3,000
EOQ = ( 2 x Annual Demand x Ordering Cost / Holding Cost ) 1/2
EOQ = (2× 3,000 × 2,000 / 5,000)1/2
EOQ = (12,000,000 / 5,000)1/2
EOQ = (2,400)1/2 or square root of 2,400
EOQ = 48.99
To minimize holding and order costs, DeMoon should order 49 units.
How to Use EOQ – Example 2
If a furniture company makes a set of dining tables and sells up to 500 sets of dining tables every year. It costs the company $100 per year to hold the sets of dining tables in inventory and the fixed cost to order is $70. What is its EOQ?
The formula to determine EOQ is:
EOQ = ( 2 x Annual Demand x Ordering Cost / Holding Cost ) 1/2
EOQ = (2× 500 × $70 / $100)1/2
EOQ = (70,000 / 100)1/2
EOQ = (700)½ or the square root of 700
EOQ = 26.46
To minimize holding and order costs, the furniture company should order 26 units.
How to Use EOQ – Example 3
YTech wants to find out its Economic Order Quantity (EOQ). Here is a breakdown of its ordering cost, holding cost, and annual demand for the year.
Ordering Cost: $10,000
Holding Cost: $2,000
Annual Demand: 5,000 units
The formula to determine EOQ is:
EOQ = ( 2 x Annual Demand x Ordering Cost / Holding Cost ) 1/2
EOQ = (2 x 5,000 x 10,000 / 2,000)1/2
EOQ = (100,000 / 2,000)1/2
EOQ = (50)1/2 or square root of 50
EOQ = 7.071 units
To minimize holding and order costs, YTech should order 7 units.
Limitations of Using the EOQ
The following are the shortcomings of making use of the EOQ:
1. The Assumption that Demand is Constant
Although Economic Order Quantity is efficient, it can only function in situations where demands are constant. In situations where the demand is not consistent, the Economic Order Quantity (EOQ) will provide a misleading figure.
2. Assumption of Constant Ordering and Holding Costs
Economic Order Quantity assumes both the ordering and holding costs are constant. Therefore, making it impossible to account for other factors that can affect the ordering and holding costs.
They include seasonal changes in inventory costs, changes in demand or orders placed by clients, revenue loss due to shortage of inventory, or discounts realized from purchasing inventory in large quantities.
3. Time Wastage
Calculating the EOQ can be confusing and time-consuming. There are times when the cost of estimation and calculation exceeds the savings made by buying that quantity.
Economic Order Quantity demands good calculation skills. This puts business owners with no mathematical skills at a disadvantage. The efficient Economic Order Quantity (EOQ) models require detailed data to calculate several figures.
4. Constant Delivery Time
Situations, where materials are not delivered on time, may occur. Determination of Economic Order Quantity (EOQ) does not put a delay in delivery time into consideration.
5. Instant Replacement of Defective Units
Faults and malfunctions tend to occur in machines, warehouses, materials, etc which may alter the normal functioning of the inventory and slow down the flow of demands. EOQ fails to consider this in its calculation.
6. The Minimum Stock Level is Zero
Stocks are not always sold out resulting in some leftovers. The EOQ assumes the lowest level at which stock can be reduced to is zero.
7. Only Product is Involved
Only the Economic Order Quantity of one product can be determined at a time. There is no room for varieties. If your company has up to fifty different products, you have to calculate the Economic Order Quantity for each one separately,
8. Dependence on Prediction
In cases where the usage of materials or products is unpredictable, the formula becomes useless. The Economic Order Quantity formula only works when the holding costs, ordering costs, and annual demand is predictable.
Economic Order Quantity (EOQ) FAQ
Economic Order Quantity (EOQ) is the equation that helps to calculate the order quantity of inventory as well as the minimum total holding and ordering costs during a definite period.
In other words, Economic Order Quantity is a technique used in inventory management to show the ideal quantity of inventory a company should order each time to minimize the costs associated with ordering and holding inventory.
It is based on a few key assumptions. The rate of demand, ordering costs, inventory costs, and delivery time are all constant, while there is no safety stock level, that is, each new order is delivered in full when inventory reaches zero.
The goal of calculating the Economic Order Quantity (EOQ) is to identify the optimal number of product units to order.
By arriving at an optimal number of products to order, the company can minimize the costs for the buying, delivery, and storage of items. This makes the economic order quantity formula very important for any business that manages and stores inventory, like an online retailing brand or a fast-food restaurant.
The EOQ model seeks to ensure that the right amount of inventory is ordered per batch so a company does not have to make orders too frequently. It reduces the likelihood of a company having excess inventory in its warehouse or store.
Too much inventory means that the company is taking on unnecessary holding costs while also running the risk of increased costs due to damaged goods. On the other hand, too little inventory can lead to stock-outs which will cause you to lose sales. Having to reorder goods frequently also racks up transportation costs.
By calculating EOQ, a business can determine when an order is to be placed and how much is to be ordered. This allows the company to make strides towards being as cost-efficient as possible while ensuring that production and sales continuity is guaranteed.
Without it, companies will tend to hold too much inventory during periods of low demand, while also holding too little inventory in periods of high demand.
There are so many online Economic Order Quantity (EOQ) calculators you can use to calculate EOQ for your company. They include Zoho Inventory EOQ Calculator, QuickBooks EOQ Calculator, and Omni Calculator.
Omni Calculator is the best EOQ formula calculator. The EOQ formula calculator allows you to input your yearly demand, order cost, and yearly cost of holding which it uses to determine your Economic Order Quantity (EOQ).
In situations where the EOQ is not a whole number, it predicts the number of units you should order to minimize your holding and order costs.
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Martin Luenendonk
Martin loves entrepreneurship and has helped dozens of entrepreneurs by validating the business idea, finding scalable customer acquisition channels, and building a data-driven organization. During his time working in investment banking, tech startups, and industry-leading companies he gained extensive knowledge in using different software tools to optimize business processes.
This insights and his love for researching SaaS products enables him to provide in-depth, fact-based software reviews to enable software buyers make better decisions.