Economic Order Quantity (EOQ)
The model used to figure out the optimal quantity for inventory is known as the Economic Order Quantity (EOQ) model. This optimal quantity is required to minimize the ordering and carrying cost. Ford W. Harris developed the EOQ model in 1913.
What does the Economic Order Quantity Model describe?
The primary objective of the EOQ model is to find the ideal amount of inventory to order. A company can decrease its ordering, carrying, and shortage costs by identifying the optimal order quantity.
EOQ is considered as a vital cash flow tool. As we all know, inventory is the main asset mentioned on the balance sheet. Thus, it is necessary to balance it. EOQ helps reduce the cost of stock levels and save cash.
EOQ indicates inventory reorder points to a company. Reordering points is vital for inventory. A business can avoid running out of stock by accurately determining the reordering point.
If this model is implemented in a company, it will automatically trigger the issue where stock needs to be reordered for production units.
Formula of EOQ
Q = Optimal Order Quantity
2 = Constant
D = demand of annual units
S = Ordering Cost per purchase order
H = Holding cost per unit
Why is Economic Order Quantity used?
The EOQ model is used to determine the ideal order quantity for the inventory. It also deals with the reorder timings. EOQ balances cost spent on orders. By using this model, businesses can reduce the acquisition and inventory holding cost.
EOQ is a valuable model for small businesses. It helps owners decide how much inventory must be kept on hand. It is also used to get information about the ordered items. A company can know how often reorders are incurring and their lowest possible cost.
How to Use EOQ
If a company is constantly placing small orders, it should immediately apply the EOQ model. It will tell them the recording point and how they can reduce the setup and storage cost.
Let’s assume a company is selling 2000 water bottles each year. The company is bearing $10 per year to hold this unsold inventory. For the setup cost, they have paid $4 per purchase order.
Now according to the formula:
The optimal order quantity for this business is 40 pieces to reduce the cost of ordering and holding inventory. It will also satisfy the customer demands because they are slightly more than 40 pieces.
The customer demand is considered constant in EOQ formulas. The holding and ordering cost also remains constant in the calculation. This is one of the crucial limitations of the EOQ model. It does not account for the changes in the business. These changes can be seasonal, trendy, etc.
Why is EOQ important?
EOQ is used in inventory management. It tells people about the optimal amount of inventory needed to meet a company’s demand. Also, it is a technique used for reducing storage and holding costs.
It helps companies make more effective decisions related to inventory management and allows businesses to manage their inventory efficiently. Without such a technique, a company might hold fewer quantities of in-demand products. It also might be possible for the firm to store an excessive amount of inventory during low demand.
Both the above scenarios are problematic for a company. If a company purchases too much inventory, it means that too little cash is on hand. On the other hand, not purchasing enough stock will cause a company to miss out.
With EOQ, investors can estimate how efficiently a company can manage its inventory efficiently.