If product demand is greater than a company’s available supply, customers may purchase products elsewhere. When they do so, the company loses revenues and possibly forfeits its customers' goodwill. If product demand is less than supply, the business stores more than the optimum inventory levels, which increases the company’s inventory costs. The economic order quantity model determines the optimal inventory levels a business should maintain to meet customer demand and minimize its inventory costs.
Economic Order Quantity Model
For many small businesses, the primary source of revenue is inventory turnover. If a company maintains too large an inventory, inventory storage, spoilage and obsolescence costs can increase operating costs and decrease a company’s income. The economic order quantity model minimizes these inventory costs by determining the optimal inventory quantity the company should keep on hand and ensuring inventory arrives in time to meet customer needs. The EOQ model accomplishes these goals by monitoring inventory and, when inventory levels fall below a certain point, ordering the inventory needed to avoid shortages. To meet these requirements, the EOQ model determines the optimal-reorder quantity for each order as well as the appropriate-reorder point.
EOQ Model Assumptions
To determine the point at which a company must receive vendor shipments to maintain required inventory levels, the EOQ model assumes that demand is constant, company operations deplete inventory at a fixed rate and that inventory replenishment occurs instantaneously. By making these assumptions, the model eliminates the need to consider such costs as those due to over- and under-stock. As a result, the primary concern of the EOQ model is the tradeoff between order costs and holding costs.
The EOQ model finds the economic order quantity by taking the square root of 2 multiplied by the number of units sold per year and the order-placement cost divided by a unit's carrying cost per period. Annual usage may equal the prior year's units sold, forecast-sales units or a combination of both. In turn, the order-placement cost includes order-processing costs, shipping and order-receipt costs and stocking costs. Such costs include the cost to create a purchase order, process the materials on receipt, process a vendor invoice and issue a payment. Carrying costs are the variable per-unit-holding costs, such as credit interest, inventory-insurance costs and storage costs.
Minimize Order Costs
The EOQ model attempts to minimize order costs, such as requisition and purchase order processing costs, shipping costs, stocking costs and invoice processing costs. A larger order quantity decreases the frequency with which a company places orders and minimizes a company’s order costs, whereas a smaller order quantity increases the ordering frequency and order costs. The EOQ model helps a company make the tradeoff between storage costs and order costs by identifying the quantity a company should use to replenish its inventory, which minimizes both its order costs and holding costs.
Minimize Holding Costs
The EOQ model identifies optimal inventory levels to optimize production processes by preventing stock outs and minimizing total costs, including holding costs, such storage costs and the opportunity cost of committing capital to the company’s inventory rather than other business opportunities. Larger order quantities mean a larger inventory, but a lower number of stock-outs and the increased likelihood that stock will be available to meet customer requirements. But larger-order quantities mean higher storage or holding costs, including inventory obsolescence. In addition, if money is tied up in inventory, it can’t be used elsewhere in ways that might generate a higher return. Smaller order quantities decrease the average-inventory size and the company’s storage costs and increase stock-outs and decrease customer satisfaction.