Every company wants to keep the cost of its inventory minimum to become profitable. There are various methods and tools used for this purpose. In this blog post, we will learn about such a tools named Economic Order Quantity (EOQ) which is used to optimize the inventory of the company.
What is Economic Order Quantity (EOQ)?
The Economic Order Quantity (EOQ) is a term which determines the maximum amount of a product or service that should be ordered by a company to minimize its inventory cost minimum. In other terms, the Economic Order Quantity helps the management to decide how much and how often a particular product or service is to be ordered. The main aim of EOQ is to keep the cost of inventory minimum while maintaining adequate inventory level.
If the quantity of products or services ordered is more than that is required, then the cost of keeping inventory will increase and it the number of orders is more than it may result in increased cost of ordering. Therefore, it is crucial to determine the optimum quantity of the products or services to be ordered and the optimum frequency of orders.
Economic Order Quantity (EOQ) is a key sustainable matrix for the organization that can help release the excess cash tied in the inventory and hence improve the cash flow of the company. That extra cash can be used for other purposes like R&D, marketing, sales, etc.
How to Calculate the Economic Order Quantity (EOQ)?
The Economic Order Quantity (EOQ) can be calculated by using the following simple formula:
Where, Demand= quantity of a product or service required annually to satisfy the business needs of the company
Ordering Costs= Total costs incurred in placing an order and it includes costs of packaging, delivery, shipping & handling, etc. It is the fixed cost in nature.
Holding Costs= Total costs required to store the products including warehousing, logistics, insurance, wastage, etc. It is variable cost in nature.
After calculating the Economic Order Quantity (EOQ), we can easily determine the frequency of placing the orders. This can be done in the following way:
(a) First step is to calculate the number of orders needed to place over the year to meet the total demand.
(b) The next step is to calculate the frequency of orders in the following manner:
Suppose a garments shop carries women’s jackets and it sells 800 jackets per year. The cost of holding a jacket is $6 per year and the fixed cost incurred to order a jacket is $2.
EOQ= Square Root of [2×800(demand)x$2(ordering cost)/$5 (holding cost)], which comes out to be 25.3 with rounding. It means that the optimum order size to minimize costs and meet customer demand is slightly more than 25 jackets.
The important thing to be noted down in this case is that it is a simple frequency calculation which is suitable for the stable business having consistent demand all over the year. However, it will not give correct result for the businesses experience seasonal(variable) demand.
Another thing to be taken care is that this tool gives fair results if we correctly estimate the total demand and the various costs involved. This may require reliable historical data for the inventory movements within the company.
Benefits of Economic Order Quantity (EOQ)
The Economic Order Quantity (EOQ) has following benefits for the businesses:
- The first benefit is that if the company knows correct quantity to be ordered then helps company to reduce their ordering and inventory carrying costs.
- This tool helps businesses improving order fulfillment by reducing lead times which ultimately results in more customer satisfaction.
- Economic Order Quantity (EOQ) model helps organizations to optimize their inventory levels which results in improved efficiency and waste reduction.
- If the companies may plan in advance the quantity and timing of orders to be place over the year, it may help them to negotiate better with the suppliers and they may take benefits like bulk discount, etc.
Limitations of Economic Order Quantity (EOQ)
As the Economic Order Quantity (EOQ) model is beneficial for the companies, it has some disadvantages also, few of which are discussed as below:
- If the demand and various costs are not calculated accurately, it may lead to give incorrect results.
- This model is suitable for stable businesses having stable demand and may not give accurate results for the businesses experiencing seasonal (variable) demand.
- If we are too conservative with the EOQ calculation, then it may result in shortage of inventory for the businesses.
- This model is based on the assumptions like consistent demand and lead time, which may not be realistic for most of the businesses.
- This method is not suitable for the startups and fast growing companies as they normally experience variable demand. This method is only suitable for stable business having consistent demand.
Other Methods Which can be Used as an Alternative to Economic Order Quantity (EOQ)
There are other alternatives which may be used instead of Economic Order Quantity (EOQ) to optimize the inventory levels of the businesses. Some of these alternatives are as below:
(i) The Pareto principle (also known as the 80/20 rule)
This rule states that 80% of the sale of company comes from the 20% of the products. So the companies may focus their effort on those 20% essential products.
(ii) The ABC Analysis
This method is used by the companies to prioritize their inventory. This concept is based on the idea that not all the inventories are equally important and some items are more important than the others.
(iii) The Four-Box System
This is another method used by the businesses to prioritize their inventory. According to this method, there are four types of inventory: fast-moving, slow-moving, non-moving, and obsolete.
Economic Order Quantity (EOQ) is a very useful tool to determine the quantities of products and services to be ordered and frequency of orders. It helps businesses optimize their inventory levels which results in reducing the cost of ordering and keeping the inventory. It also results in increased efficiency and waste reduction for the businesses. The cost saved in inventory may be used in other functions of the business like R&D, production, marketing, customer support, etc. This model has some disadvantages also like it is based on the assumptions like stable demand and lead time, which may not be realistic for many businesses. This method is not suitable for the growing businesses and is only suitable for the stable businesses having stable demand.
Also read: Economic Indicators: Types and Description