Definition: Economic Order Quantity (EOQ) is a production formula used to determines the most efficient amount of goods that should be purchased based on ordering and carrying costs. In other words, it represents the optimal quantity of inventory a company should order each time in order to minimize the costs associated with ordering and holding inventory.
What Does Economic Order Quantity Mean?
What is the definition of economic order quantity? The benefit for an organization to spend time calculating EOQ is to minimize 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 minimize 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.
The EOQ formula is calculated by using the demand rate, setup costs, production costs, and interest rate:
- S represents the cost to place the order
- D represents the demand for the good
- P represents production costs
- I represents the opportunity cost of holding the good, which can be the risk free rate of investing the money in US Treasuries
This equation shows that ordering and carrying costs are interrelated. Personnel and shipping costs are associated with ordering inventory while warehousing and security costs are associated with carrying costs. All of these must be included in any inventory cost allocation because management is trying balance both sets of costs. Less shipments of higher quantity lower the ordering costs, but increases the carrying costs because more inventory will be sitting on shelves longer. The opposite is true with more shipments.
Let’s look at an example.
Example
Jenna is the CEO of the latest fashion company, which designs fashionable jeans at an affordable price of $15 per pair. She wants to minimize inventory costs, so she digs into the company’s financials for a few key figures: the demand per month is 10,000 pairs, the cost to place the order is $2, production costs for the good are $12, and the opportunity cost of holding the good is investing the money, which comes out to 3%.
Next, she uses the EOQ calculation to develop her ordering strategy.
Thus, Jenna should order 334 pairs of jeans in each order. If she ordered any more than that, she would increase carrying costs. If she ordered less, she would increase ordering costs. This is the perfect balance of each.
Here’s another example.
QRS, Inc. is a small manufacturing company in Seattle. It is trying to determine how much it should purchase from its suppliers in order to make sure that they can cover production but also minimize inventory costs. The company has an annual demand of 40,000 units. It’s puchase cost is $1,600 and its carrying cost is $25 per unit annually.
We can calculate economic order quantity formula by plugging the variables into the equation mentioned above:
√( 2 ( 40,000 ) ( 1,600 ) / ( (25) )) = 2,263
Thus by ordering 2,263 units, QRS will improve efficiency by cutting inventory costs without negatively impacting the manufacturing process.
Summary Definition
Define Economic Order Quantity: EOQ means a calculation that helps to determine the amount of material a company should request from suppliers and hold in its inventory given certain factors including demand, production, and inventory cost. In other words, it’s the ideal lot size to purchase for an organization.
