When ordering inventory from suppliers, most companies purchase only enough to meet current sales or reorder the same quantity every time.
Knowing the economic order quantity (EOQ) when purchasing inventory can help minimize costs while still meeting customer demand.
The EOQ formula draws from actual company data, including storage costs and sales orders, and is a simple way for companies to determine their ideal order size.
What is EOQ?
Economic order quantity (EOQ) is the optimal amount of inventory that should be purchased to best minimize costs and still fulfill customer sales.
The EOQ formula accounts for all costs and demand, and calculates the exact on-hand inventory levels a company should maintain for every product.
By looking at historical data metrics to determine the most optimal order quantity, EOQ effectively reduces the risk of inventory shortage or unsold inventory.
EOQ is used by businesses of all industries and sizes that work with suppliers for any type of inventory, such as raw materials, packaging, or finished goods.
Benefits of using EOQ for inventory management
Using EOQ eliminates the guesswork from managing inventory levels, and gives a precise number of orders based on previous sales numbers. Thanks to its clear-cut approach, EOQ also benefits many other areas of business:
Reduces holding and storage costs
Without properinventory planning, a company can end up with too much stock and added costs. Not only is there the cost of the product itself, but also associated storage, labor, and other overhead. By calculating for the order quantity that closely matches demand, companies will only order what they need and reduce any unnecessary expenses.
Prevents loss of sales from stockouts
EOQ calculations provide specific numbers for how much inventory to hold and when to reorder so a company never runs out of stock (also referred to as a stockout). Holding enough products to meet demand results in easier order fulfillment, a better customer experience, and continuous revenue.
Creates more efficient fulfillment
By applying a defined formula to a previously ad hoc process, EOQ creates a more efficient inventory control and order management process. Knowing the ideal order quantity helps purchasing and warehouse teams better prepare resources for inventory shipments.
Sales teams are also more confident to engage customers, knowing there’s enough stock to accommodate orders.
Challenges of using EOQ
As a data-driven model, the EOQ formula is easy to apply, but inflexible when it comes to any fluctuations in demand and sales. Here are some challenges that can arise when using the EOQ model:
Requires accurate inventory data
EOQ relies on having accurate information about previous costs and customer demand. Unfortunately, this can prove challenging for startups or companies that don’t use a reliable means of tracking information, such as an inventory management system.
Without the necessary data, a company will order the wrong amount of inventory, and either lose sales from not having enough stock or lose its investment on products that don’t sell.
Doesn’t adjust to business growth
With EOQ, a company orders a predetermined amount of products each time its inventory levels reach the reorder point. While this method works for businesses that can forecast consistent demand rates, it can potentially lead to insufficient stock and shortages for businesses in growth mode.
Doesn’t accommodate product seasonality
Companies that sell seasonal products, such as camping equipment or holiday decorations, will find EOQ more challenging to use. A new order quantity has to be calculated every time customer demand shifts, which can be every few months in some cases.
EOQ also assumes constant availability of products and the same lead time from suppliers. However, in periods of seasonal demand, even suppliers may run out of stock and leave companies unable to fulfill orders.
Only calculates one type of product at a time
Unless a company offers only one product, or products with similar per unit costs and demand, it will need to calculate a separate EOQ for every one of its products. This is time-consuming, especially for companies carrying a wide assortment of inventory or if its product cost or demand are frequently changing.
How to use the EOQ formula
The EOQ formula is straightforward and relatively simple once you have all the required variables. The three variables include:
- Annual demand: The total number of product units estimated to sell per year, derived from historical sales data.
- Order cost (or setup cost): Includes all the purchase costs of placing a single order, including shipping, handling, and delivery.
- Annual holding cost (or carrying cost): The total cost of stocking a product unit for a year, including salaries, storage costs, insurance, and any other costs incurred when holding inventory.
The formula for EOQ is:
EOQ = √(2DS/H)
Where:
D = Demand in units (per year)
S = Order cost (per order)
H = Holding costs (per unit, per year)
Using the above EOQ formula, say a retail company orders bicycles from a wholesale manufacturer. Last year, the retailer sold 5,000 bicycles, and spent $1,000 per order and $1 holding cost per unit.
Applying the formula to the retailer’s data, the EOQ for its bicycles is 3,162 units.
EOQ = √[2*5,000*1,000]/1
EOQ = √[10,000,000]/1
EOQ = √[10,000,000]/1
EOQ = 3,162
How QuickBooks optimizes inventory management
The economic order quantity formula only works if there’s accurate data, which is best collected using inventory management software.
QuickBooks Enterprise monitors every aspect of order fulfillment, from the warehouse to the customer’s doorstep, and makes it easy to track the entire supply chain management from one central dashboard. Reliable, real-time data can be instantly accessed, including on-hand inventory levels, number of units sold per year, and total order and holding costs.
Not only does this make it simple to calculate the EOQ for any product, companies can also build custom reports to gain deeper insights and make more informed business decisions.
Final thoughts
The economic order quantity model is a calculated way to minimize inventory costs, while still meeting customer demand. It ensures a company doesn’t order more than it can sell, which translates to significant savings on cost, time, and resources.
To use EOQ successfully, a company has to start with accurate sales numbers, fixed costs, and consistent demand. The best way to verify this is with an inventory system that automatically tracks every step in the order fulfillment process, and delivers reliable real-time data to improve your bottom line.
