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Economic Order Quantity (EOQ)

Economic Order Quantity (EOQ)
BusinessCorporate Finance and AccountingAccounting

What Is Economic Order Quantity (EOQ)?

Economic order quantity (EOQ) is the ideal order quantity a company ought to purchase to limit inventory costs, for example, holding costs, shortage costs, and order costs. This production-planning model was developed in 1913 by Ford W. Harris and has been refined over the long haul. The formula accepts that demand, ordering, and holding costs all stay consistent.

Formula for Calculating Economic Order Quantity (EOQ)

The formula for EOQ is:
Q=2DSHwhere:Q=EOQ unitsD=Demand in units (typically on an annual basis)S=Order cost (per purchase order)H=Holding costs (per unit, per year)\begin &Q = \sqrt{ \frac{2DS} }\ &\textbf\ &Q=\text\ &D=\text{Demand in units (typically on an annual basis)}\ &S=\text{Order cost (per purchase order)}\ &H=\text{Holding costs (per unit, per year)}\ \end

Everything the Economic Order Quantity Can Say to You

The goal of the EOQ formula is to distinguish the optimal number of product units to order. Whenever accomplished, a company can limit its costs for buying, conveying, and putting away units. The EOQ formula can be modified to decide different production levels or order spans, and corporations with large supply chains and high variable costs utilize an algorithm in their computer software to decide EOQ.

EOQ is an important cash flow tool. The formula can assist a company with controlling the amount of cash tied up in the inventory balance. For some companies, inventory is its largest asset other than its human resources, and these businesses must carry adequate inventory to address the issues of customers. On the off chance that EOQ can assist with limiting the level of inventory, the cash savings can be utilized for some other business purpose or investment.

The EOQ formula decides a company's inventory reorder point. At the point when inventory tumbles to a certain level, the EOQ formula, whenever applied to business processes, sets off the need to place an order for additional units. By deciding a reorder point, the business tries not to run out of inventory and can keep on filling customer orders. On the off chance that the company runs out of inventory, there is a shortage cost, which is the revenue lost in light of the fact that the company has deficient inventory to take care of a request. An inventory shortage may likewise mean the company loses the customer or the client will order less from here on out.

Illustration of How to Use EOQ

EOQ considers the timing of reordering, the cost incurred to place an order, and the cost to store merchandise. On the off chance that a company is continually putting in small requests to keep a specific inventory level, the ordering costs are higher, and there is a requirement for extra storage space.

Expect, for instance, a retail clothing shop conveys a line of men's pants, and the shop sells 1,000 pairs of pants every year. It costs the company $5 each year to hold a pair of pants 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 limit costs and fulfill customer need is somewhat in excess of 28 pairs of pants. A more complex portion of the EOQ formula gives the reorder point.

Limitations of EOQ

The EOQ formula accepts that consumer demand is consistent. The calculation likewise accepts that both ordering and holding costs stay steady. This reality makes it troublesome or unimaginable for the formula to account for business occasions, for example, changing consumer demand, seasonal changes in inventory costs, lost sales revenue due to inventory shortages, or purchase discounts a company could understand for buying inventory in larger amounts.

Highlights

  • One of the important limitations of the economic order quantity is that it accepts the demand for the company's products is steady over the long run.
  • The economic order quantity (EOQ) is a company's optimal order quantity for limiting its total costs connected with ordering, getting, and holding inventory.
  • The EOQ formula is best applied in circumstances where demand, ordering, and holding costs stay consistent after some time.

FAQ

How Is Economic Order Quantity Calculated?

Economic order quantity is an inventory management technique that helps settle on efficient inventory management choices. It alludes to the optimal amount of inventory a company ought to purchase to fulfill its need while limiting its holding and storage costs. One of the important limitations of the economic order quantity is that it accepts the demand for the company's products is steady after some time.

Why Is Economic Order Quantity Important?

Economic order quantity is important in light of the fact that it assists companies with dealing with their inventory efficiently. Without inventory management techniques, for example, these, companies will generally hold too much inventory during periods of low demand while additionally holding too little inventory during periods of high demand. Either problem sets out missed open doors.

How Does Economic Order Quantity Work?

Economic order quantity will be higher assuming that the company's setup costs or product demand increases. Then again, it will be lower assuming that the company's holding costs increase.