What is EOQ?
EOQ stands for economic order quantity and it helps to find a volume of production or order that the company should add with the objective of minimizing the holding cost and ordering cost.
Let us look at the critical components of EOQ and its formula –
#1 – Holding Cost
Holding cost is the cost of a holding of inventory in storage. It is the direct costDirect CostDirect costs are costs incurred by an organization while performing its core business activity and can be attributed directly in the production cost, such as raw material costs, wages paid to factory staff, power & fuel expenses in a factory, and so on, but do not include indirect costs such as advertisement costs, administrative costs, etc. that needs to be calculated to find the best opportunity whether to store inventory or instead of it invest it somewhere else- assuming demand to be constant.
H = i*C
- H= Holding cost
- i= Carrying cost
- C= Unit cost
Here as demand is constant, inventory will decrease with usage when it reduces to zero-order placed again.
#2 – Ordering Cost
Ordering cost is the cost of placing an order to the supplier for inventory. The number of orders is calculated by the annual quantity demanded divided by volume per order.
Number of orders = D / Q
- D = Annual quantity demanded
- Q = Volume per order
- Annual Ordering Cost
An annual ordering cost is the number of orders multiply by ordering costs.
Annual ordering cost = (D * S) / Q
- S = Ordering cost
#3 – Annual Holding Cost
Annual holding cost is the sum product of volume per order and holding cost, which can be written as.
Annual Holding Cost= (Q * H) / 2
#4 – Total Cost
The sum of the two costs gives an annual total cost of an order.
By adding annual ordering cost and annual holding cost, we get below equation.-
Annual Total Cost or Total Cost = Annual ordering cost + Annual holding cost
Annual Total Cost or Total Cost = (D * S) / Q + (Q * H) / 2
To find EOQ – Economic Order Quantity Formula, differentiate total cost by Q.
EOQ = DTC / DQ
Let’s take an example to calculate EOQ – Economic Order Quantity for a pen manufacturing company where the company’s annual quantity demanded is 400, holding cost is $2, and the ordering cost is $1. Now we will put these values in the above equation.
In the below-given figure, we have shown the calculation for the EOQ for a pen manufacturing company.
So, the calculation for EOQ2 = (2*400*1)/2
Therefore ,EOQ =20.
Let us understand this with an example. A company names Den Pvt. Ltd. wants to know EOQ as it is a tool to calculate volume and frequency of order required for minimizing the cost of per order.
In the below-given table is the data for the calculation of EOQ – Economic Order Quantity Formula for company Den Ltd.
Take the below assumption.
By keeping the above values in the below tabular equation, we get total cost with a combination of different volumes.
Through the above data, we get below the graph.
From it, we can clearly see EOQ is 250. EOD set point where minimize the cost of inventory.
A company manufactures steel boxes for that it needs steel to calculate the quantity required EOD needs to be calculated.
Taking below Assumptions:-
- Ordering Cost = $10 per order
- Annual quantity demanded = 2000 units
- Holding cost = $1 per unit
In the below-given figure, we have shown the calculation of the EOQ for a manufacturing company.
So, the calculation for EOQ2=(2*2000*10)/1
EOQ = (40000)1/2
Therefore, EOQ = 200
Further, we will calculate holding cost, ordering cost, and the number of orders per year and combine ordering and holding costsHolding CostsHolding cost refers to the cost that an entity incurs for handling and storing its unsold inventory during an accounting period. It is calculated as the sum total of storage cost, finance cost, insurance, and taxes as well as obsolescence and shrinkage cost. at economic order quantity.
- Numbers of orders per year
The below table shows the calculation of the number of orders per year.
A number of orders per year = Annual quantity demanded/ EOQ.
So, the calculation of EOQ for numbers of orders per year is =2000/200
Therefore, a number of orders per year =10
- Ordering Cost
The below table shows the calculation of the Ordering cost.
Ordering cost = Number of orders per year * cost per order
So, the calculation of EOQ for ordering cost is = 10*10
Therefore, ordering cost = 100
- Holding Cost
The below table shows the calculation of the Holding cost.
Holding cost = Average unit * Holding cost per unit
So, the calculation of EOQ – Economic Order Quantity Formula for holding cost is = (200/2) * 1
Therefore, holding cost = 100
- Combine ordering and holding cost at economic order quantity
The below table shows the calculation of the combined ordering and holding cost at economic order quantity.
Ordering cost + Holding Cost
So, the calculation for combine ordering and holding cost at economic order quantity formula is = 100 + 100
Here, holding cost and ordering costs is the same, i.e., $100.
Therefore, combine ordering and holding cost at economic order quantity formula is= 200
Let’s see the table how we can derive the same.
From this table, we also get EOQ = 200.
Relevance and Uses
- Cash flow planningCash Flow PlanningCash flow plans are those in which an insurance company assesses its income and expenses in order to maintain cash flows and also to keep cash flows above expenses. It can also refer to an individual's plan to ensure cash liquidity in such a way that they manage their expenses while maintaining a minimum balance.– EOQ formula is used to minimize the cost of inventory and save cash.
- Reordering Point- This formula is used to calculate the reordering point, i.e., point at which one gets a trigger to order inventory.
- It helps the company to reduce waste.
- It helps to minimize storage and holding costs.
This has been a guide to Economic Order Quantity (EOQ) and its definition. Here we learn the formula to calculate economic order quantity using practical examples and downloadable excel template. You can learn more about financial analysis from the following articles –