Any type of business that requires inventory faces the challenge of ordering exactly the right amount of stock to arrive at exactly the right time. Order too many items, and you may incur additional storage costs; order too few, and you'll have to authorize another production run with all its associated charges. The EOQ is designed to solve this dilemma. Businesses use it to find the ideal order amount where storage and purchasing costs are minimized.
TL;DR (Too Long; Didn't Read)
EOQ stands for economic order quality, and you need three variables to calculate it: product quantity, ordering or setup cost and the cost of storing the items.
What is Economic Order Quality?
Suppose Joe wants to buy shirts to sell in his neighborhood clothing shop. He can buy the shirts for $10 each from a local factory and sell them in his shop for $20. He estimates that he will sell 1,200 shirts per year. Originally, Joe planned to buy 100 shirts per month for a total of 1,200 shirts annually. What he hadn't planned on, though, is the factory charging him an additional $150 setup cost every time he makes an order. At one order per month, this would add $1,800 to the cost of the shirts.
Joe then considers buying all 1,200 shirts upfront for a one-time $150 setup fee, which saves him $1,650. The problem now is Joe doesn't have enough space in his shop to store the extra shirts. He could rent storage space but this is also expensive, in the region of $1.50 per shirt, per year. What's the optimal number of shirts that Joe should order at any one time to minimize both storage and production setup costs? This is the problem that economic order quality seeks to solve.
How Do You Calculate EOQ?
The EOQ formula calculates the best or the optimal number of units you should buy under certain conditions. It's calculated using the simple formula:
EOQ = square root of (2 x D x S/H) or √ (2DS / H)
- D is the demand, or how many units of product you need to buy.
- S is the setup cost.
- H is the holding fee or storage cost per unit of product.
Returning to Joe's shirt dilemma, we see that he needs to buy 1,200 shirts (D) at a setup cost of $150 (S) and a holding fee of $1.50 per shirt. Plugging those numbers into the EOQ formula, you get:
EOQ = √ (2 (1,200 x $150) / $1.50)
EOQ = √ (360,000 / $1.50)
EOQ = √ 240,000
The EOQ in this example is 489.90. This means that Joe should buy 490 shirts at a time. At this number, the factory setup costs per year equal the holding or storage costs per year.
What It All Means
The EOQ formula is typically used in conjunction with the reorder point or the level of inventory that triggers the need for you to place a new order to stop you from running out of inventory. Together, these metrics tell you when to place an order (reorder point) and how much order to place (EOQ formula). The idea is to prevent an inventory shortage – which may result in lost revenues and customers – while not having an oversupply that causes additional storage costs.