Economic Order Quantity (EOQ)

EOQ is the most economic re-order quantity of inventory which helps the business both ensure that the business is not holding too much inventory (which ties down working capital) and that they don't keep so little inventory, which can interrupt the production process. 

These two situations can prove to be costly to the business and both situations will need to be avoided as much as possible. Increasing the inventory quantity ordered will increase the holding costs to the business and will reduce the ordering costs due to fewer orders being placed through the year. 

In an ideal operating condition, a mathematical model can be used to determine the optimum order quantity that will help minimise these two costs to the business. The formula involves:

1. Ordering costs- administrative costs of placing each order. This does not include the cost of the materials. It will include costs like stationery, postage, telephone etc.

2. Annual usage- quantity of inventory in units used per year or the annual demand.

3. Inventory holding costs- cost of holding one unit of inventory per year. This will be the total cost of keeping and maintaining the inventory by the business. It will include costs like rent, insurance, wages, deterioration, etc. 

The formula is as follows:

Assumptions of EOQ:

 Demand and lead time are constant and known

 Purchase price is constant

 No buffer inventory is held 

The economic order quantity chart will be as below; 

Illustration: A company operates a 300-day year and it uses 30 units of inventory each day. For any orders placed, it incurs administrative charge of £40 and its inventory holding cost is £4.00 per unit per year. Calculate the EOQ. 

Solution: Annual usage = 300 days x 30 units = 9,000 units EOQ = £4.00 2 x £40 x 9,000 = 424 units