Economic Order Quantity (EOQ)

Companies making purchasing (rather than production) decisions often compute the
economic order quantity (EOQ), which represents the least costly number of units to order.
The EOQ indicates the optimal balance between ordering and carrying costs by
mathematically equating total ordering costs to total carrying costs. The EOQ is a tool that is
used in conjunction with traditional push production and inventory management systems.
Because EOQ implies acquiring and holding inventory before it is needed, it is incompatible
with pull systems such as JIT.
Purchasing managers should first determine which supplier could offer the appropriate quality of
goods at the best price in the most reliable manner. After the supplier is selected, the most
economical inventory quantity to orderat a single timeis determined. The EOQ formula is:
Where:
EOQ = economic order quantity in units
Q = estimated annual quantity used in units (can be found in the annual purchases budget)
O = estimated cost of placing one order
C = estimated cost to carry one unit in stock for one year
Note that unit purchase cost is not included in the EOQ formula. Purchase cost relates to the
question of from whom to buy, which is considered separately from the question of how many to
buy at a single time. Inventory unit purchase cost does not affect the other EOQ formula costs;
except to the extent that opportunity cost is calculated on the basis of investment.
All inventory-related costs must be evaluated when purchasing or production decisions are
made. The costs of ordering and carrying inventory offset each other when estimating the
economic order quantity.
Case & Calculation Example:
Lie Dharma Company uses 80,000 pounds of a particular plastic in producing the Lie Dharmas
dolls. The cost associated with placing each order is $12.25. The carrying cost of 1 pound of the
plastic is $1.00 per period. Therefore, Lie Dharmas EOQ for this plastic is calculated as
follows:
Economic Production Run (EPR)
In a manufacturing company, managers are concerned with how many units to produce in
a batch in addition to how many units (of raw material) to buy. The EOQ formula can be
modified to calculate the appropriate number of units to manufacture in an economic
production run (EPR). This estimate reflects the production quantity that minimizes the total
costs of setting up a production run and carrying a unit in stock for one year.
The only change in the EOQ formula is that the terms of the equation are redefined as
manufacturing, rather than purchasing, costs. The formula is:
Where:
EPR = economic production run quantity
Q = estimated annual quantity to be produced in units (can be found in annual production
budget)
S = estimated cost of setting up a production run
C = estimated cost to carry one unit in stock for one year
Case & Calculation Example:
Another product manufactured by Lie Dharma Company is a doll crib. A total of 162,000 units
of this product are made each year. The setup cost for a doll crib production run is $40 and the
annual carrying cost for each doll crib is $4. The economic production run quantity of 1,800
doll cribs is determined as:
The cost differences among various run sizes around the EPR may not be significant. If
such costs were insignificant, management would have a range of acceptable, economical
production run quantities.
The critical element in using either an EOQ or EPR model is to properly identify costs.
Identifying all the relevant inventory costs (especially carrying costs) is very difficult, and some
costs (such as those for facilities, operations, administration, and accounting) traditionally
viewed as irrelevant fixed costs may, in actuality, be long-term relevant variable costs. The EOQ
model also does not provide any direction for managers attempting to control all of the separate
costs that collectively comprise purchasing and carrying costs. By only considering the trade-off
between ordering and carrying costs, the EOQ model does not lead managers to consider
inventory management alternatives that may simultaneously reduce both categories of costs.
Additionally, as companies significantly reduce the necessary setup time (and thus cost) for
operations and move toward a stockless inventory policy, a more comprehensive cost
perspective will indicate a substantially smaller cost per setup and a substantially larger
annual carrying cost. If the setup and carrying cost information given for Molly Memories were
reversed, the EPR would be only 180 units. Using either a new perspective of variable cost or
minimizing setup cost will provide much lower economic order or production run quantities than
indicated in the past.
Re-Order Point and Safety Stock
The economic order quantity or production run model indicates how many units to order or
produce. But managers are also concerned with the order point. Quantity of Re-order Point
and Safety Stock reflects the level of inventory that triggers the placement of an order for
additional units.
Determination of the order point is based on three factors:
1. Usage Usage refers to the quantity of inventory used or sold each day
2. Lead Time The lead time for an order is the time in days it takes from the placement of
an order to when the goods arrive or are produced. Many times companies can project a
constant, average figure for both usage and lead time
3. Safety Stock The quantity of inventory kept on hand by a company in the event of
fluctuating usage or unusual delays in lead time is called safety stock.
If usage is entirely constant and lead time is known with certainty, the order point is equal
to daily usage multiplied by lead time:
Order point = Daily usage x Lead time
Case & Calculation Example:
Assume that Lie Dharma Company produces rhinestone tiaras for sale to chain department
stores. Lie Dharma Company uses 400 rhinestones per day, and the supplier can have the stones
to Lie Dharma Company in four days. When the stock of rhinestones reaches 1,600 units, Lie
Dharma Company should reorder.
The order point formula minimizes the dollars a company has invested in its inventory.
Orders would arrive at precisely the time the inventory reached zero.
Note: This formula, however, does not take into consideration unusual events such as variations
in production schedules, defective products being provided by suppliers, erratic shipping
schedules of the supplier, or late arrival of units shipped. To provide for these kinds of events,
managers carry a buffer safety stock of inventory to protect the company from stock-outs.
When a safety stock is maintained, the order point formula becomes:
Order point = (Daily usage x Lead time) + Safety stock
Safety stock size should be determined based on how crucial the item is to production or to the
retail business, the items purchase cost, and the amount of uncertainty related to both usage and
lead time.
One way to estimate the quantity of safety stock is to allow one factor to vary from the
norm. For example: either excess usage during normal lead time or normal usage during an
excess lead time can be considered in the safety stock calculation.

