Inventory-heavy businesses constantly look at ways to optimize their inventory balances. If a company purchases too much stock, it ties up too much cash into inventory and ends up experiencing high storage costs. If the company buys too little, on the other hand, it won’t be able to meet customers’ or production needs.
The Economic Order Quantity (EOQ) is a calculation that determines the maximum amount of a product or service that a company should order at one time to minimize costs. In simpler terms, EOQ helps us find the ‘sweet spot’ of how much and how often to order.
The EOQ considers ordering costs, inventory carrying costs, and lead time. The goal is achieving the lowest possible cost while maintaining an adequate inventory level.
This article will explore the Economic Order Quantity model, how to run the calculation, and what it means for your business. Knowing this, you can make more informed decisions about inventory management and keep your expenses low.
What is the Economic Order Quantity (EOQ)
In essence, EOQ is a tool we use to determine the unit volume and order frequency the company needs to satisfy a given level of demand while minimizing the cost per order.
It’s a key sustainability metric for the business and a cash flow tool that can help the company manage cash tied in inventory. Keeping too much money as stock means fewer resources for R&D, marketing, sales, business growth, etc., which can seriously harm the company’s prospects.
Many companies would benefit from using the EOQ formula to optimize their inventory management. The more inventory a company manages, the more the Economic Order Quantity model can influence profitability and the bottom line. However, calculating the EOQ can be tricky, and several variables must be considered. This article looks at calculating the EOQ for your business.
How Does the EOQ Formula Work
The EOQ formula is relatively simple:
Where:
- Demand is the annual required quantity of the product to satisfy the company’s clients or production needs.
- Ordering Costs (fixed costs) are the total costs for placing an order, including packaging, delivery, shipping & handling, etc.
- Holding Costs (variable costs) are the total costs needed to store the products, including warehousing, logistics, insurance, wastage, etc.
Once we have the Economic Order Quantity figure, we can calculate the frequency of placing the orders. We can calculate the frequency using the following two equations in a straightforward scenario.
First, we can calculate the number of orders we need to place over the year to meet the total demand.
Next, we can calculate the frequency of orders as follows:
Remember that this is a simplified frequency calculation, which may be helpful for stable businesses with consistent demand throughout the year. However, it won’t work for companies experiencing any seasonality.
Proper Economic Order Quantity Model calculations require reliable historical data for the inventory movements within the company. We need to estimate the total demand and the various costs involved correctly.
Advantages of Using the EOQ Model
Using the Economic Order Quantity (EOQ) formula has several business benefits.
- The EOQ can help companies save money by reducing their ordering and inventory carrying costs.
- The Economic Order Quantity model can help companies optimize their inventory levels, increasing efficiency and reducing waste. The EOQ model can also lead to quantity discounts for the company, as planning and timing orders can help take advantage of bulk discounts.
- The model can help businesses improve order fulfillment by reducing lead times and improving customer satisfaction.
Limitations of the Economic Order Quantity Model
There are also some disadvantages to be aware of when using the EOQ formula.
- The EOQ does not consider all factors affecting inventory management (such as demand variability and seasonality).
- Poor data availability is one of the significant challenges in calculating a meaningful EOQ model.
- The Economic Order Quantity model is unsuitable for fast-growing companies; it works better for stable businesses with more consistent inventory needs.
- The EOQ formula is based on several other assumptions that may not be realistic for all businesses (such as constant demand and lead time).
- If we are too conservative with the EOQ calculation, it may lead to shortages for the business.
Despite these limitations, the EOQ is still a helpful tool for companies to use when trying to optimize their inventory management.
However, it is crucial to understand these limitations and make sure that it applies to your specific business. These limitations make it essential for companies to use the EOQ formula cautiously. Additionally, businesses should supplement the Economic Order Quantity with other inventory management techniques to ensure that their inventory is well-managed.
Examples of how the EOQ can be used in different businesses
Many businesses can benefit from using the Economic Order Quantity (EOQ) formula. Here are a few examples:
- Retail companies can use the EOQ to optimize their inventory levels and reduce lead times.
- Manufacturing businesses can use the EOQ to reduce their ordering and inventory carrying costs.
- Service businesses can use the Economic Order Quantity to improve customer satisfaction by reducing lead times.
- Wholesale businesses can use the EOQ to reduce their ordering and inventory carrying costs.
These are only a few examples of how different businesses can use the EOQ model. Many other companies can also benefit from using this formula.
Alternatives to the EOQ formula
Businesses can use several alternatives to the Economic Order Quantity (EOQ) formula to optimize their inventory management. Here are a few examples:
- The ABC analysis: The ABC analysis is a technique that helps businesses to prioritize their inventory. It is based on the idea that not all stock is created equal and that some items are more important than others.
