Understanding Economic Order Quantity – factors | investigate | works
Understanding Economic Order Quantity
What’s the perfect amount of inventory to order? Many people will say it’s the order that results in the lowest total inventory cost. Well, that’s the definition of the economic order quantity or EOQ. The goal of EOQ is to balance the cost of placing inventory orders with the cost of holding the inventory.
For example, you made a forecast, so you know how many items you will need for the year. But you need to determine how many orders to place this year and how much to order each time. Every time you place an order, there’s a cost. The cost to negotiate a contract, place that contract, and receive the material.
So you can save money by placing fewer orders throughout the year. But if you do this, each order will be for a large amount of inventory. More than you need at that time, and you will have to pay extra costs to hold that extra inventory until you need it. That’s where EOQ comes in. The economic order quantity is the amount that perfectly balances the cost of ordering inventory with the cost of holding inventory throughout the year.
That’s how much you will order each time. With this quantity, the cost of placing the order is exactly equal to the cost of holding inventory until it is needed. That amount keeps your total inventory costs at the lowest level. And equally important, the order quantity helps you control your inventory levels. Because you are ordering the same amount each time, you are controlling the maximum inventory you will have on hand.
And as business conditions change over the course of the year, you can manage your total inventory by adjusting the order quantity up or down as needed. Now the EOQ concept has been around a long time. And it’s still used today in many computer-driven inventory control systems, but I want to point out one aspect that limits how it is used. Demand for the item is assumed to be constant over time, so you will use up the item at a constant rate.
A straight-line graph is a little too simplistic. In practice from day to day, you most likely will use up the inventory at different rates. It won’t actually be a straight line, it might look more like an uneven staircase. Because of this, your orders will not automatically be placed at regular intervals. When you place an order, this should be determined by three things.
First, how quickly you’re using up the inventory. Second, how much inventory you have on hand, and third, how long it takes for the order to be delivered. EOQ is a valuable tool, but most companies do not use it as a standalone model for decision-making. It’s normally one component of their overall inventory control system and a foundation of their inventory computer models. You can investigate how EOQ is used in your organization.
Pick a single item your company buys from a supplier, find out the annual ordering cost for that item, and the annual holding cost of inventory. It’s possible the two costs won’t be equal. Which means your orders are not the optimal size, the EOQ size. If not, ask yourself why you are not using the economic order quantity. What other factors might be influencing the decision. The answers will tell you a lot about how your company manages their inventory.