Determine Economic Order Quantity to Minimize Associated Inventory Costs
As a manufacturer or distributor you always want to keep your inventory as low as possible and at the same time be able to supply the current demand. In order to do that you want to make sure you don’t run out of stock and also not hold unnecessary inventory that eats up your cash flow and takes up space in your warehouse.
The question most companies are asking themselves is: How much should I order to minimize my cost of carrying the inventory and minimizing the cost to order the inventory.
In order to make this determination Economic Order Quantity (EOQ) comes into place.
What is EOQ?
EOQ is essentially an accounting formula that determines the point at which the combination of order costs and inventory carrying cost are the least. The result is the most cost effective quantity to order.
When should you apply EOQ?
If you are having repetitive purchasing or planning on an item, you should consider applying EOQ. Some obvious examples using EOQ would be purchase-to-stock and make-to-stock. Repetitive buy maintenance, repair, and operating (MRP) inventory is also a good application for EOQ.
How is EOQ determined?
The basic EOQ formula is as follows:
SQRT(2 * (Annual usage in units) * (Order Cost) / (Annual Carrying cost per unit))
- Annual Usage is the forecasted annual usage
- Order cost is determined be what is the cost to place the order. This includes the cost to enter the order, the cost to process the receipt, inspection, invoicing and paying the vendor. Some items may also have to be returned because of defects and that also adds to the order cost
- Annual Carrying Cost is the cost of having the inventory in the warehouse. That includes the interest the inventory is carrying by not having it as cash on hand. Insurance, taxes and storage costs also needs to be included
Annual Usage = 10,000
Cost per order = $2
Cost per unit (CU) = $8
Carrying cost percentage (percentage of CU)= 0.02
Carrying cost per unit = $8*0.02=$0.16
EOQ = SQRT (2*2*10,000 / 0.16) = 500