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23 Oct

EOQ Calculation – An Inventory Management Tool

When building a business multiple factors need to be considered—cost, logistics, manpower, operations, packaging, seasonality, and more! However, the main pin-point that drives all the factors is inventory/ stocks. How much stock/ Inventory do we need? What is the actual demand? What is the forecast? How much inventory do we need in the off-season and the high season? These all are very crucial. An effective strategy is required to know exactly the need for stock-ups. There are several strategies for inventory management but the most important strategy for order quantity is Economic Order Quantity/ EOQ Calculation. The overall business performance is dependent on effective Inventory Management, Operations Excellence, Profitability, and Growth.

 

But first things first. What is Inventory Management?

 

What is Inventory Management?

 

Inventory Management is the end-to-end extensive system of procedures and processes from ordering, receiving, storage, tracking, delivering, and returns (if any) for each SKU a business sells. 

 

Every Business needs an optimum level of inventory to run their business. Each SKU’s stocks, misplaced stock, damaged stock, and excess stock affect the inventory. It can boost your profits, manage your taxes, and can hit your business too low. That is why you need to have an effective Inventory Management System.

 

Explore more about Inventory Management Fundamentals for Supply Chain on our Website!

Explore more about Inventory Management Fundamentals for Supply Chain  on our Website! 

 

Firstly, we need to understand how many types of stock are there:

 

Types of Stock

 

The main types of stock that directly play a vital role in inventory management are Cycle Stock and Safety Stock. Let’s discuss each of them below in detail.

 

Cycle Stock

 

The Cycle stock is the stock/ inventory that goes up and down daily. These stocks/ inventories are sold and require replenishment on a daily basis. 

 

Safety Stock

 

Safety stock is the extra quantity of stock that is kept at the warehouse to prevent out-of-stock situations. It serves as insurance against fluctuating demand. Safety stock means we hold something that is not anticipated to happen.

 

Reason for Safety Stock

 

The most important reasons to keep safety stock are as below:

 

  1. Demand is not what was expected or forecasted.
  2. Sudden orders.
  3. If replenishment stock does not arrive on time when we need it.

 

Keeping all the factors discussed above in consideration, it is very important to know where we are standing at stock levels and how much we need in the future. For that reason, there are several methods are adopted for inventory ordering. One of them is Economic Order Quantity. Let’s learn what is Economic Order Quantity. What is its significance?

 

Economic Order Quantity/ EOQ Calculation

 

Economic Order Quantity (EOQ Calculation) is the optimum/ minimum amount of inventory to order at a given time. It is the mathematical model that trade-off between inventory holding and order costs, aiming to minimize total costs.

 

The formula for Economic Order Quantity (EOQ Calculation)

 

The Formula for Economic Order Quantity is as below:

 

The Formula for Economic Order Quantity is as below:

 

Where, 

 

EOQ = Economic Order Quantity

D = Demand (in units)

S = Set Up/ Holding Cost (per order)

H = Holding Cost (per Unit per year)

 

Examples

 

Let’s assume a company produces and sells perfumes. The Company is expecting an annual Demand for perfumes is 10,000 units, costing $200 per order. The carrying cost for the company is $2 per unit per year. The cost per unit of perfume is $5.

 

Using the EOQ calculation formula, we can calculate the optimal order quantity for the company:

 

EOQ = sqrt ((2DS)/(H))

 

Where: D = annual demand = 10,000 units, O = ordering cost per order = $200, H = Holding Cost per unit per year = $2

 

Plugging the value in the formula for Economic Order Quantity:

 

EOQ = √ (2 * 10,000 * 200/2) = 141 units (rounded up)

 

Let’s assume the company has placed an order for 1095 units of perfume at a time to minimize the total cost of ordering and carrying inventory.

 

EOQ : To calculate the total cost of inventory, we can use the following formula: 

 

Where,

 

C = Cost of per unit of perfume = $5

Q = Order Quantity = 1095 units

D = Annual Demand = 12,000 units

O = ordering cost per order = $100

H = holding cost per unit per year = $2

 

Plugging the values:

 

Total Annual Inventory Cost = (12,000*5 / 1095) + (1095/ 2*2) + (12,000*200) = $6,302.29

 

So, the expected inventory cost per year for perfumes is $6302.29 if the ordering of 1095 units is placed at a time.

 

What does Economic Order Quantity/ EOQ Calculation Interpret?

 

The EOQ calculation shows the minimum/ optimal level of quantity to order at one time, which eventually reduces the total inventory Costs. If the order is less than the EOQ, the order will be more frequent and eventually need more frequent orders and higher setup costs while ordering more than the EOQ will result in higher holding costs. 

 

The efficient use of EOQ helps companies to have the right balance in the optimization of inventory management. It provides the right balance between setup and holding costs.

 

While implementing the EOQ model, certain assumptions are required. Such as a constant demand and a fixed set-up cost. However, in planning and management of inventory, it is still a useful and valuable tool for organizations.

 

Learn more about Mastering Supply Chain Management – A Comprehensive Introduction about it on our Website!

 

Economic Order Quantity: Learn more Mastering Supply Chain Management - A Comprehensive Introduction about it on our Website!

 

 

Significance of Economic Order Quantity 

 

The EOQ pertains to prominent significance in inventory management and to the whole business. The major significance is as below:

 

Realistic forecasting through Economic Order Quantity

 

EOQ is solely dependent on realistic and accurate forecasting. If forecasting is accurate then EOQ value will help you attain better stock levels.

 

Stock Levels

 

EOQ calculation provides a bird’s eye view of the stock levels. It helps in determining the inventory levels and turnover rates. This helps businesses to confident enough and able to make informed decisions about when and how much it is required to reorder.

 

Lead time Accuracy

 

To avoid stock outs lead time accuracy is very important. EOQ value of each SKU to ensure availability all the time. 

 

Performance Metrics

 

Regular monitoring against EOQ helps you to monitor Key performance indicators related to inventory management.

 

Learn more about Optimize Your Inventory: A Guide to Planning Methodsit on our Website!

Learn more about Optimize Your Inventory: A Guide to Planning Methods it on our Website!

 

Conclusion

 

All in all, the EOQ business model helps businesses to achieve cost savings and improve efficiency in inventory management. Some companies make mistakes by directly jumping into sourcing which ultimately raises the stock levels. However, if effective inventory management is left for too long it will become a headache and negatively affect business, customers, and profits. EOQ value improves the overall business performance, streamlines the inventory processes, and eventually makes the business profitable.

 

Head to our YouTube channel for an extensive discussion on 5 Levels of Supply Chain Planning!

 

About the Author – Dr. Muddassir Ahmed

 

Dr. Muddassir Ahmed is the Founder & CEO of SCMDOJO. He is a global speakervlogger, and supply chain industry expert with 19 years of experience in the Manufacturing Industry in the UK, Europe, the Middle East, and South East Asia in various Supply Chain leadership roles. Dr. Muddassir has received a PhD in Management Science from Lancaster University Management School. Moreover, Muddassir is a Six Sigma black belt. He has founded the leading supply chain platform SCMDOJO. It enables supply chain professionals and supply chain teams to thrive by providing best-in-class knowledge content, tools, and access to experts.
You can follow him on LinkedInFacebookTwitter or Instagram.