Case & Calculation Example:

Assume that Lie Dharma Company never uses more than 500 rhinestones in one day. One
estimate of the necessary safety stock is 400 stones, computed as follows:
Maximum daily usage = 500 stones
Normal daily usage = (400) stones
- [+]
Excess usage = 100 stones
Lead time x 4 days
- [x]
Safety stock = 400 stones
Using this estimate of safety stock, Lie Dharma Company would re-order rhinestones when
2,000 stones = (1,600 original order point + 400 safety stock) were on hand.

Economic Order Quantity (EOQ)

3 COMMENTS

The Economic Order Quantity (EOQ) is the number of units that a company should add to
inventory with each order to minimize the total costs of inventorysuch as holding costs, order
costs, and shortage costs. The EOQ is used as part of a continuous review inventory system in
which the level of inventory is monitored at all times and a fixed quantity is ordered each time
the inventory level reaches a specific reorder point. The EOQ provides a model for calculating
the appropriate reorder point and the optimal reorder quantity to ensure the instantaneous
replenishment of inventory with no shortages. It can be a valuable tool for small business owners
who need to make decisions about how much inventory to keep on hand, how many items to
order each time, and how often to reorder to incur the lowest possible costs.

The EOQ model assumes that demand is constant, and that inventory is depleted at a fixed rate
until it reaches zero. At that point, a specific number of items arrive to return the inventory to its
beginning level. Since the model assumes instantaneous replenishment, there are no inventory
shortages or associated costs. Therefore, the cost of inventory under the EOQ model involves a
tradeoff between inventory holding costs (the cost of storage, as well as the cost of tying up
capital in inventory rather than investing it or using it for other purposes) and order costs (any
fees associated with placing orders, such as delivery charges). Ordering a large amount at one
time will increase a small business's holding costs, while making more frequent orders of fewer
items will reduce holding costs but increase order costs. The EOQ model finds the quantity that
minimizes the sum of these costs.

The basic EOQ relationship is shown below. Let us look at it assuming we have a painter using
3,500 gallons of paint per year, paying $5 a gallon, a $15 fixed charge every time he/she orders,
and an inventory cost per gallon held averaging $3 per gallon per year.

The relationship is TC = PD + HQ/2 + SD/Q ' where

TC is the total annual inventory costto be calculated.

P is the price per unit paidassume $5 per unit.
D is the total number of units purchased in a yearassume 3,500 units.
H is the holding cost per unit per yearassume $3 per unit per annum.
Q is the quantity ordered each time an order is placedinitially assume 350 gallons per
order.
S is the fixed cost of each orderassume $15 per order.

