What Is The EOQ Formula (Economic Order Quantity)?

| Updated on: September 29, 2021

What is EOQ?

Economic order quantity or EOQ is used in cost accounting to calculate how much optimum inventory levels of a product should be maintained to prevent understocking and overstocking. Understocking leads to losing sales while overstocking increases overall costs, wastage, and limits cash flow. EOQ is also known as optimum lot size and is a tool that calculates the right stock levels. EOQ is particularly beneficial for small businesses that find inventory management challenging. It acts as a starting point to understand how much stock to maintain so that sufficient inventory is available to run the business effectively. 

The EOQ formula is based on certain assumptions. Firstly, it assumes the customer demand, purchase order lead time, carrying cost, and ordering cost for the particular product. Second, EOQ assumes that for every reorder, you are going to place an order of the same quantity. Third, it assumes that there is no stockout cost involved meaning you never suffer from zero stock. Fourth, EOQ assumes that no matter what the order size is, you will pay the same on a per-unit basis. This means the formula assumes that you regularly check the inventory levels and demand. Lastly, it doesn’t take quality costs into account when calculating optimal inventory levels.

Why use EOQ?

The EOQ formula is used because it has numerous benefits such as the following.

Lowers costs

EOQ enables businesses to lower costs such as carrying costs because you are not holding inventory unnecessarily in the warehouse for long periods of time. This cost reduction means capital can be used elsewhere in more productive areas for business growth such as increasing the production of products that are frequently purchased.

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Boosts space optimization

The EOQ aids in your business optimizing space better. If there is overstocking, products that are not yet sold are holding warehouse space for a long time. With the right stock at hand, there is no wastage of space which means the products that are selling are being stocked. The space utilization effectively takes place when you know how much inventory your business should have at a given time.

Improves customer satisfaction

The EOQ formula helps businesses better serve their customers. Nothing puts off customers more than finding out the product they need is out of stock. Businesses can ensure they maintain correct stock levels at all times so they can keep their customers happy. This can lead to an increase in customer loyalty and trust.

Increases employee productivity

The EOQ improves employee productivity because the business works more efficiently. When the business is aware of the actions it needs to take, it can cut on the wastage and improve efficiency. EOQ can be used in addition to inventory management. It can aid in the staff knowing what needs to be done so they are better prepared and work better.

Eases repetitive purchases

EOQ is beneficial for businesses that make repeat purchases. It can uncover products that fit into the JIT model and how much inventory to keep. As repeat purchases are going to be part of the business when using EOQ, it can enhance supplier relationships and ensure a stockout situation never occurs. For example, setting reorder levels ensure you can stock your inventory correctly without delay.

EOQ formula and EOQ factors

The EOQ formula is as follows.

EOQ = Square root of [(2 x demand x ordering cost) / carrying cost]

Demand

The demand remains constant according to the assumptions made by EOQ. The demand is how much inventory is used per year or how many units are sold per year.

Ordering cost

The EOQ formula contains the ordering cost which is a fixed cost. This is how much you spend on placing and then receiving your order. This cost includes all the resources you need to put into receiving the order. For instance, making calls, sending reminder emails, and taking delivery-related costs are used to calculate the ordering cost. It includes the time it takes for the order to reach you as well. Ordering cost can be calculated by dividing the demand per year by volume per order. When you have to pay a fixed amount for the order regardless of order quantity, you can calculate ordering cost per year by dividing demand per year by volume per order multiplied by set cost.

Carrying cost

The carrying cost is also known as the storage cost or holding cost of inventory. It is what you need to spend to store your inventory in a warehouse. The carrying cost includes warehouse fees and opportunity costs. If the inventory is destroyed or stolen from the warehouse then it can be a part of the carrying cost. If you are paying interest to purchase inventory, then the amount you are paying to the bank should be made part of the carrying costs. The insurance costs with regard to the inventory are also taken into account in carrying cost calculation. Carrying costs are variable costs as they will depend on your inventory.

EOQ formula example

EOQ formula is best understood with a simple example. Let us say that you are a dog products retailer. You sell leashes, muzzles, brushes, treats, collars, chews, bowls, dog food, and more. You want to know how much inventory of designer collars you should keep. You sell each designer collar for $7. In a month you sell 30 collars which equate to 360 collars per year. The ordering cost is $10 per order because you are taking into account the processing time and people who work for you. The carrying cost for collars is $2 per unit and this includes the opportunity cost.

Here is how the economic order quantity is calculated for this scenario.

EOQ = Square root of [(2 x demand x ordering cost) / carrying cost]

EOQ = Square root of [(2 x 360 x 10) / 2]

EOQ = Square root of [3600]

EOQ = Square root of [3600]

EOQ = 60

This means you need to have at least 60 collars in the inventory to ensure you are rightly stocked at any given time. You can use the same EOQ formula to calculate how many leashes, muzzles, treats, and chews you should keep so you avoid understocking and overstocking.

EOQ formula calculators

You don’t need to manually calculate using the EOQ formula although it is possible if there are no big calculations involved. Generally, small business owners prefer using online calculators that require the input of carrying costs, demand, and so on. Every calculator isn’t built the same and the EOQ formula can differ depending on the calculator that you choose to use. In some cases, the calculator can require more than one type of input which means you need to have the costs ready with you so that calculation doesn’t take long.

How can software help?

Data is at the root of calculating EOQ with the EOQ formula. Accounting software with inventory management capabilities ensures you have the right data at any time.TallyPrime, complete business management helps you manage optimum inventory level.  The inventory control such as reorder level helps you get rid of risk arising from overstocking as well understocking. 

re-order level in TallyPrime

The re-order status report is quite helpful as it summarizes key information about your stocks, pending purchase orders, and more importantly, you will get to know the shortfall and the quantity of stock that needs to be replenished.

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TallyPrime

Inventory management just became much simpler with TallyPrime.