- The four-box system: The four-box system is another technique that helps businesses to prioritize their inventory. It is based on the idea that there are four different types of inventory: fast-moving, slow-moving, non-moving, and obsolete.
- The Pareto principle (also known as the 80/20 rule): The 80/20 rule states that 80% of a company’s sales come from around 20% of its products. This rule can help businesses focus their efforts on essential products.
These alternatives all have their strengths and weaknesses, and businesses must choose the suitable option. It is also important to note that no one choice is perfect, and companies should use various methods to optimize their inventory management.
Sign Up for our Newsletter
And Get a FREE Benchmark Analysis Template
Using the Economic Order Quantity Model template on the Magnimetrics platform
To simplify calculating your Economic Order Quantity, we have prepared a template on the Magnimetrics platform that you can use and modify as needed.
Prep Step: Get Your Free Magnimetrics Account
To use the Economic Order Quantity template (and all the other templates in the library), first, you need to have a Magnimetrics account. Those are free to get (no credit card required).
Ready to get started? Get your free account today and see how Magnimetrics can help you transform your existing company data into insightful reports.
Step 1: Import the Economic Order Quantity Template to your Projects
The Economic Order Quantity template is in the Start With a Template section on your Dashboard.
Alternatively, you can click the New Project button on the Projects screen and select the Economic Order Quantity template from the drop-down menu.
Don’t forget to mark the Copy Over Sample Data option whichever way you go. This will ensure that all necessary sample data points are copied into your new project.
Step 2: Adjust the inputs on the Assumptions tab
After you import the EOQ template, the screen will show the dashboard for the project.
First, head to the Assumptions tab to adjust the length of your analyzed periods (in days) as needed:
- PERIOD_DAYS: the number of days in a period
Step 3: Adjust the required Historical Data
(If you only want to see how the template works with the dummy data, skip this step)
Click on the Data Imports link on the left and open the Historical Data template. Here you can adjust the three required data points:
- Total Annual Demand: the annual required quantity of the product to satisfy the company’s clients or production needs.
- Ordering Costs per Batch: the total costs for placing an order, including packaging, delivery, shipping and handling, etc.
- Holding Costs per Item: the total costs needed to store the products, including warehousing, logistics, insurance, wastage, etc.
Step 4: Run the Economic Order Quantity Model report
Once you have imported/adjusted all the necessary data points, head to the Reports tab and Launch the Economic Order Quantity Model report.
The app executes the report and shows a summary Economic Order Quantity calculation table. It also narrates how EOQ has developed over the analyzed periods.
If you feel adventurous and want a deeper understanding of how things work, click Edit Report to see how we construct a report, build logic and tables, and adjust everything to your liking. To see the entire picture, you can also go to the Formulas tab, where you can see how we calculate each step in the template.
Step 5: Download the Results in PDF
Once you are happy with the report’s appearance, you can use the Download button to export it as a PDF.
Conclusion
The Economic Order Quantity (EOQ) formula can be used to calculate the optimal order quantity for a business. It considers the cost of ordering and storing inventory and the cost of lost sales due to out-of-stock items. The goal is achieving the lowest possible cost while maintaining an adequate inventory level. Businesses can use the EOQ formula to ensure they are not overstocking their inventory, leading to increased profits.
It is essential to understand that the EOQ has some limitations. We must ensure that it applies to our specific business and use it cautiously.
The Magnimetrics software makes it easy to calculate your company’s EOQ and provides templates that you can use to get started immediately. Sign up today and try our Economic Order Quantity Template!
Dobromir Dikov
FCCA, FMVA
Hi! I am a finance professional with 10+ years of experience in audit, controlling, reporting, financial analysis and modeling. I am excited to delve deep into specifics of various industries, where I can identify the best solutions for clients I work with.
In my spare time, I am into skiing, hiking and running. I am also active on Instagram and YouTube, where I try different ways to express my creative side.
The information and views set out in this publication are those of the author(s) and do not necessarily reflect the official opinion of Magnimetrics. Neither Magnimetrics nor any person acting on their behalf may be held responsible for the use which may be made of the information contained herein. The information in this article is for educational purposes only and should not be treated as professional advice. Magnimetrics and the author of this publication accept no responsibility for any damages or losses sustained as a result of using the information presented in the publication. Some of the content shared above may have been written with the assistance of generative AI. We ask the author(s) to review, fact-check, and correct any generated text. Authors submitting content on Magnimetrics retain their copyright over said content and are responsible for obtaining appropriate licenses for using any copyrighted materials.
