Economic Order Quantity is the calculating method used to determine the best level of inventory for production while being the most cost effective for holding and ordering. EOQ, as it is referred to, has been around since the rise of modern manufacturing processes back in the early 20th century. The first model for calculating EOQ was designed in 1913 by F.W. Harris.
What EOQ basically does is determine the best point where the costs for inventory holding and ordering are at the lowest. This helps to determine the number of units of stock to order to re-supply inventory without spending too much money on overstock.
How Does EOQ Work?
EOQ is not used in every type of business and industry. Most companies that deal with large volumes of stock use a form of EOQ. It is common in manufacturing where the ordering of stock is constant and repetitive. EOQ is primarily used for purchase-to-stock distributors and make-to-stock manufacturers. These are businesses that have multiple orders, release dates for their products, and have to plan for their components.
Another type of business that uses EOQ are those that have maintenance, repair, and operating inventory (or MRO). Businesses that have a steady demand for stock are the most suitable for EOQ applications but some seasonal items can benefit from the method, too.
How To Calculate EOQ
Economic Order Quantity must be calculated using a mathematical equation. By using a set of numbers for production, demand, and a few other variables, a company’s inventory costs can be minimizes. Here is the equation for EOQ:
The sub-components that make up the equation are as follows:
Annual Usage – This part is pretty self-explanatory. Based on units, a company simply enters the predicted annual usage amount.
Order Cost –This component is the sum of the fixed costs that occur every time an item is ordered. They are not associated with the quantity ordered, only with the actual physical act required to process the order.Also known as purchase cost or set up cost.
Carrying Cost – This part is the financial costs of carrying and storing inventory at or near the business. The amount is mostly made up of the costs associated with physically storing the inventory and the financial investment for the inventory. It is also referred to as holding cost.
As long as the data used for the calculations is accurate, this formula is a good method for determining EOQ. However, many inventory management systems are plagued with inaccurate data. Miscalculations such as exaggerated costs are common mistakes. If a company only uses the data from purchasing and receiving, or from product storage and handling, the calculations will yield very high numbers.
Companies all across the world use software to determine EOQ but despite the accuracy of computers, there can still be errors. Often, the users of this software do not understand how to properly utilize it. Also, sometimes the goals of a company do not meet the product of the EOQ calculations. When this happens, company leaders and executives usually ignore the EOQ calculations.
The EOQ formula is not absolute and can be modified slightly from its original form. It can be used to determine many things such as production levels and lengths of time between orders.
There are two main methods to implement EOQ in a business. It is assumed before you do that the data for costs have already been gathered. The first method is to use a spreadsheet and manually enter the quantity one at a time onto the inventory sheet. While simple, this can be very time-consuming. It also works best for companies that deal with smaller amounts of inventory.
If the company in question has a large inventory, say more than several thousand units, then you will have to use the EOQ software along with your existing inventory system. This method will calculate it at a much quicker rate and save money on manpower and resources.
The second method you can use is to download company data to a spreadsheet. Once the calculations are finished, you can upload them to your inventory system manually or with a batch program. Either way will work.
To make sure that the EOQ you are using for your company is running efficiently, there are some things you can do. The first is to run a test on the model. This should be done before the EOQ model is finalized to make sure it is accurate and no glitches are involved. The best way to test it is to run the method on a sample batch of items. Afterwards, manually check the results to make sure they match the model’s final numbers.
Adjust the EOQ formula if needed. By running tests, you can determine how the method will work on inventory storage and ordering costs. Try to look at a long term plan if possible. Small changes may not be readily apparent with the model and may only become noticeable over time. To reach the best inventory level, the EOQ model may need to be slightly adjusted.