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EOQ or Economic Order Quantity is a critical calculation used by companies to minimise total costs when updating the inventory. The EOQ formula calculates the total cost of the inventory like the costs of holding, shortage, or order during the continuous review inventory system. In the EOQ model of inventory management when stock-in-hand reaches the ‘x’ level, ‘n’ units are reordered to maintain sustainability in order fullfilment.
Thus, EOQ is a powerful tool that helps businesses decide when to reorder, how much to order and how frequently to reorder, such that inventory management costs are at their lowest.
Here we explore how to use the EOQ formula with examples and understand the business implications and the challenges of optimising inventory management using EOQ equations.
The EOQ formula is the ideal tool to determine stocking parameters such as frequency of reordering, units to be reordered and time to order. The components of the formula and an analysis of it are discussed in detail here.
In the EOQ model, a theoretical approach is used for the purchase of an ideal quantity of goods. Several factors are taken into consideration for this calculation. Demand and inventory depletion are assumed to be constant and at fixed rates until they reach zero. The number of units that need to be ordered to return the inventory to its starting level is calculated when the stock reaches zero. The model also assumes immediate replenishment of stock and does not factor in inventory shortages or the costs associated with it.
Thus, the cost of inventory using the EOQ model is limited to balancing the total holding cost versus the order cost. For example, when a company places a single order for a large number of units, the holding cost increases and the order cost decreases. Similarly, when fewer units are ordered, the holding costs decrease but the order costs go up. It is only with the EOQ model that a company is able to determine the point at which the optimised quantity will minimise the sum of the costs.
TC= PD+HQ/2+SD/Q
TC- annual inventory cost
P- price per unit
D- number of units ordered in a year
H- holding cost incurred per unit per year
Q- units purchased per order
S- cost of each order
In effect, the EOQ formula determines that an ideal order quantity is possible only when half of the products of the holding costs per unit and units per order equals the result of the quotation when the fixed price costs of each order and the number of units per year are divided by the per order units.
EOQ formula = Square root of 2DS/H.
EOQ analysis helps inventory managers to calculate the ideal order size. It is a quick and effective way to avoid stockouts, and reduce inventory and carrying costs. An EOQ analysis provides insights on:
The primary insight from the EOQ formula is that businesses decide on how much they need to invest in maintaining their inventory. It helps in determining the ideal order size, minimises overspending on orders and lowers holding costs and excess inventory.
Explanation of the EOQ formula, with example, is the best way to understand the working of economic order quantity concept. The equation takes into account a number of factors such as the timing of your order, the cost to place the order, and merchandise storage. When a company is continuously ordering in small quantities such that the specific inventory level is maintained, there is a surge in ordering costs apart from additional storage space. By using economic order quantity calculations, businesses can find the best number of units to be ordered.
For example, a motorsports store selling ATVs and off-road vehicles for teens and adults sells 1000 units annually. The company incurs a cost of USD 1200 annually to hold its stock. The charge of placing an order is USD 720.
The EOQ formula = square root 2DS/H
That is the square root of (2 x 1000 units x 720 order cost)/(1200 holding cost) = 34.64.
Based on this result, 35 units is the optimal number of units the store needs to optimise inventory costs. For further reordering, the company needs to use the advanced version of the formula.
The EOQ model of inventory management creates opportunities for saving order costs, holding costs and upfront capital investments in buying stock.
EOQ is an ideal tool for businesses that buy and hold inventory for manufacturing, resale and even for internal consumption of stock. It can help businesses to achieve efficiency in a number of ways. Some of them are:
However, EOQ relies on assumptions that may not always hold true in real-world scenarios. These are:
The ideal situation for using EOQ is when consumer demand is constant for an extended period of time and inventory depletes at a fixed, consistent rate.
Economic order quantity in inventory management is sometimes a challenge for businesses to adopt. Some of the difficulties when determining EOQ are:
It is possible to improve inventory management and optimise it by calculating EOQ and determining the ideal order size, maximising profits. It ensures that you do not guess and order, resulting in overstocking, overordering or understocking issues. Predictive ordering is very easily managed with EOQ equations, apart from helping businesses create a schedule to optimise their supply chain.
In many ways, the EOQ equation can be defined as the master key to control inventory costs and help businesses have a streamlined stockpile of their products. EOQ formula and analysis help businesses understand consumer demand and generate comprehensive supply chain optimisation options. Businesses can leverage formula-based accurate data prediction to control their inventory spending. More importantly, it calculates both ordering as well as holding costs and helps in incorporating the losses due to damages, defective inventory and more. Besides, EOQ also provides analytic viewpoints that guide businesses in addressing seasonal changes in inventory costs and account for losses in revenue.
Yes, EOQ calculations can be integrated into enterprise resource management software platforms for efficient management of inventory and minimise inventory management costs.
Yes, both the formulas determine different factors. EPQ finds the holding cost per year and is calculated to guide production levels. EOQ calculates the ideal order size to minimise business costs and guides inventory management.
Yes, EOQ and Wilson formulas define different factors. EOQ finds the best number of orders and units to be placed to save inventory costs. However, the Wilson formula finds the optimal quantity to order. It considers the administrative cost, discount offered for the size of the order against the cost of capital investment, and storage risk.
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