Definition of EOQ:
The Economic Order Quantity is also known as Optimal Order Quantity. EOQ is the order quantity that minimizes total holding and ordering costs for the year. It indicates to confirm whether, or not the current order quantities are reasonable. To minimize holding costs, shortage costs, and ordering costs, a company should use the economic order quantity rule.
EOQ (Economic Order Quantity) is considered an efficient order quantity but the average inventory on hand over time cannot be calculated from EOQ alone. However, many people use “EOQ” to refer to a min/max inventory system. In such a system, every time inventory levels fall to the minimum level / re-order point, an order is placed for the economic order quantity.
Inventory management costs are ordering costs and carrying costs. Ordering costs are the costs that are incurred at the time of placing an order and receiving the new shipment of inventories. Ordering costs include communication costs, transportation costs, insurance on transit costs, inspection costs, etc. On the other hand, carrying costs is the inventory holding costs that may include opportunity costs of money held up in inventories, storage costs i.e. warehouse rent, insurance, spoilage costs, etc.
Ordering cost is independent of the quantity ordered, while carrying cost (which includes storage costs, handling costs, upkeep expenses, insurance charges, cost of obsolescence, etc.
Thus, Ordering cost decreases as the size of purchase increases because in that case, the number of purchases decreases, but the carrying cost increases with the increase in the size of purchase. Hence, it is important to make a balance between ordering costs and carrying costs in order to find a favorable quantity.
Factors that affect EOQ:
The following factors influence the Economic Order Quantity:
Storage Cost per unit: Storage cost includes space costs, rent of the store, electricity, software, depreciation, warehouse personnel, etc.
Annual Usage: Annual usage simply means how much of a product an entity expecting to sell in one year. For example, if an entity sold 100 units over one month, their projected sales would be 1,200 units in a year.
Order Costs: Order costs includes communication costs, transportation costs, insurance on transit costs, inspection costs, etc.
Formula of EOQ:
EOQ can be calculated with the help of the mathematical formula:
EOQ = 2ab/c
a = Annual usage of inventories (units)
b = Buying cost per order
c = Carrying cost per unit
Limitations of EOQ:
There is some problems exists for determining the EOQ which are enumerated as follow:
- It is assume that all costs are known and constant (ordering cost, unit cost etc) which is not correct.
- Carrying cost is determined on the basis of estimation that may vary over the time
- It is assumed that the consumption or usage throughout the year will be constant which would not true because it would change season to season.
Though EOQ may estimate how much inventory should be ordered, it does not give an answer to when should it be ordered. This model assumes that material may be needed instantly. However, procurement of material needs some time. This is known as lead time. So ordering level for the material is generally defined as:
“Lead Time in days * Average Daily Usage”.
Thus, EOQ can be an effective tool in inventory management to find the optimum quantity to be ordered. But, it cannot be adopted as the one-stop solution for total inventory management. Therefore, other techniques and methods need to be considered and adopted along with EOQ.