Economic Order Quantity The EOC formula will produce measurable results in stock investment even if the formula

values are just estimates. The formula simply provides a standard methodology for making changes in inventory levels.
Underlying assumptions (for this example) 1. 2. The ordering cost is constant. The rate of demand is constant The lead time is fixed The purchase price of the item is constant i.e. no discount is available The replenishment is made instantaneously, the whole batch is delivered at once.

3.
4. 5.

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 = Cost per U nit Annual Units Ordering Cost = O rders per Year O rder Cost O rders per Year = H olding Costs ( warehouses Annual U nits Quantity per Order pace , insurance , utilities , etc .) H olding Costs

Holding Cost = Average Inventory

Annual Demand Total Cost = Cost per U nit Annual Units + Order Q uantity D Q TC = PD + S + H Q 2 .

Order Cost + ( Average Inventory

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

D Q S = H Q 2

Economic Order Quantity

100 90 80 70 60 50 40 30 20 10 0 1 25

Ordering + Holding Costs

Ordering Costs
50 75 100 Order Quantity 125 150 175

Holding Costs
200

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

HQ 2 = DS 2 DS 2 Q2 = H DS 2 Q= H

Long method:

DS HQ DS Q HQ Q HQ 2 2 HQ 2 2 2 DS = * = * DS = DS * = * 2 DS = HQ 2 Q 2 = Q 2 Q 1 2 1 2 1 2 1 H

Q2 =

2 DS Q = H

2 DS H

Therefore:

Q* is independent of P (purchase price); it is a function of only S (Ordering cost), D (Annual demand quantity), and H (holding costs). Use the EOC formula to adjust inventory investment: Adjust Ordering Costs and Holding Costs estimates to control how much cash is invested in stock on the shelf. Increase Ordering Costs or decrease Holding Costs to increase inventory. Decrease Ordering Costs or increase Holding Costs to reduce inventory.