Economic order quantity

Economic order quantity is the level of inventory that minimizes the total inventory holding
costs and ordering costs. It is one of the oldest classical production scheduling models. The
framework used to determine this order quantity is also known as Wilson EOQ Model or
Wilson Formula. The model was developed by F. W. Harris in 1913, but R. H. Wilson, a
consultant who applied it extensively, is given credit for his early in-depth analysis of it.

How Does EOQ works?

EOQ is not used in every type of business and industry. Most companies that deal with large
volumes of stock use a form of EOQ. It is common in manufacturing where the ordering of stock
is constant and repetitive. EOQ is primarily used for purchase-to-stock distributors and make-to-
stock manufacturers. These are businesses that have multiple orders, release dates for their
products, and have to plan for their components.

Another type of business that uses EOQ are those that have maintenance, repair, and operating
inventory (or MRO). Businesses that have a steady demand for stock are the most suitable for
EOQ applications but some seasonal items can benefit from the method, too.

Implementing EOQ
There are two main methods to implement EOQ in a business. It is assumed before you do that
the data for costs have already been gathered. The first method is to use a spreadsheet and
manually enter the quantity one at a time onto the inventory sheet. While simple, this can be very
time-consuming. It also works best for companies that deal with smaller amounts of inventory.

If the company in question has a large inventory, say more than several thousand units, then you
will have to use the EOQ software along with your existing inventory system. This method will
calculate it at a much quicker rate and save money on manpower and resources.

The second method you can use is to download company data to a spreadsheet. Once the
calculations are finished, you can upload them to your inventory system manually or with a batch
program. Either way will work.

To make sure that the EOQ you are using for your company is running efficiently, there are some
things you can do. The first is to run a test on the model. This should be done before the EOQ
model is finalized to make sure it is accurate and no glitches are involved. The best way to test it
is to run the method on a sample batch of items. Afterwards, manually check the results to make
sure they match the model’s final numbers.

Adjust the EOQ formula if needed. By running tests, you can determine how the method will
work on inventory storage and ordering costs. Try to look at a long term plan if possible. Small
changes may not be readily apparent with the model and may only become noticeable over time.
To reach the best inventory level, the EOQ model may need to be slightly adjusted.
Overview
EOQ only applies where the demand for a product is constant over the year and that each new
order is delivered in full when the inventory reaches zero. There is a fixed cost charged for each
order placed, regardless of the number of units ordered. There is also a holding or storage cost
for each unit held in storage (sometimes expressed as a percentage of the purchase cost of the
item).

We want to determine the optimal number of units of the product to order so that we minimize
the total cost associated with the purchase, delivery and storage of the product

The required parameters to the solution are the total demand for the year, the purchase cost for
each item, the fixed cost to place the order and the storage cost for each item per year. Note that
the number of times an order is placed will also affect the total cost, however, this number can be
determined from the other parameters

How to calculate EOQ?

Economic Order Quantity must be calculated using a mathematical equation. By using a set of
numbers for production, demand, and a few other variables, a company’s inventory costs can be
minimizes. Here is the equation for EOQ:

The sub-components that make up the equation are as follows:

Annual Usage – This part is pretty self-explanatory. Based on units, a company simply enters
the predicted annual usage amount.

Order Cost –This component is the sum of the fixed costs that occur every time an item is
ordered. They are not associated with the quantity ordered, only with the actual physical act
required to process the order.Also known as purchase cost or set up cost.

Carrying Cost – This part is the financial costs of carrying and storing inventory at or near the
business. The amount is mostly made up of the costs associated with physically storing the
inventory and the financial investment for the inventory. It is also referred to as holding cost.
As long as the data used for the calculations is accurate, this formula is a good method for
determining EOQ. However, many inventory management systems are plagued with inaccurate
data. Miscalculations such as exaggerated costs are common mistakes. If a company only uses
the data from purchasing and receiving, or from product storage and handling, the calculations
will yield very high numbers.

