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Economic Order Quantity (EOQ) – Its Relevance For SME Sector

The Economic Order Quantity (EOQ) is the optimum quantity of goods to be purchased at one time in order to minimise the annual total costs of ordering and carrying or holding items in inventory. EOQ is also referred to as the optimum lot size. In other words, it represents the optimal quantity of inventory a company should order each time, in order to minimise the costs associated with ordering and holding inventory.

The benefit for an organisation to spend time calculating EOQ is to minimise its inventory costs and, in turn, make strides toward being as efficient as possible. A business can use this calculation to determine exactly when an order needs to be placed and exactly how much should be ordered so that the company can continue normal production and minimise inventory costs.

EOQ is an extremely effective tool for managers because they can use it to figure out what is the optimal amount of inventory to hold on hand as well as to calculate when to order more merchandise because new sales should be generated.

EOQ is based on the following set of assumptions:

  • Reorder point:The reorder point is the time when the next order should be placed. EOQ assumes that you order the same quantity at each reorder point.
  • Demand, relevant ordering cost, and relevant carrying cost:Customer demand for the product is known. Also, the ordering and carrying costs are certain. A relevant cost refers to a cost you need to consider when you make a decision. The term is used throughout this book.
  • Purchase order lead time:The lead time is the time period from placing the order to order delivery. EOQ assumes that the lead time is known.
  • Purchasing cost per unit:The cost per unit doesn’t change with the amount ordered. This removes any consideration of quantity discounts. Assume you’ll pay the same amount per unit, regardless of the order size.
  • Stock-outs:No stock-outs occur. You maintain enough inventory to avoid a stock-out cost. This means that you monitor your customer demand and inventory levels carefully.
  • Quality costs:EOQ generally ignores quality costs.

Economic order quantity uses three variables: demand, relevant ordering cost, and relevant carrying cost. Use them to set up an EOQ formula:

  • Demand:The demand, in units, for the product for a specific time period.
  • Relevant ordering cost:Ordering cost per purchase order.
  • Relevant carrying cost:Carrying costs for one unit. Assume the unit is in stock for the time period used for demand.

Note that the ordering cost is calculated per order. The carrying costs are calculated per unit. Here’s the formula for economic order quantity:

Economic order quantity = square root of [(2 x demand x ordering costs) ÷ carrying costs]

That’s easier to visualise as a regular formula:

 image

Q is the economic order quantity (units). D is demand (units, often annual), S is ordering cost (per purchase order), and H is carrying cost per unit.

Let us consider an example, as under:

Ranjan runs a clothing shop which also sells men’s shoes. The shoes are priced at Rs.2,500/- per pair. He sells 100 pairs of shoes a month, or 1,200 per year.

Your ordering cost is Rs.3,500/- per order. You add up the total time spent by everyone who’s involved in the ordering process, and you figure that the combined time to process each order is one hour. Based on average salary and benefit costs, you assign a Rs.3,500/- cost per order.

The carrying cost per unit is Rs.180/-. That rate covers the occupancy costs and insurance where the inventory is stored. The amount also accounts for the opportunity cost of carrying the inventory.

Based on the data for the hiking boots, here’s your economic order quantity:

Economic order quantity = square root of [(2 x demand x ordering costs) ÷ carrying costs]

Economic order quantity = square root of [(2 x 1,200 x 3500) ÷ 180]

Economic order quantity = square root of [84,00,000 ÷ 180]

Economic order quantity = square root of 46,667(approx.)

Economic order quantity = 216 (approx.)

You just determined that the ideal order level is 216 units. At that level, you minimise ordering and carrying costs.

 


Pulak Kumar Sinha is a retd. General Manager at State Bank of India. He is a Certified Associate of Indian Institute of Bankers and has a P.G. Diploma in Management from All India Management Association (AIMA). His specialised areas are Credit and General Banking. He was also a Chairperson of Reserve Bank of India Working Group on Evaluation of Feasibility of Aadhaar based Biometric Authentication as Additional factor of Authentication for card related transactions and other issues.


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