Economic Order Quantity (EOQ) The economic order quantity (EOQ) method of inventory control is a procedure for balancing

ordering costs and carrying costs so as to minimize total inventory costs. Ordering costs are administrative, clerical, and other expenses incurred in initially obtaining inventory items and placing them in storage. There also is the carrying, or holding cost, the expenses associated with keeping an item on hand (such as storage, insurance, pilferage, breakage). Finally, there are stock-out costs. They include the loss of customer goodwill and possibly sales because an item requested by customers is not available. In order to determine the EOQ, calculus is used in the development of the mathematical model. The method uses an equation that includes annual demand (D), ordering costs (O), and holding costs (H). The basic equation for EOQ is presented below: EOQ = square root [(2 * annual demand * ordering costs) /holding costs]

Use of EOQ The EOQ equation helps managers decide how much to order. However, managers also need to determine the reorder point (RIP), the inventory level at which a new order should be placed. To determine the reorder point, managers estimate lead time (L), the time between placing an order and receiving it. In the formula for ROP, lead time is multiplied by average daily demand: Reorder level = Average daily usage rate * lead-time in days

The model described is one of the simplest to develop. The sophistication level of the model depends on the actual need of the company and demands of the environment. Implementing EOQ There are primarily two ways to implement EOQ. Both methods obviously require that you have already determined the associated costs. The simplest method is to set up your calculation in a spreadsheet program, manually calculate EOQ one item at a time, and then manually enter the order quantity into your inventory system. If your inventory has fairly steady demand and costs and you have less than one or two thousand SKUs you can probably get by using this method once per year. If you have more than a couple thousand SKUs and/or higher variability in demand and costs you will need to program the EOQ formula into your existing inventory system. This allows you to quickly recalculate EOQ automatically as often as needed. You can also use a hybrid of the two

systems by downloading your data to a spreadsheet or database program, perform the calculations and then update your inventory system either manually or through a batch program. Whichever method you use you should make sure to follow the following steps: Test the formula- Prior to final implementation you must test the programming and setup. Run the EOQ program and then manually check the results using sample items that are representative of the variations of your inventory base. Project results- Youll need to run a simulation or use a representative sampling of items to determine the overall short-term and long-term effects the EOQ calculation will have on warehouse space, cash flow, and operations. Dramatic increases in inventory levels may not be immediately feasible, if this is the case you may temporarily adjust the formula until arrangements can be made to handle the additional storage requirements and compensate for the effects on cash flow. If the projection shows inventory levels dropping and order frequency increasing, you may need to evaluate staffing, equipment, and process changes to handle the increased activity. Maintain EOQ- The values for Order cost and Carrying cost should be evaluated at least once per year taking into account any changes in interest rates, storage costs, and operational costs. A related calculation is the Total Annual Cost calculation. This calculation can be used to prove the EOQ calculation. Total Annual Cost = [(annual usage in units)/(order quantity)(order cost)]+{[.5(order quantity)+(safety stock)]*(annual carrying cost per unit)}. This formula is also very useful when comparing quotes where vendors offer different minimum order quantities, price breaks, lead times, transportation costs.