Effective Inventory Management and the Economic Order Quantity
Updated: Feb 24, 2022
Stock-outs and rush orders can be expensive for your business. Ordering fees and shipping costs can add up throughout the year and result in low profit margins. Likewise, holding too much inventory that ends up just sitting on your shelves ties up assets and warehouse space. So how does an organization balance ordering enough inventory to satisfy customers’ requirements while reducing the amount of inventory they maintain? That’s where the EOQ comes in.
The Economic Order Quantity
The Economic Order Quantity, or EOQ, is the optimal ordering quantity to minimize annual ordering and holding costs. To calculate the EOQ, a company must understand three important variables: Annual Quantity Demanded, Ordering Costs, and Holding Costs. While historical data for the organization can supply the annual quantity demanded, calculating the ordering costs, and holding costs can take a bit more effort.
Bulk shipping makes financial sense. Ordering fees and shipping costs can add up quickly, especially for small orders. The more inventory that is ordered, the more those costs are spread out, resulting in lower overall costs per unit. This makes it tempting to stock large quantities of inventory in order to capitalize on the reduced costs. The result is that you can have massive quantities of stock on hand with no guaranteed sales. But what does it cost to store all that inventory?
Every item in your inventory that sits on the shelf costs money. Rent, utilities, and the costs of the item itself all can be factored in when determining holding costs. The longer an item sits unsold, the greater the holding costs that item incurs. Holding costs can also be considered the opportunity costs of holding that inventory rather than investing the money elsewhere. As such, they are normally calculated by multiplying the cost per unit by the interest rate.
To find your holding costs, it is helpful to look at another equation as described by Alecia Bland in her article here.
Capital costs + inventory service costs + inventory risk costs + inventory storage costs, divided by average inventory value
Capital costs include the actual cost of your products/materials, as well as other factors such as interest and fees (e.g., loan maintenance fees).
Inventory service costs are those related to holding products, such as IT hardware or software, tax, and insurance premiums.
Inventory storage costs refer to the costs associated with owning and operating a storage facility, including leasing costs as well as utilities and shipping.
Finally, inventory risk costs include any that might reduce the value of your inventory, or its salability, such as shrinkage, error, theft, and loss of product value (i.e., reduced market demand, obsolescence).
The total cost for an item in your inventory is the sum of the ordering cost plus the holding cost. As the graph above shows, total costs decrease with an increase in quantity ordered but start to rise again as holding costs are added to each item. In order to minimize total cost, items should be ordered when the total costs are at their lowest.
The Economic Order Quantity Formula
The EOQ can be calculated using the following formula:
D: Annual Quantity Demanded
S: Ordering Costs
H: Holding Costs
Economic Order Quantity – Example A local Oil and Mining supply company has a demand for earplugs totaling 16,000 boxes per year. The company has calculated that each box of earplugs costs $2.50 to store in their warehouse per year, and it costs them $50 each time they reorder the earplugs. The EOQ is calculated as follows:
The company should order 800 boxes of earplugs to minimize costs.
This is a simple example, but the EOQ can be used with the reorder point to determine a minimum stocking level. Many financial websites have a detailed breakdown of the EOQ, such as the Corporate Financial Institute.
The Drawback to Using the EOQ
Not every system is perfect. While the Economic Order Quantity is a good indicator of how much to order, it is not a panacea. There are several disadvantages to the EOQ.
Assumes all variables are constant
Perhaps the biggest drawback is that the Economic Order Quantity assumes that ordering costs, holding costs, and total costs are constant. It does not account for situations such as seasonal fluctuations or freight rate changes due to supply/demand shifts.
Impossible to forecast demand
While an organization's historical sales data can be a good indicator of demand, it is not always a good forecaster of future demand. If a customer had a large contract that required extra boxes of earplugs last year, it does not mean they will have the same contract next year.
Impossible to account for supplier availability
As the world has discovered over the last year, suppliers do not always have inventory to ship you, or the transportation capabilities to get you what your order. The EOQ can tell you when you should reorder, but it cannot help you if the supplier does not have what you are ordering.
Another problem may occur if the supplier offers a good discount. If the ordering and holding costs are offset by bulk ordering, it may be in your organization's interest to stock up on inventory.
The EOQ and Inventory Management
Using the Economic Order Quantity Formula can save companies by reducing total costs associated with annual ordering. For small businesses with a constant customer demand and ordering schedule, this can be accomplished with a simple Excel spreadsheet. For larger companies, there are many software solutions for all aspects of your Inventory Management, including EOQ calculators. Knowing how much inventory to order and how much to keep on hand can increase your company’s profit margins and result in satisfied customers without overstocked or understocked warehouses.
ABOUT THE AUTHOR
Jason Kelly is completing an internship with ASCI. He is currently a senior at the University of Alaska Anchorage completing his final semester for a bachelor’s degree in Global Logistics Supply Chain Management with a minor in Computer Information Systems. He is also scheduled to receive an Occupational Endorsement Certificate in Business Analytics. His experience in logistics lies in oilfield supply, inventory consignments, and air cargo shipping.
Contact us at firstname.lastname@example.org or (907)348-1610 if you would like to set up a free consultation appointment to help with your business’ inventory management needs.
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