EOQ Formula: Finding Economic Order Quantity for a Business

Economic order quantity (or EOQ) refers to the total costs and number of units necessary to maintain ideal inventory levels for your business.

To find this data, you need to input different factors, including ordering costs (per purchase order), demand in units, and holding costs into a predefined equation. Once you obtain your EOQ, you’ll get a far better grasp on supply chain management as a whole. Keep in mind, however, the EOQ model operates on an annual basis, so you might need to make modifications if your business experiences variable costs due to seasonality.

EOQ comes in handy for a various reasons. Here are just a few key metrics to consider when judging its effectiveness:

• Determining cash flow: EOQ allows you to better grasp how much money you can expect to flow in and out of your business. Your EOQ enables you to maintain a calibrated inventory, often leading to reduced fixed costs in other areas of your business. If you have high production costs, reducing inventory expenditures can help you bring in more profits.
• Ensuring efficiency: Once you know your EOQ, you can reduce lead time for your inventory system. This formula allows you to see when your reorder point should be, as well as how much you should be paying in unit costs to maintain your inventory turnover throughout the year.
• Preventing inventory shortages: Once you know your EOQ, you gain a massive amount of inventory control over your goods and services. To avoid stockouts (or shortages), you need to know the right amount of goods to keep on hand at all times. Your EOQ is shorthand for this very information.
• Reducing waste: Just as your EOQ can help you keep your lot size of units from dwindling too small, it can also ensure you don’t allow your holding inventory to become bloated. While it’s useful to keep a safety stock of extra goods on hand in the case of an ordering surge, it’s wasteful to bring in more units in inventory than you’re selling. EOQ helps you match the number of orders you can expect.
• Saving money: Once you calculate your EOQ, you can lower your storage costs to better fund other areas of your company. This increases bottom-line profits and helps you avoid unnecessary opportunity costs when it comes to maintaining inventory. The more money you save in inventory costs, the more you can reinvest it into other areas of your business or keep it in the form of profits.

The formula for EOQ is √(2DS/H). To make more sense of how to put this equation into practice, follow these four steps:

1. 1. Assign variables. In the EOQ formula, D stands for demand in units, S for order cost (per individual purchase cost), and H for holding costs. Ascertain all the numeric values for these variables when it comes to your own business and then plug them into the formula. Make sure to also keep the number two in your numerator—you’ll multiply both your D and S variables by it.
2. 2. Discover the numerator’s product. For the next step in the EOQ model, multiply all the numbers in your numerator. Remember to include the number two in your calculations. In other words, multiply your demand in units by your order cost per individual purchase and then double that value.
3. 3. Divide by holding costs. Take your numerator and divide by the holding costs in your denominator. These holding costs include basic storage costs as well as employee salaries, depreciation expenditures, and additional opportunity costs. Now, you’re well on your way to determining your optimal order quantity and costs.
4. 4. Take the square root. To complete your EOQ calculation, take the square root of the quotient. This will show you the ideal number of units you need to keep on hand to prevent either shortages or overstocking in your inventory. Keep in mind, this model works off the assumption you’ll input annual demand in units and annual holding costs. If you want to use it for a shorter period of time, just make sure to remain consistent with all of your variables.

Suppose a company wants to optimize their management system by discovering their EOQ. Perhaps they’ve found themselves reordering too often to deal with shortages. Maybe they’ve found themselves with too many goods on hand, contributing to waste and profit loss.

Imagine this company sells just one specific type of toy. They sell 5,000 of these toys every year (demand in units or D). It costs them $10 in holding costs (H) to store these goods in their inventory, and they sell them to consumers at $5 a toy (S).

First, you would plug in your variables for √(2DS/H) so it appears as √([2 * 5,000 * 5]/10). Second, multiply all the variables in the numerator: this gives you a total of 50,000. Third, divide this by 10, leading to a quotient of 5000. Fourth, take the square root of 5,000. This leaves you with an EOQ of 70.7, which you can round to 71. In other words, the company should keep a rotating stock of 71 toys in their inventory at all times throughout the year to meet demand.

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