Economic order quantity is a mathematical model used to determine the best order size to keep variable inventory costs as low as possible. You can keep the cost of placing orders down by making large orders a few times each year. However, this approach increases the cost of holding inventory because it results in more stock on hand. Conversely, placing many small orders keeps holding costs down but increases the annual cost of placing orders. Calculating order quantity tells you the order size that produces the lowest total cost for ordering and holding inventory.
To calculate the optimum order quantity "Q," take the square root of the following: "2N" multiplied by "P" and divided by "H." "N" is the number of units sold per year, "P" is the cost to place one order and "H" is the cost of holding one unit of inventory for one year. The formula looks like this: sqrt(2N * P/H), with “sqrt” standing for square root. Suppose Company XYZ expects to sell 5,000 widgets in the coming year. The cost of placing an order is $40 and the cost of holding one widget in inventory for a year is $1.60. Plug these numbers into the equation and you have sqrt(2 * 5,000 * $40/$1.60). The order quantity for this example that minimizes variable inventory costs works out to 500 widgets per order.