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One of the most common problems businesses face is keeping warehousing costs down while still meeting customer demand. Knowing when and how to order inventory without overstocking or understocking can be challenging. Many businesses try to solve this problem by ordering on an as-needed basis, which can often lead to operational inefficiencies. A better, more efficient way to place orders for your business is with the help of an economic order quantity formula.
Economic order quantity (EOQ) is a mathematical calculation businesses use to figure out the ideal quantity of units to order while meeting demand and preventing stockouts. Using this formula can help you minimize the cost of logistics and utilize warehousing space efficiently by optimizing inventory levels.
EOQ plays a big role in efficient supply chain management. It offers a range of benefits, including:
Using the EOQ formula can enable you to order enough inventory to fulfill customer demands without taking up extra storage space, which can lower overhead costs related to inventory management. It can also prevent financial losses associated with understocking and enhance customer satisfaction through consistent order fulfillment.
Following the EOQ formula will enable you to only order the stock you need so that your cash doesn’t get tied up in unnecessary inventory. That way, you can invest your company’s funds in other areas of business development for continued growth.
By using the EOQ formula to maintain optimal inventory levels, you will be able to meet your customers’ demands consistently. Your customers will never have to experience the disappointment of an “Out of Stock” notification and will be more likely to continue ordering from your company when they realize your products are always available.
Placing consistent product orders at regular intervals can streamline your order fulfillment for suppliers. If your inventory needs are predictable, you can even set up a subscription with product suppliers, eliminating the need to place new orders manually.
Having the right amount of inventory on hand can help you improve your cash flow and meet customer demand, resulting in higher profitability. These factors play a critical role in helping your business grow over time.
The formula for economic order quantity (EOQ) is:
EOQ = √ [ (2 x S x D) / H]
In this formula,
“S” may vary from one order to the next, while “D” can be derived from the previous year’s sales data.
To calculate "H," follow the equation below:
Holding Cost (H) = (Storage Costs + Employee Salaries + Opportunity Costs + Depreciation Costs) / Total Value of Annual Inventory
Let’s assume you run an online clothing store and want to calculate the economic order quantity of your business’s most popular product: a graphic t-shirt. After looking at some data and conducting some research, you figure out that your:
The next step is to plug these variables into the EOQ formula:
EOQ = √ [(2 x 2 x 10,000) / 1]
EOQ = √ [40,000 / 1]
EOQ = √ 40,000
EOQ = 200
The formula shows that the optimal number of inventory units for your business to purchase in each order is 200. Using this number, you can maintain optimal inventory levels and avoid overstocking and understocking.
Although economic order quantity is a reliable metric to integrate into your inventory management, it does have some limitations and challenges that businesses should consider.
EOQ takes into account constant demand rate as a key factor in its formula. However, it’s very unusual for demand to stay consistent. This means that the EOQ formula will not work if your demand unexpectedly skyrockets or plummets. Thankfully, there are alternative models that can accurately forecast demand and enable you to scale your operations to fluctuating order levels.
Suppliers often provide significant discounts on bulk orders. If you frequently take advantage of these discounts, EOQ might not be the ideal formula for inventory management. For instance, EOQ might tell you that your optimal order quantity is 475 units, but your supplier might be offering huge discounts on purchases of 500 units or more. In such a case, you will need to weigh your options differently.
If you sell perishable goods, you probably order them on an as-needed basis. Depending on how soon your products expire, you might need to purchase units daily, weekly, or monthly. EOQ doesn’t take perishability into account, which makes it non-applicable for sellers of perishable items.
EOQ requires accurate data. If your business does not have a proper record of every variable, or if you use the wrong numbers in the formula, you will order the wrong amount of inventory units. This can lead to understocking and overstocking, and impact your cash flow negatively.
If you operate in multiple locations with varying levels of demand, you will need to calculate a separate EOQ for each location. This can be time-consuming, especially when you are performing calculations manually.
While EOQ is a good formula for calculating the ideal order quantity for your business, it has certain limitations and challenges. Maintaining proper sales records and tracking order fulfillment and inventory management expenses is crucial to calculating EOQ accurately. At Encore Fulfillment, we take care of both the practical and administrative aspects of inventory management and order fulfillment so that your business can optimize its supply chain management with minimal effort. Contact us today for a free quote.
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