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Economic Order Quantity: Challenges and Advantages

• Yashoda Gandhi
• Jul 11, 2022

Managers and retailers frequently struggle to determine the exact number of items they should order to replenish their stock of a specific item daily.

Order quantity is a major consideration—ordering too many items raises your holding costs, while ordering too few items can result in an out-of-stock situation. Both are detrimental to any business and should be avoided if you want to keep your operations running.

The Economic Order Quantity (EOQ) formula assists in avoiding mis-stocking situations. It calculates the optimal number of units to order so that the cost is minimal and the number of units is optimal.

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What is Economic Order Quantity?

The economic order quantity (EOQ) is the order size that minimizes the sum of raw material or merchandise inventory ordering and holding costs.

In other words, it is the optimal inventory size that should be ordered from the supplier to reduce the business's total annual inventory cost. Economic order quantity is also referred to as optimal order size and optimal order quantity.

Manufacturing and merchandising firms both calculate the economic order quantity. Manufacturing firms use it to determine the optimal order size of raw materials inventory while merchandising firms use it to determine the optimal order size of ready-to-use merchandise inventory.

How to calculate Economic Order Quantity?

How Economic Order Quantity is Calculated

Any order has two components: the cost of the order and the cost of holding inventory. The EOQ is calculated using these two components, as well as the quantity or volume ordered.

1. Order cost

Each order incurs a fixed cost. It is generally unaffected by the number of units ordered or the volume of the order. This is known as the ordering cost of an order and includes packing and forwarding charges, freight, and so on.

1. Holding Cost

Inventory has its own set of costs. It can take the form of godown space or storage area rentals, as well as electricity bills, repairs, and maintenance. Carrying cost is another term for it. Then there's the cost of human resources to keep the stock in good condition.

Furthermore, if the company had not invested in the product under consideration, it could have been used for something else. It is the cost of holding a specific product.

Similarly, if the money was invested somewhere else, there could be an interest cost associated with the inventory. The holding costs also include inventory insurance and costs incurred due to perishability, leakage, or theft of goods.

The annual holding cost is calculated as follows:

Order quantity/2 x Product holding cost per unit

EOQ Calculation

The EOQ is calculated using the following formula:

EOQ = square root of (2xDxS/H).

D denotes the annual demand for a product in units,

S denotes the ordering cost per order,

H stands for product holding cost per unit.

Also Read | What is Economic Batch Quantity (EBQ)?

Why should we calculate EOQ?

EOQ calculations for your company provide a number of advantages that affect your bottom line. It's an excellent method for determining how much product is required to maintain an efficient e-commerce supply chain while keeping costs low.

The following are the primary advantages of calculating EOQ.

1. Reduced inventory costs

Having an excess inventory can quickly increase storage costs. Inventory costs can also rise as a result of how you order, what gets damaged, and which products never sell. If you're constantly re-ordering products with low velocity, EOQ can help you figure out how much to order in a given time frame.

1. Reduce stockouts

EOQ can help you understand how much and how frequently you need to reorder. You can avoid stock outs by calculating how much inventory you need based on how much you sell in a given period of time.

You might be surprised to learn that ordering in smaller quantities is more cost-effective for your company, or that the opposite is true — calculating EOQ can help you determine this.

1. Increasing overall effectiveness

Overall, calculating EOQ can assist you in making better decisions regarding inventory storage and management. The truth is that many e-commerce businesses place orders based on a "gut feeling" of how much product is required, rather than ordering how much product is required. Calculating EOQ is an efficient way to better quantify how much you require based on key cost variables.

Factors affecting EOQ

Economic Order Quantity Influencing Factors are mentioned below:

1. Carrying relevant cost:  The total cost of maintaining and carrying the stock for the specified period.

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Challenges with Economic Order Quantity

A company must have the right data to make accurate calculations. EOQ assumes that there is a consistent demand for products and that you can replenish them immediately. It also takes into account fixed costs for:

• Inventory items
• Order fees
• Holding costs

This makes accounting for changes in consumer demand or seasonality difficult, if not impossible, for businesses. You'll have the wrong amount of inventory if you don't have accurate, real-time data on holding or order costs, which can quickly lead to a stockout.

