Economic Order Quantity – EOQ

What Is Economic Order Quantity (EOQ)?

Economic order quantity (EOQ) is the ideal order quantity a company should
purchase to minimize 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 formula assumes that demand, ordering,
and holding costs all remain constant.

Formula and Calculation of Economic Order Quantity (EOQ)

The formula for EOQ is:

Q=H2DSwhere

: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

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, delivery, 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 Using 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.

Holding Costs

Holding costs are those associated with storing inventory that remains unsold.

These costs are one component of total inventory costs, along with ordering and
shortage costs. A firm’s holding costs include the price of goods damaged or
spoiled, as well as that of storage space, labor, and insurance.

Understanding Holding Costs

Minimizing inventory costs is an important supply-chain management strategy.
Inventory is an asset account that requires a large amount of cash outlay, and
decisions about inventory spending can reduce the amount of cash available for
other purposes. For example, increasing the inventory balance by $10,000 means
that less cash is available to operate the business each month. This situation is
considered an opportunity cost.

Holding Cost Reduction Methods

One way to ensure a company has sufficient cash to run its operations is to sell
inventory and collect payments quickly. The sooner cash is collected from
customers, and the less total cash the firm must come up with to continue
operations. Businesses measure the frequency of cash collections using
the inventory turnover ratio, which is calculated as the cost of goods sold (COGS)
divided by average inventory.

Another important strategy to minimize holding costs and other inventory spending
is to calculate a reorder point, or the level of inventory that alerts the company to
order more inventory from a supplier. An accurate reorder point allows the firm to
fill customer orders without overspending on storing inventory. Companies that
use a recorder point avoid shortage costs, which is the risk of losing a customer
order due to low inventory levels.

The reorder point considers how long it takes to receive an order from a supplier,
as well as the weekly or monthly level of product sales. A reorder point also helps
the business compute the economic order quantity (EOQ), or the ideal amount of
inventory that should be ordered from a supplier. EOQ can be calculated using
inventory software.

Example of Holding Costs

Assume that ABC Manufacturing produces furniture that is stored in a warehouse
and then shipped to retailers. ABC must either lease or purchase warehouse space
and pay for utilities, insurance, and security for the location. The company must
also pay staff to move inventory into the warehouse and then load the sold
merchandise onto trucks for shipping. The firm incurs some risk that the furniture
may be damaged as it is moved into and out of the warehouse.

Ordering Cost
The number of orders that occur annually can be found by dividing the annual
demand by the volume per order. The formula can be expressed as:

 
 

For each order with a fixed cost that is independent of the number of units, S, the
annual ordering cost is found by multiplying the number of orders by this fixed
cost. It is expressed as:

 
TOPIC: Reorder level
Reorder level of stock (also known as reorder point or ordering point) in a
business is a preset level of stock or inventory at which the business places a new
order with its suppliers to obtain the delivery of raw materials or finished goods
inventory.

Every business has to maintain a certain level of raw materials or finished goods in
its store. This is done in order to sustain the continuity of production in case of raw
materials and the continuity of sales in case of finished goods. For this purpose, the
business must set a specific level at which it should place a new order with the
suppliers of inventory.

Formula:

The two formulas used to calculate the re-order level are given below:

1. When the business does not need to maintain safety stock:

Maximum demand or usage (in days, weeks or months) × Maximum lead time (in
days, weeks or months)

2. When the business needs to maintain a safety stock:

[Maximum demand or usage (in days, weeks or months) × Maximum lead time (in
days, weeks or months)] + Safety stock

What is lead time?

The timing difference between placing an order with the supplier and arrival of the
goods is known as the lead time.

What is safety stock (also known as buffer stock)?

In some scenarios, it may be unlikely that the reorder level could be estimated
accurately. This is because the demand and the lead time of the goods could differ
than the usual trends and in that case the business may run out of stock. So, a level
of safety stock is set to avoid such a condition. It is also known as buffer stock.
Example 1 – reorder level without safety stock

The David IT Store sells 500 laptops on an average in a week. The maximum
demand in a week is 523 laptops. If, the lead time is 4.5 week then the reorder
level would be:

Reorder level = Maximum weekly usage × Lead time in weeks

= 523 units × 4.5 weeks
= 2,354 units

It means that every time the number of laptops decreases to 2,354, the David IT
Store must place a new order.

Example 2 – reorder level without safety stock

A business manufactures tires. The average demand for the business is 645
tires/week and the maximum demand is 670 tires/week. To manufacture one tire 3
kilos of rubber is required as raw material. So, the production department of the
business requires a maximum of 2,010 (= 670 × 3) kilos of rubber per week. If the
lead time to get rubber from the supplier is 1.5 weeks then re-order level would be:

Reorder level = Maximum demand per week × Lead time in weeks

= 2,010 kilos × 1.5 weeks
= 3,015 kilos

The production department must place a new order when the raw material (rubber)
reaches 3,015 kilos.

Example 3  – with safety stock

The following information belongs to Kim Kardashian Clothing Outlet:

Usage or demand

 Minimum demand: 390 sweaters per month

 Average demand:420 sweaters per month
 Maximum demand:435 sweaters per month
 Safety stock: 120 sweaters

Lead time
  Minimum lead time: 1.2 months
 Average lead time: 1.5 months
 Maximum lead time: 1.75 months

Required: Compute reorder level of Kim Kardashian Clothing Outlet.

Solution

Reorder level = (Maximum demand × Maximum lead time) + Safety stock

= (435 units × 1.75 weeks) + 120 units
= 761 units + 120 units
= 881 units