Calculating TC with these values, we get a total inventory cost of $18,175 for the year. Notice
that the main variable in this equation is the quantity ordered, Q. The painter might decide to
purchase a smaller quantity. If he or she does so, more orders will mean more fixed order
expenses (represented by S) because more orders are handlesbut lower holding charges
(represented by H): less room will be required to hold the paint and less money tied up in the
paint. Assuming the painter buys 200 gallons at a time instead of 350, the TC will drop to
$18,063 a year for a savings of $112 a year. Encouraged by this, the painter lowers his/her
purchases to 150 at a time. But now the results are unfavorable. Total costs are now $18,075.
Where is the optimal purchase quantity to be found?

The EOQ formula produces the answer. The ideal order quantity comes about when the two parts
of the main relationship (shown above)"HQ/2" and the "SD/Q"are equal. We can calculate
the order quantity as follows: Multiply total units by the fixed ordering costs (3,500 $15)
and get 52,500; multiply that number by 2 and get 105,000. Divide that number by the holding
cost ($3) and get 35,000. Take the square root of that and get 187. That number is then Q.

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In the next step, HQ/2 translates to 281, and SD/Q also comes to 281. Using 187 for Q in the
main relationship, we get a total annual inventory cost of $18,061, the lowest cost possible with
the unit and pricing factors shown in the example above.

Thus EOQ is defined by the formula: EOQ = square root of 2DS/H. The number we get, 187 in
this case, divided into 3,500 units, suggests that the painter should purchase paint 19 times in the
year, buying 187 gallons at a time.

The EOQ will sometimes change as a result of quantity discounts offered by some suppliers as
an incentive to customers who place larger orders. For example, a certain supplier may charge
$20 per unit on orders of less than 100 units and only $18 per unit on orders over 100 units. To
determine whether it makes sense to take advantage of a quantity discount when reordering
inventory, a small business owner must compute the EOQ using the formula (Q = the square root
of 2DS/H), compute the total cost of inventory for the EOQ and for all price break points above
it, and then select the order quantity that provides the minimum total cost.

For example, say that the painter can order 200 gallons or more for $4.75 per gallon, with all
other factors in the computation remaining the same. He must compare the total costs of taking
this approach to the total costs under the EOQ. Using the total cost formula outlined above, the
painter would find TC = PD + HQ/2 + SD/Q = (5 3,500) + (3 187)/2 + (15
3,500)/187 = $18,061 for the EOQ. Ordering the higher quantity and receiving the price discount
would yield a total cost of (4.75 3,500) + (3 200)/2 + (15 3,500)/200 = $17,187. In
other words, the painter can save $875 per year by taking advantage of the price break and
making 17.5 orders per year of 200 units each.

EOQ calculations are rarely as simple as this example shows. Here the intent is to explain the
main principle of the formula. The small business with a large and frequently turning inventory
may be well served by looking around for inventory software which applies the EOQ concept
more complexly to real-world situations to help purchasing decisions more dynamically.

Economic Order Quantity (EOQ)

Economic order quantity (EOQ) is the order quantity of inventory that minimizes the total cost of
inventory management.

Two most important categories of inventory costs are ordering costs and carrying costs. Ordering
costs are costs that are incurred on obtaining additional inventories. They include costs incurred
on communicating the order, transportation cost, etc. Carrying costs represent the costs incurred
on holding inventory in hand. They include the opportunity cost of money held up in inventories,
storage costs, spoilage costs, etc.

Ordering costs and carrying costs are quite opposite to each other. If we need to minimize
carrying costs we have to place small order which increases the ordering costs. If we want
minimize our ordering costs we have to place few orders in a year and this requires placing large
orders which in turn increases the total carrying costs for the period.

We need to minimize the total inventory costs and EOQ model helps us just do that.

Total inventory costs = Ordering costs + Holding costs

By taking the first derivative of the function we find the following equation for minimum cost

EOQ = SQRT(2 Quantity Cost Per Order / Carrying Cost Per Order)

Example

ABC Ltd. is engaged in sale of footballs. Its cost per order is $400 and its carrying cost unit is
$10 per unit per annum. The company has a demand for 20,000 units per year. Calculate the
order size, total orders required during a year, total carrying cost and total ordering cost for the
year.

Solution

EOQ = SQRT(2 20,000 400/10) = 1,265 units

Annual demand is 20,000 units so the company will have to place 16 orders (= annual demand of
20,000 divided by order size of 1,265). Total ordering cost is hence $64,000 ($400 multiplied by
16).

Average inventory held is 632.5 ((0+1,265)/2) which means total carrying costs of $6,325 (i.e.
632.5 $10)