To determine the proper amount of inventory, you must estimate needs based on historical demand. If you're using spreadsheets and don't have any tracking in place, this can be time-consuming. Software for Inventory management, on the other hand, can compile this data in just a few clicks. so you can apply the right data to your EOQ formula.

1. Seasonality and Changing demand

The EOQ model is a straightforward model for products that have consistent demand all year. This, however, is not always the case. Newly launched products may have a higher initial demand that fades over time. Products with seasonal demand, where sales fluctuate throughout the year, may render EOQ calculations invalid.

You can't just measure EOQ at the start of the year and expect it to be accurate. As a result of inconsistent reordering, this could result in stockouts or excess inventory.

1. Supply constraints

Inventory shortages are another limitation of the EOQ model. Some businesses that are new to using EOQ may be conservative in their reordering, resulting in smaller orders and your store being understocked.

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Advantages of Using Economic Order Quantity

The main advantage of using EOQ is increased profitability. Here's a list of advantages that add up to savings and improvements for your company:

1. Improved Order Fulfillment: When you need a specific item or something for a customer order, optimal EOQ ensures that the product is on hand, allowing you to complete the order on time and keep the customer satisfied. This should improve customer satisfaction and possibly lead to increased sales.

1. Less Waste: Better order schedules should reduce obsolete inventory, especially for businesses that keep perishable inventory, which can result in dead stock.

1. Reduced Storage Costs: When your ordering corresponds to your demand, you should have fewer products to store. This can result in lower real estate, utility, security, insurance, and other costs.

1. Quantity Discounts: If you plan and time your orders correctly, you will be able to take advantage of the best bulk order or quantity discounts offered by your vendors.

Other factors that can help with inventory optimization include:

Seasonality and large sales can also have an impact on inventory accuracy. Aside from EOQ, there are a few other methods for optimizing inventory.

1. Points should be reordered.

Instead of manually checking inventory levels to reorder products, you can set automatic reorder points that place an order automatically when your inventory levels reach a certain threshold. This is made simple by investing in inventory management software or partnering with a 3PL).

1. Safety stock dimensions

There are times when demand spikes unexpectedly or when there are problems with a supplier that prevent you from having enough inventory. Safety stock is simply excess inventory that exceeds expected demand.  Safety stock is also frequently used during peak shopping seasons such as the holidays or during a big promotion or flash sale.

1. Inventory tracking in real-time

By tracking inventory in real-time, you can easily monitor and control stock levels, as well as know where products are stored in your warehouse. This allows you to know how much product can be shipped right now, make faster inventory ordering decisions, and communicate any out-of-stock item delays quickly.

Also Read | What is the Opportunity Cost? How is it Calculated?

Economic Order Quantity underlying assumptions

The following assumptions are used to calculate the economic order quantity (EOQ):

1. The total number of units that will be consumed during the period is certain.

1. Throughout the period, the total ordering cost remains constant.

1. Throughout the period, the inventory cost remains constant.

1. No cash or quantity discounts are available.

1. The entire amount of ordered inventory is delivered in a single batch.

1. Each invariable or stock item's optimal quantity is calculated separately.

1. The lead time is constant, and the order is delivered on time with the full order quantity.

1. The assumptions described above are also known as the economic order quantity constraints (EOQ).

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Economic Order Quantity may not take into account all of the factors that affect each business, but it is still a useful tool for assisting an entrepreneur or manager in making more informed decisions.

The fact that the EOQ is dynamic and can be revisited as your business grows makes it a compelling tool. If any of your inventory costs change, you can always tweak the formula and generate a new EOQ to reflect the new conditions.

Calculating the EOQ for your company allows you to strike a good balance between order and inventory costs, which are easy to overlook in day-to-day operations. The EOQ formula is not sacred, but it is a useful tool for informed, effective inventory control.