Would you like to know exactly when you need to reorder stock and how much you need to reorder?
Then you need to calculate your economic order quantity (EOQ).
EOQ – much like a reorder point formula – helps you take the guesswork out of stocking your warehouse and keeping up with customer demand.
We’ll show you how to use an EOQ formula, it’s advantages and disadvantages, and the one tool you need to optimize your use of EOQ and any other inventory formulas.
Economic order quantity is the lowest amount of inventory you must order to meet peak customer demand without going out of stock and without producing obsolete inventory.
That’s the ideal use of EOQ.
The EOQ model assumes that demand is constant and that inventory is depleted at a predictable rate. While this isn’t the case for many businesses, the model still helps companies better approximate when they need to replenish their inventory and how much they should order.
To help you calculate EOQ, here is the formula from Kenneth Boyd, author of Cost Accounting for Dummies:
Economic order quantity uses three variables: demand, relevant ordering cost, and relevant carrying cost. Use them to set up an EOQ formula:
Note that the ordering cost is calculated per order. The carrying costs are calculated per unit. Here’s the formula for economic order quantity:
Economic order quantity = square root of [(2 x demand x ordering costs) ÷ carrying costs]
That’s easier to visualize as a regular formula:
Q is the economic order quantity (units). D is demand (units, often annual), S is ordering cost (per purchase order), and H is carrying cost per unit.
Economic order quantity has been successfully used for decades by businesses of all types, so it certainly has a few advantages.
Here are some of them:
The primary purpose of EOQ is to help keep inventory carrying costs as low as possible.
The more inventory you have on hand, the more you have to pay for insurance, taxes, security, etc.
Accurately calculating how much inventory you need will help you maintain a budget you can afford.
Economic order quantity can help you understand how often you should be ordering. You may discover that ordering small quantities more often is better for your bottom line or vice versa.
By calculating how much you need in proportion to how much you sell over a given period of time, you can ensure you always have enough stock to satisfy your customers.
Many vendors advertise deals throughout the year to entice you to buy more of their inventory which usually ends up increasing your cost of inventory even if you received a discounted price.
The EOQ model helps you purchase only what you’re going to use.
It’ll help you take advantage of a vendor deal if, after plugging the numbers into your EOQ formula, you find out you’re not overpurchasing but getting the right amount at a lower price.
While economic order quantity has some benefits and a long history of use, it’s not without its shortcomings.
Here are a couple of them:
The largest complaint about EOQ is that it requires numerous assumptions.
The model assumes that there’s steady demand, steady sales, and fixed costs.
Plus, the basic EOQ model assumes you have a one-product business. If you sell multiple products, you’ll have to calculate and track each one separately.
The biggest problem with assumptions of steady demand and steady sales in the EOQ model is that it doesn’t allow you to account for fluctuations in demand during holidays or particular seasons.
If your sales yo-yo throughout the year, then EOQ won’t be able to keep up.
Realistically, you’re unlikely (and not lucky enough) to operate a business with fixed rates and steady sales that almost never fluctuate.
If you run a business similar to the rest of ours, then you’re constantly dealing with uncertainties in your reorder point and customer demand forecasts.
EOQ can still help you make more informed guesses about when and how much inventory should be ordered, but to make EOQ calculations work properly, you’re going to need a way to monitor and track your order quantities, reorder points, safety stock levels, etc.
With the right inventory management system, you could even forget about EOQ altogether and use more up-to-date formulas that automate reordering for all of your products.
Interested in such a system?
Then we can help…
Whether you want to use economic order quantity or not, our cloud-based inventory management system will help you streamline your business processes. From tracking your inventory in real-time to producing up-to-the-minute reports on past sales and future projections, DEAR Inventory will make sure you avoid stockouts and obsolete inventory while effectively serving your customers.
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