Calculate Economic Order Quantity for your business

D

2

X

Demand

X

Order Cost

/

Holding Cost

D

1/2

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Your Economic Order Quantity is

Why do you need the Economic Order Quantity formula?

In day-to-day business, managers and retailers often face difficulty in determining the exact number of items they should order to refill their stock of a particular item. Order quantity is not a minor issue — ordering too many items increases your holding cost, and ordering too little can result in an out-of-stock situation. Both are unfavorable for any business and should be avoided to keep your business operations viable

The Economic Order Quantity (EOQ) formula helps to avoid these mis-stocking situations. It calculates the ideal number of units you should order, such that the cost involved is minimal and number of units is optimal.

Calculating Economic Order Quantity

The following formula is used to calculate the EOQ:

Economic Order Quantity:
√(2 x S x D)/H

Annual Demand (D)

The Annual demand is the number of units that you sell annually. If actual units are not available, then you can use expected sales figure based on your sales trend.

Order cost (S)

This refers to the costs that are involved with an order but cannot be directly associated with the purchase cost.

Holding cost (H)

This refers to all the costs that are involved in storing or handling the items in your store or warehouse. Usually, holding costs are fixed in nature.

What are the components of Economic Order Quantity?

Annual Demand(D)→ Order cost Per Order (S)→ Holding Cost(H)→

Annual Demand Calculation (D)

The Annual demand is the number of units that you sell annually. If actual units are not available, then you can use expected sales figure based on your sales trend.

The following table will give you a better idea about what the other factors are that can have an impact on demand and your business operations:

Market conditions

Change in customer taste
Competition
Shift in industry standards

Economic conditions

Change in tax rate
Trade regulations, domestic and international
Monetary policy

Order Cost Calculation (S)

This refers to the costs that are involved with an order but cannot be directly associated with the purchase cost.

Examples include,
► Transport charges and custom duties incurred during the movement of the items
► Clerical charges paid to an outsourced agency for recording transaction
► Salary paid to the quality check team before the items enter your warehouse
► Amount spent in setting up a machine or equipments

Holding cost calculation (H)

This refers to all the costs that are involved in storing or handling the items in your store or warehouse. Usually, holding costs are fixed in nature.

Examples include,
► Monthly rent for the shop or warehouse that you use to store items
► Employees salary and warehouse labor wages
► Electricity and insurance cost

Assumptions while calculating EOQ

The EOQ is a great metric for any business dealing with the buying and selling of goods. However, it's important to remember the assumptions that the EOQ formula is based on:

1.

Constant demand

The EOQ assumes that the demand for your products will remain constant throughout the year. It does not consider seasonal changes or fluctuations in demand.

2.

Constant holding and ordering cost

The EOQ assumes that holding and ordering cost remain constant, which may not always be the case. An increase or decrease in your transport charges, a change in the salary of your employees, or rising rent for your warehouse can all impact your costs and affect the calculations that go into the EOQ.

3.

No discounts

The EOQ also fails to factor in vendor discounts. Sometimes it makes sense for a retailer to buy a product in bulk from the vendor to get a discount. In such cases, buying items in fewer installments can actually optimize the retailer's costs despite what the EOQ predicts.

The bottom line

Economic Order Quantity may not consider all the factors that affect each business, but it is still a powerful tool to help an entrepreneur or manager to make more calculated decisions. What makes the EOQ a compelling tool is that it is dynamic and can be revisited from time to time as your business grows. If there's a change in any of your inventory costs, you can always tweak the formula and generate a new EOQ to suit the current conditions.

Calculating the EOQ for your business helps you find a good balance for your order and inventory costs, which are easy to overlook in day-to-day business. The EOQ formula shouldn't be taken as gospel, but it's a useful tool for informed, effective inventory control.

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