Economic Order Quantity: How to Calculate EOQ and Apply it in Inventory Management

Economic Order Quantity (EOQ) is the quantity of any purchase order placed at each indent to add the optimum number of units to the inventory at minimum overall costs. It is the ordering quantity that reduces the overall costs of inventory, such as ordering costs, holding costs, and shortages or losses. 

Before studying how to calculate EOQ, let us know about the components of Inventory cost. 

Inventory cost is made up of the following components:

• Unit cost: This is the purchase price per unit of the item purchased.
• Order Cost: This is the cost incurred each time while placing an order. It includes transportation/shipping costs, handling charges, and any other expenses such as octroi and toll tax.
• Holding Cost: This is the storage cost incurred, like building or godown rent, insurance, interest paid or lost due to capital invested, salaries paid to store staff, and any other costs like refrigeration, maintenance, etc., incurred in storing the inventory.
• Losses: This element of cost is due to shortages, damages to items during handling, or loss due to tear and wear of stocks. 
• All these losses are to be borne by the business. So, they are included in the cost of stocks by increasing their unit cost.

How to Calculate Economic Order Quantity

EOQ is calculated using a formula EOQ = square root of {(2*D*S)/H}

Q is the Economic Order Quantity

D is the annual Demand quantity

S is the cost for Setting/placing an order, known as order cost (some put it as K also)

H is the Holding cost per unit, and storage losses can be added to this holding cost

This formula assumes that two opposite forces are affecting your order quantity. The forces of ordering cost and holding cost. So, the median of these two opposing forces is the EOQ.

Now, let us apply this formula in an example:

Suppose your business enjoys an annual demand of 10,00,000 bags of cement
Placing one order, say, costs $10, and let the holding cost be $2 per 1000 bags or .002 per bag

Now, according to above formula, EOQ = the square root of {2*1000000*10 / .002}

Let us first solve the result of the figures within the brackets:

So, (2*1000000*10)=20000000

Now divide by .002

The net figure=200,00,000/.002 = 1,00,000

Now, we have to calculate the square root of 1,00,000, which comes to 3162.28

So EOQ is 3,162 bags. So you have to place each order for 3,162 bags. 

The above is a sample for calculating Economic Order Quantity in a more or less reasonable sense. 

But some factors may affect the accurate calculations in actual circumstances.

Factors affecting EOQ calculation

• Employing the EOQ formula assumes that prices are constant over a given period.
• It is assumed that stockouts (running out of stock) do not happen.
• It is assumed that order-placing costs are constant.
• It also assumes that interest rates and storage rentals do not change during the period.
• It further assumes that demand is constant for those goods.

How to Apply EOQ Method Prudently

We cannot guarantee or predict changes in tastes, prices, or any other factors governing EOQ calculations. 

• A good finance manager should review the calculations at frequent intervals to ensure their efficient application in managing inventories.
• He should be in constant touch with the production, purchases, and marketing teams regarding any changes in production targets, purchase prices, or market demands to ensure that EOQ calculations are constant. 
• If the initial calculations prove to be incorrect or no longer feasible, you should revise the calculations to reflect current circumstances and modify your orders to minimize negative impacts from variations in the factors controlling your Economic Order Quantity calculations.