Economic Order Quantity (EOQ) Formula
Economic Order Quantity = √ (2DS) / Hwhere,
D: Demand of the product (typically annually)
S: Cost of placing the order
H: Holding cost(average inventory holding cost (a %) * unit cost)
Things to Consider When Evaluating Economic Order Quantity
There are a number of factors to consider when determining the cost of placing an order, for example:
- Cost of employees (hourly/salary wage)
- The number of employees involved in the ordering process
- The complexity of the goods being purchased. A small business with 3 or 4 employees will spend a lot less making purchases than a large company with 100,000 employees. While a larger company may capture economies of scale, there is a higher level of effort required in the purchasing process.
The cost includes the full scope of the ordering process, for example:
- Filling out paperwork
- Review of proposals (Request for Quote- RFQ// Request for Proposal- RFP)
Pending the size of the organization, a time study may be required to establish an accurate cost associated with placing an order. It is important to note the relationship between cost to place an order and the cost of the good; if the cost of the good being purchased is low-dollar value (i.e. $1) and the cost of placing an order is high-dollar (i.e. $500), the model is going to say buy-buy-buy, but as the cost of the good begins to exceed the cost of placing an order, the model will become more conservative.
The holding cost is also an important factor to take into consideration. There is a cost associated with each square foot of space taken up on the shelf; lighting the facility, heating/cooling, maintenance, equipment, leasing expense, and employees. A ballpark estimate for holding cost is between 10%-20%. An organization may determine that they spend 15% for every dollar spent.
It should be noted the model reflected on this page is also referred to as the Harris-Wilson EOQ model. The model considers the trade-off between ordering cost and storage costs to determine just the right quantity to use when restocking inventory.
Economic Order Quantity in inventory management is often used in supply chain and operations for the purposes of demand forecasting. It is often referred to in the industry as Reorder Quantity (or ROQ). Pending the organization and guidance from management regarding how inventory decisions will be made, it is one piece of the buying decision process.
Supply chain professionals often establish a Safety Stock Level (SSL), Reorder Point (ROP), Economic Order Quantity (or ROQ), and Target Stocking Level (TSL). As it implies, SSL is a safety stock position to mitigate risk as a result of variation in demand. The Reoder Point is the inventory position level that will trigger a buy. EOQ is how much you want to buy each time you place an order and on an annual perspective, for planning purposes, you will want to end the year at TSL.
As a final note, there are many assumptions built into the formula; demand can increase or decrease, ordering costs will vary, and holding costs are influenced by facility expenses, wages, and other fixed costs. However, with the variability, this model provides businesses with the ability to try and optimize inventory purchasing decisions to maintain just the right amount of inventory while reducing the likelihood of a lost sales opportunity.