To maximize company profit, a business has to minimize the costs of ordering and storing its inventory. That means it has to have some sort of financial metric to calculate the optimal quantity of inventory to order and store. That metric is economic order quantity or EOQ.
A company's profitability will start to suffer if it has too much or too little inventory on hand. If the business has too much inventory, it could be slow-moving or obsolete inventory which keeps cash flow hostage and drags down the company's inventory turnover ratio. If the company has too little inventory, then it is subject to stockouts, lost sales, and declining customer goodwill.
EOQ Formula Inputs: Carrying Costs
The carrying costs of inventory also called holding costs or storage costs, go up in direct proportion to the amount of inventory you have on hand. This is why you don't want to have too much inventory sitting around in a warehouse. If you do, the carrying costs of that inventory will impact your cash flow and profit.
If you have to borrow any money to buy inventory, the interest charges you pay on that loan is part of carrying costs. Since you probably pay insurance on the value of your inventory, that is also part of carrying costs as are any taxes you have to pay on the value of your inventory.
Other possible costs of carrying inventory include potential theft and destruction of that inventory and opportunity cost, or the profits you lose because your money is tied up in inventory instead of being put to use in more profitable ventures. You should also consider obsolescence and deterioration of the inventory.
All carrying costs, as part of the economic order quantity formula, should be variable costs since they change with the amount of inventory you are holding.
Ordering costs in the economic order quantity model are the costs of placing and receiving an order. Where carrying costs are usually variable costs, ordering costs are often fixed costs. They include the time and resources spent sending emails or memos about the order, telephone calls, and taking delivery of orders of inventory.
It is often best to divide ordering costs into orders for purchased items and orders for manufacturing. Orders for purchased items would have costs that include initiation of the purchase order, the approval steps, processing the receipt, and inspection. For manufacturing, the cost of the ordering process is a little different. Costs would include the work order, production scheduling time, and inspection time. These lists for costs for purchased items and manufacturing are not all-inclusive.
Inventory Usage or Demand
The last input to the economic order quantity formula is your company's annual usage or turnover of inventory. This is the easy portion of the EOQ formula. Estimate the amount of annual inventory you use, in units, and you have this input.
How to Calculate Economic Order Quantity
Economic order quantity is really a simple concept. EOQ can be calculated by using a financial formula that arrives at the point at which the combination of ordering costs and carrying costs are minimized. This is what lowering inventory costs means.
Use the following formula to calculate the EOQ:
EOQ = square root of: (2SD) / P
Input the following numbers:
- S = Setup (order) costs
- D = Demand rate (units)
- P = Production cost (carrying costs)
Let's say that XYZ, Inc. uses 4,800 units of inventory each year and their order cost is around $2 per order. They have calculated their carrying cost per unit to be $6 per unit. So, the calculated EOQ for XYZ, Inc. is EOQ = (2)(4800)(2)/(6) = 3,200.
Next, take the square root to arrive at EOQ = 57 units
This means that if you order 57 units of inventory every time you place an order you will minimize your inventory costs, both your ordering and your carrying costs.
Note that this EOQ formula does not consider any effects of interest or opportunity cost. You can factor this in by using the current risk-free rate in the equation's denominator, by multiplying it by the production or carrying a cost. You can also use an online calculator for EOQ if you don't have a calculator handy.