EOQ stands for Economic Order Quantity, which is a measurement used in the field of Operations, Logistics, and Supply Management. It is a tool used to determine the volume and frequency of orders required to satisfy a given level of demand while minimizing the cost per order. EOQ is calculated using the annual product demand, order cost, and holding cost per unit, per year. The formula can be automated with an inventory management system that’s often part of a larger ERP platform.
The EOQ formula assumes that consumer demand is constant and that both ordering and holding costs remain constant. This makes it difficult or impossible for the formula to account for business events such as changing consumer demand, seasonal changes in inventory costs, lost sales revenue due to inventory shortages, or purchase discounts a company might realize for buying inventory in larger quantities.
The components of the EOQ formula are the cost of holding inventory and the cost of ordering that inventory. The key notations in understanding the EOQ formula are as follows:
- D: Annual Quantity Demanded
- Q: Volume per Order
- S: Ordering Cost (Fixed Cost)
- C: Unit Cost (Variable Cost)
The EOQ formula is calculated by minimizing the total cost per order by setting the first-order derivative to zero. The formula is:
EOQ = √ [2DS/H]
Where:
- D = Demand in units (annual)
- S = Order cost
- H = Holding costs (per unit, per year)
The Economic Order Quantity is a set point designed to help companies minimize the cost of ordering and holding inventory. The cost of ordering inventory falls with the increase in ordering volume due to purchasing on economies of scale. However, as the size of inventory grows, the cost of holding the inventory rises. EOQ is the exact point that minimizes both of these inversely related costs.
In summary, EOQ is a cost accounting tool used to calculate the ideal quantity of units a company should purchase to meet demand while minimizing inventory costs such as holding costs, shortage costs, and order costs.
