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.Â
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.
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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.Â
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:
- Demand is not what was expected or forecasted.
- Sudden orders.
- 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:
Where,Â
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.
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.Â
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.
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Significance of Economic Order QuantityÂ
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.Â
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!
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.
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Frequently Asked Questions: Economic Order Quantity and Inventory Management
What is the difference between Cycle Stock and Safety Stock?
Cycle stock refers to the inventory that fluctuates daily as items are regularly sold and replenished. Safety stock acts as an insurance buffer, consisting of extra inventory kept in the warehouse to prevent out of stock situations caused by unexpected demand spikes, sudden orders, or delayed replenishment deliveries.
What is Economic Order Quantity (EOQ)?
Economic Order Quantity is a mathematical model used to determine the optimal or minimum amount of inventory a business should order at a given time. Its primary goal is to minimize total inventory costs by finding the perfect balance between inventory holding costs and order setup costs.
How is the EOQ calculated?
The EOQ calculation relies on the annual demand in units ($D$), the setup or ordering cost per order ($S$), and the holding cost per unit per year ($H$). The mathematical formula is:
What happens if an order quantity is higher or lower than the EOQ?
If a business orders a quantity smaller than the EOQ, they will need to place orders more frequently, which drives up the total setup costs. Conversely, ordering a quantity larger than the EOQ will result in excess inventory sitting in the warehouse, which significantly increases holding costs.
What assumptions are necessary to use the EOQ model effectively?
To accurately implement the EOQ calculation, a business must assume that there is a constant, predictable demand for the product and that the setup costs for placing an order remain fixed.
Why is accurate forecasting critical for utilizing EOQ?
The EOQ mathematical model is solely dependent on realistic data inputs. If the demand forecasting is highly accurate, the resulting EOQ value will help the business attain optimal stock levels, improve inventory turnover rates, and ensure lead time accuracy to avoid stockouts.
About the Author – Dr. Muddassir Ahmed
Dr. Muddassir Ahmed is a globally recognized supply chain expert, thought leader, and keynote speaker. As the Founder & CEO of
 SCMDOJO, he has built one of the world’s leading platforms dedicated to empowering supply chain professionals with cutting-edge knowledge, practical tools, and access to expert insights. With over 19 years of leadership experience spanning the UK, Europe, the Middle East, and Southeast Asia, Dr. Ahmed has held key roles at Bridgestone, Doncasters Group, Eaton, and Volvo Cars, managing multi-million-dollar supply chain operations.
His expertise spans all facets of supply chain management, with a particular focus on leveraging technology and innovation to optimize processes and build resilient supply chains.
Recognized among the Top 10 Supply Chain Influencers in the World by Supply Chain Digital, Dr. Ahmed has been instrumental in shaping industry best practices through his extensive research, vlogs, and thought leadership. Holding a PhD in Management Science from Lancaster University Management School, he is also a certified Six Sigma Black Belt.
His platform, SCMDOJO, serves a vibrant community with over 51,000 monthly visitors. Moreover, he has 72,000 newsletter subscribers, and a social media following exceeding 105,000 supply chain professionals
A sought-after keynote speaker and thought leader, sharing his insights on industry trends, best practices, and the future of supply chain management. Dr. Ahmed delivers high-impact talks on supply chain excellence, digital transformation, and strategic leadership. His mission is clear: to help supply chains thrive
You can follow him on LinkedIn, Facebook, Twitter
