Economic Order Quantity
Economic Order Quantity (EOQ) is a fundamental inventory management concept that helps firms estimate the ideal order size to minimize overall inventory expenses, which include ordering costs, holding costs, and shortage costs.
Key Components of EOQ
- Demand (D): This refers to the overall quantity of units required over a certain period, often measured annually. Efficient EOQ computations depend on precise demand forecasts.
- Order Cost (O): Regardless of order amount, this fixed cost is incurred each time an order is placed and is also referred to as setup cost. It covers costs like shipping and handling.
- Holding Cost (H): The cost of keeping unsold goods for a year per unit is known as the holding cost. Depreciation, insurance, warehousing fees, and opportunity costs associated with capital invested in inventories are examples of holding costs.
Here's the formula:
EOQ = √ (2 x D x O / H)
Example
After analyzing your data, you calculate that you normally sell an average of 2,500 widgets each year. You also look through your purchase orders and inventory costs to calculate that each shipment of 100 widgets costs $75. And you find that storage of each widget costs you $20 per year.
With these variables in hand, you can now calculate your optimal EOQ for widgets. Let's plug them in.
EOQ = √ (2 x D x O / H)
EOQ = √ (2 x 2500 x 75 / 20)
EOQ = 136.9 or 137 widgets
We discover that the optimal order size is 137 widgets.