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If you are a business owner, there are times when you place orders based on current sales. At other times, you forecast demand and place orders. In both cases, your decision to purchase stock impacts inventory, warehousing and logistics costs. Ideally, you should analyse and order optimally as per requirements. The concept of economic order quantity in logistics provides value here.
In this article, we will understand the meaning of economic order quantity (EOQ), how to calculate using EOQ formula, examples of EOQ and more.
What is Economic Order Quantity (EOQ)?
Let us first look at how to define economic order quantity. EOQ refers to the optimal order quantity that businesses should order to save costs and storage space and avoid stockouts. It also enables businesses to have visibility on their inventory and plan raw material procurement and purchase in a systematic manner throughout the year.
With economic order quantity in inventory management businesses can avoid overspending and overstocking, and order quantity that meets customer demands and storage and stocking capacity.
EOQ formula: How to calculate economic order quantity
Let us look at the economic order quantity formula and how businesses can use it to calculate EOQ.
EOQ = √(2DS/H)
D = Annual demand (i.e., the number of units sold in a particular year)
S = Setup cost per order
H = Holding cost per unit per year
Annual demand (D):
This refers to the actual number of units you sell every year. This may include online and offline sales in which case the EOQ should be calculated accordingly.
Setup costs (S):
This refers to the cost your business incurs to sell each unit. This includes shipping and handling costs and any other relevant expenses. For example, if you own a fruits and vegetables grocery and use cold chain logistics, the cost you incur for transportation is included in setup costs.
Holding costs (H):
This refers to the costs incurred to store per unit of inventory every year.
This may include: Product costs, storage costs, cost of risks associated, any services costs and more. For instance, if you are using third-party services for fulfilment centres or warehouses, then the associated costs are included in holding costs.
To get the EOQ for your business, you will have to calculate the independents costs and use the formula to arrive at the optimal order quantity.
Economic order quantity example
Let us understand the concept better with an example of EOQ.
Consider a business scenario with three businesses – ‘Company A’, ‘Company B’ and ‘Company C’ each selling handbags. All three companies sell 5000 handbags every year and spend ₹500 to stock and hold each handbag. The setup cost is ₹100 per handbag.
- Company A: Looks at their sales records and reorders 50 handbags
- Company C: Consults with the sales team, looks at sales figures and reorder 40 handbags
- Company B: Uses the economic order quantity calculator or EOQ formula to find out the optimal order quantity and places the order accordingly:
EOQ = √(2DS/H)
i.e. EOQ = √(2x5000x100/500) = 44.72 (or 45 round off)
By placing a reorder for 45 handbags, Company B is able to match demand/supply and keep costs in check. By reordering 50 handbags, Company A is overstocking, leading to additional inventory and associated costs. Company C on the other hand is understocking, often having to turn customers away.
Why is EOQ important for small businesses?
It is evident that EOQ enables businesses to optimise their inventory. And whether you are a small or large business, this is important. Small businesses often do not own warehousing and storage spaces, nor the optimal storage facilities. Funds are also a recurring challenge and efforts are always towards lowering costs across functions. By following the model of economic order quantity in inventory management, they can optimise storage, manage seasonal demand, and lower costs.
Some of the other benefits of using the economic order quantity model are:
- Lower storage expenses and wastage
Whether you are warehousing through a 3PL service provider or owning your own warehouse, there are expenses you incur. For instance, if you are storing perishable items, you will need to maintain or rent special storage solutions. When you order optimally, there are lesser chances of overstocking and wastage and optimal usage of storage space. Together they add to lowering storage expenses.
- Avoid running out of stock
In our previous example, Company C that reorders 40 handbags every time will often have to turn customers away as it will run out of stocks. True, it can manage during lean seasons, but with economic order quantity it can optimise and prevent situations of stockouts and overstocking.
For a small business, turning a customer away translates to direct revenue loss. It may also lead to losing the customer to a competitor. This is not an ideal situation. Planning purchase using the economic order quantity model can enable MSMEs bring efficiency in inventory management, minimise spends, and have enough stock till the reordered quantity is delivered.
- Maintain funds for other business activities
With the economic order quantity in inventory management, you can determine when to reorder, how much to reorder, and even keep cash handy instead of tying it to inventory. In the case of Company A for instance, it is spending cash to buy additional stock which will not sell. Instead, if it buys just the required stock, the excess cash can be invested in other business activities, such as marketing and sales or purchase of a new machinery or any other.
Economic order quantity in logistics: Role and purpose
The economic order quantity model has a vital role to play in logistics. Rising transportation costs is a pressing concern for all business. Lack of visibility on supply chain operations adds to that. By optimising inventory management, businesses can reduce the number of shipments, transportation expenses, timely orders and delivery.
For businesses to reap returns from EOQ, efficiency in logistics is critical. EQO assumes efficiency in logistics systems, i.e., deliveries will be in time, there will be no shipping damages, there will be no ad hoc costs involved, etc. This, however ideal, is not the real-world case. In reality, there can be shipment delays, road blockages, in transit damages all disturbing the order of things.
Moreover, in cases of bulk orders, delivery does not always take place in one go. There are times when due to logistics challenges, shipments are delivered in parts. In such cases, your logistics processes can impact overall business operations including procurement and purchase based on EOQ.
As a business, though there are no absolute solutions to logistics challenges, there are measures that can be taken. For instance, to ensure deliveries on time and minimise damages caused during loading and unloading, PTL shipping can be opted for. Part truckload is cost-effective, quick and preferred by many small and medium businesses.
Limitations of EOQ and how to solve for it
While the economic order quantity model has several advantages, there are some basic limitations.
For instance, it assumes that all values will be be constant. This is not always the case in the real world. For instance, for seasonal businesses, demand is usually low during lean seasons and high during peak season. This means the basic assumption of economic order quantity will not work in such cases.
Similarly, it does not account for the quality of product. There is also no room for offers and discounts when calculating EOQ.
As a business therefore, it’s a good practice to understand the concept of economic order quantity in logistics and leverage it. However, it’s also important to use relevant data, follow market trends and changes in customer behaviour to strategise what works best for your business.
FAQs on EOQ in logistics
We provide more details on the EOQ model in logistics by answering some of the most commonly asked questions:
What are the components of economic order quantity?
- Annual demand (D)
- Setup costs (S) (or Order cost)
- Holding costs (H)
What is the objective of EOQ?
What are the factors that affect economic order quantity?
- Lead time: This is the time between you placing the order and the actual delivery. The formula takes lead time into account.
- Reorder point: The time when you need to reorder. The reorder quantity is to remain constant.
- Purchasing cost per unit: This remains the same throughout.