Economic order quantity (EOQ) is the ideal order quantity a company should purchase for its inventory given a set cost of production, demand rate and other variables. This is done to minimize variable inventory costs, and the equation for EOQ takes into account storage, ordering costs and shortage costs.
The full equation is:
EOQ = √(2SD / H), or the square root of (2 x S x D / H).
S = Setup costs (per order, generally includes shipping and handling)
D = Demand rate (quantity sold per year)
H = Holding costs (per year, per unit)
EOQ applies only when demand for a product is constant over the year and each new order is delivered in full when inventory reaches zero. There is a fixed cost for each order placed, regardless of the number of units ordered. There is also a cost for each unit held in storage, commonly known as holding cost, sometimes expressed as a percentage of the purchase cost of the item.
The economic order quantity is computed by both manufacturing companies and merchandising companies. Manufacturing companies compute it to find the optimal order size of raw materials inventory and
merchandising companies compute it to find the optimal order size of ready to use merchandise inventory.
The ordering and holding costs
The two significant factors that are considered while determining the economic order quantity (EOQ) for any business are the ordering costs and the holding costs.
The ordering costs are the costs that are incurred every time an order for inventory is placed with the supplier. Examples of these costs include telephone charges, delivery charges, invoice verification expenses and payment processing expenses etc. The total ordering cost usually varies according to the frequency of placing orders. Mostly, it is directly proportional to the number of orders placed during the year which means If the number of orders placed during the year increases, the annual ordering cost will also increase and if, on the other hand, the number of orders placed during the year decreases, the annual ordering cost will also decrease.
The holding costs (also known as carrying costs) are the costs that are incurred to hold the inventory in a store or warehouse. Examples of costs associated with holding of inventory include occupancy of storage space, rent, shrinkage, deterioration, obsolescence, insurance and property tax etc. The total holding cost usually depends upon the size of the order placed for inventory. Mostly, the larger the order size, the higher the annual holding cost and vice versa. The total holding cost is some time expressed as a percentage of total investment in inventory.