Companies all across the world use software to determine EOQ but despite the accuracy of
computers, there can still be errors. Often, the users of this software do not understand how to
properly utilize it. Also, sometimes the goals of a company do not meet the product of the EOQ
calculations. When this happens, company leaders and executives usually ignore the EOQ
calculations.

The EOQ formula is not absolute and can be modified slightly from its original form. It can be
used to determine many things such as production levels and lengths of time between orders.

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Production EOQ:
Instead of instantaneous replenishment, we include the finite Production Rate R which leads
to the following formula: (You can see, that production rate must be greater than demand rate,
in order to fulfill the demand!)

EOQ = sqrt ( 2 * A * P / (S*(1-A/R))

Backlogging EOQ:
By including the Backlogging Cost B, which is the cost of back-logging one unit per period,
we get the following formula:

EOQ = sqrt (2 * A * P * (S+B) / S * B)

Underlying assumptions
1. The ordering cost is constant.
2. The rate of demand is constant
 3. The lead time is fixed
4. The purchase price of the item is constant i.e no discount is available
5. The replenishment is made instantaneously, the whole batch is delivered at once.

EOQ is the quantity to order, so that ordering cost + carrying cost finds its minimum. (A
common misunderstanding is that the formula tries to find when these are equal.)

Variables
• Q = order quantity
• Q * = optimal order quantity
• D = annual demand quantity of the product
• P = purchase cost per unit
• S = fixed cost per order (not per unit, in addition to unit cost)
• H = annual holding cost per unit (also known as carrying cost or storage cost) (warehouse space,
refrigeration, insurance, etc. usually not related to the unit cost)

The Total Cost function

The single-item EOQ formula finds the minimum point of the following cost function:

Total Cost = purchase cost + ordering cost + holding cost

- Purchase cost: This is the variable cost of goods: purchase unit price × annual demand quantity.
This is P×D

- Ordering cost: This is the cost of placing orders: each order has a fixed cost S, and we need to
order D/Q times per year. This is S × D/Q

- Holding cost: the average quantity in stock (between fully replenished and empty) is Q/2, so
this cost is H × Q/2

To determine the minimum point of the total cost curve, set the ordering cost equal to the holding
cost:

Solving for Q gives Q* (the optimal order quantity):

Therefore: .

Note that interestingly, Q* is independent of P; it is a function of only S, D, H.

Extensions
Several extensions can be made to the EOQ model, including backordering costs and multiple
items. Additionally, the economic order interval can be determined from the EOQ and the
economic production quantity model (which determines the optimal production quantity) can be
determined in a similar fashion.

A version of the model, the Baumol-Tobin model, has also been used to determine the money
demand function, where a person's holdings of money balances can be seen in a way parallel to a
firm's holdings of inventory.

Example
• Suppose annual requirement (AR) = 10000 units
• Cost per order (CO) = $2
• Cost per unit (CU)= $8
• Carrying cost %age (%age of CU) = 0.02
• Carrying cost Per unit = $0.16

Economic order quantity =

Economic order quantity = 500 units

Number of order per year (based on EOQ)

Number of order per year (based on EOQ) = 20

Total cost = CU * AR + CO(AR / EOQ) + CC(EOQ / 2)

Total cost = 8 * 10000 + 2(10000 / 500) + 0.16(500 / 2)

Total cost = $80080
If we check the total cost for any order quantity other than 500(=EOQ), we will see that the cost
is higher. For instance, supposing 600 units per order, then

Total cost = 8 * 10000 + 2(10000 / 600) + 0.16(600 / 2)

Total cost = $80081

Similarly, if we choose 300 for the order quantity then

Total cost = 8 * 10000 + 2(10000 / 300) + 0.16(300 / 2)

Total cost = $80091

This illustrates that the Economic Order Quantity is always in the best interests of the entity.

Conclusion
Economic Order Quantity is the calculating method used to determine the best level of inventory
for production while being the most cost effective for holding and ordering. EOQ, as it is
referred to, has been around since the rise of modern manufacturing processes back in the early
20th century. The first model for calculating EOQ was designed in 1913 by F.W. Harris.