Economic Order Quantity: Explanation & EOQ Formula
Originally Published: 12 June 2024
Last Updated: 26 July 2024
An important part of running a business effectively is ensuring that you are getting the most value out of your storage and logistics costs. With so many micro-costs and variables involved in the supply chain, it can be difficult to know where to begin optimizing the efficiency of your processes.
Thankfully, the Economic Order Quantity (EOQ) formula can help you find the ideal amount of inventory to send to and store inside a warehouse at any given time. It’s a pivotal technique that can assist you to make efficient inventory management choices.
Today, we’re taking a look at why eCommerce businesses should use this formula, how to calculate it and how to optimize inventory levels in general.
In this article
Economic Order Quantity model explained
Using the EOQ model can help you make data-lead decisions on how much inventory you have in the warehouse at any given time. The calculation is designed to help you reduce storage, buying, and shipping costs by only storing the ideal amount of stock over a specific period.
EOQ helps ensure you keep up with demand without paying for storage costs you don’t need.
Data you’ll require for calculating Economic Order Quantity
To calculate your EOQ, there’s a few bits of data you’ll need. Much of it is historical data, so the formula works best if you’ve been trading for at least a year. The longer you’ve been trading, the more accurate your calculations will be. Here’s the three bits of data you’ll need:
- Holding costs – your holding cost, or carrying cost, are made up of each cost associated with storing inventory. This includes storage costs, labor costs, fulfillment costs, total cost of inventory, insurances, and depreciation costs.
- Demand – the annual demand of your goods. To find this, look at your sales over the past year.
- Ordering costs or setup cost – The typical fixed cost associated with making an order. This will usually include any shipping, handling, and administration costs you incur when ordering goods.
- Variable cost – This includes figures, such as purchase cost and production cost.
With accurate data in your arsenal, you’ll be ready to calculate the formula.
The Economic Order Quantity formula
To calculate your EOQ, take your:
ordering cost (O)
demand (D),
holdings costs (H)
and place them into the following formula:
EOQ = square root of [2O*D] / H
EOQ in practice
Let’s have a look at the EOQ formula using real numbers. Imagine that you’ve got an order cost of £300, a demand of 6,000 products per yet and an annual holding cost of £0.45 per product. The formula would look like this:
EOQ = square root of (2 x 300 x 6000) / 0.45
Therefore, EOQ = 2828 units.
4 Benefits of Economic Order Quantity
There are numerous ways the EOQ calculation can benefit your business. It helps you to find the ideal balance between having enough stock in place while helping minimize costs as low as possible.
It’s particularly useful for businesses that shift large amounts of products, or those businesses that sell products with a fluctuating customer demand, such as an online retail clothing shop. Here are some of the benefits of the EOQ formula in more detail:
1. Reduce average cost of inventory
The more inventory you have inside a warehouse, the higher your costs will be. It’s far more than just the cost of storage though; with bigger inventory comes more variables, and a higher risk that stock gets damaged during transit, or sits on the shelf for too long.
An EOQ calculation can help minimize inventory costs by aiding you in preventing overstocking situations, while helping you to eliminate unnecessary risks.
2. Prevents items from going out of stock
Every time a product goes out of stock, your business loses money. It can be devastating if this happens to a popular product.
By using the EOQ formula, you’re able to have a better grasp of how much inventory you need at all times to prevent stockouts, while not paying for unnecessary storage costs.
3. Helps you make better decisions
Running an eCommerce business is all about making those tough decisions. Using the EOQ can help you make better decisions based on a tried-and-tested method, rather than guesswork.
The EOQ calculation makes good use of existing data to help you improve your operational efficiency and make better use of your resources.
4. Frees up cash
As an eCommerce business, much of your assets are held within your products. If you overorder products, you’ve spent cash unnecessarily and are missing out on the advantages of using it elsewhere.
By only ordering and storing the optimal amount of goods, you can free up cash to spend on other areas of your business, such as marketing or customer service.
4 Factors that affect EOQ
It’s important to remember that the EOQ formula isn’t perfect, and results will vary depending on a number of factors. The EOQ formula has several assumptions, and its accuracy will diminish if these assumptions aren’t met.
Here are some factors that affect the EOQ formula:
1. Demand
The EOQ formula assumes that demand stays constant. If you have various peaks and troughs of demand throughout the year, you may find the calculation to be unreliable.
Therefore, EOQ is more suitable for product lines that have steady, predictable demand throughout the course of the year. It isn’t particularly useful for seasonal products.
2. Bulk discounts
Some suppliers may offer discounts if you purchase in bulk quantities. The EOQ formula won’t account for this, so it may end up to be more cost-effective if you order more products than the EOQ recommends.
3. Fixed costs
Continuing from the point above, one disadvantage of the EOQ formula is that it assumes that all costs are steady. Once again, it won’t take into account seasonal variations on inventory costs, shipping costs, geopolitical situations, inventory shortages, and other events outside of your control.
4. Math skills
While the formula itself isn’t particularly difficult, you will need to have a good understanding of data to use the EOQ formula effectively. Data calculations can be complex, and without a good competency in math it may be difficult to work out sums accurately. There is, however, software to assist with these kinds of calculations.
Make EOQ a breeze with J&J Global Fulfillment
J&J is a 3PL provider specializing in eCommerce fulfillment. We store, pick, pack, and ship orders on your behalf, using state-of-the-art fulfillment technology to achieve industry-leading accuracy and speed. With an international network of fulfillment centers, we’re helping hundreds of eCommerce businesses reach new markets in an efficient, cost-effective way.
We also provide you with the tools you need to make accurate EOQ calculations. Our in-house inventory management system, ControlPort™, presents you with all the data you’ll need to make accurate decisions, and all of your product lines can be managed directly through our software.
We make it easy for you to ensure you have the right amount of stock in storage at the right time, and give you the power to make smarter decisions every day.
Partner with James and James to save time, grow your business, and massively improve the efficiency of your operations. Feel free to get in touch with our fulfillment experts to learn more.
EOQ FAQs
What is the difference between EOQ and EPQ?
Economic Production Quantity (EPQ) takes a similar concept to EOQ, however the calculation is made at the production stage, rather than the ordering stage. It is applied earlier in the supply chain to determine the optimal amount of products to be created on the production line.
What is the difference between EOQ and MOQ?
Minimum order quantity (MOQ) is a calculation that some businesses use to determine the minimum number of orders to be purchased at one time. This is required in order for businesses to remain profitable.
It’s often used when businesses operate on small margins and require large order volumes to generate enough revenue to maintain their business.
What is the reorder point in relation to EOQ?
The reorder point is the time at which a new order is placed with the supplier. It’s often made automatically when the stock level of a particular product drops to a specified amount.
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