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EOQ is a method for setting a consistent order quantities that both minimize ordering and inventory carrying costs. EOQ can be used hand in hand with reorder point systems as they function under similar assumptions:
- That demand is relatively constant and known.
- The order quantity is usually the same. (The EOQ will remain constant until the review period or if changes in the supply chain warrant a reformulation of the EOQ.)
EOQ has some additional requirements and assumptions:
- The product is purchased or produced in batches or lots.
- Order preparation costs are known.
- Inventory carrying costs are known.
- Annual usage is known.
- Replenishment occurs all at once.
Let’s look at EOQ’s requirements and assumptions one at a time:
- The assumption that the product is purchased or produced in batches or lots is due to the consistent nature of the EOQ and the demand that determines it. In other words, you won’t be ordering 7 now, 3 tomorrow and 12 next week. The EOQ is formulated and is set until the next review period. However, if the EOQ calculates to a number not divisible ty the batch or lot size you will need to round the EOQ up to a quantity divisible by the batch or lot quantity.
- You will need to know your order preparation costs. This holds true for both purchased and manufactured items. You’ll need to know:
– The number of orders placed annually. This is determined by the annual demand / the standard order
quantity. If there is no standard order quantity use the average order quantity understanding you will need
to review the EOQ sooner than anticipated.
– How long it takes to process an order and the overhead costs associated with that process such as employee
salaries and the costs of purchase orders. - The inventory carrying costs in the EOQ are expressed as a percentage of the average annual inventory. The inventory carrying costs fall into 3 main categories with the following sub-categories:
– Capital
– Inventory capital
– Insurance
– Taxes
– Storage
– Handling
– Security
– Storage
– Record keeping
– Space
– Risk
– Deterioration
– Theft
– Obsolescence - You will need to know your annual usage. If that isn’t known you can extrapolate the data but you will need to review the EOQ sooner than anticipated.
- Replenishment arrives and is ready for use all at once. No partial shipments or a portion of the order quantity held in a QC queue for example.
The calculation for the EOQ is: the square root of 2 x the annual demand x ordering costs / annual carrying costs x the unit costs. As an example:
Annual usage = 1,000,000
Ordering costs = $5
Inventory carrying costs (as a percentage) = 0.20 (20%)
Unit costs = $2
Square root of:
2 x 1,000,000 x 5 / 0.20 x 2 or…
Square root of:
10,000,000 / 0.40 or…
Square root of:
25,000,000
EOQ = 5,000
If you wish to lower your EOQ you must take into account the following:
- As your annual demand increases so does your EOQ to satisfy the increased need.
- If your inventory carrying costs decrease your EOQ will increase as it is now more cost efficient to carry more inventory compared to unchanging unit costs and ordering costs.
- If the unit costs decrease your EOQ will increase as it is now more cost efficient to purchase more inventory compared to unchanging carrying costs and ordering costs.
- If you decrease your ordering costs your EOQ will decrease as it is more cost efficient to place more frequent orders compared to unchanging carrying and unit costs.
So, to lower your EOQ batch size you must lower your ordering costs. This can be achieved through applying lean principles or mapping the process, identifying the waste and then removing the waste from the process.
If the EOQ assumptions and requirements are not valid for your company there are many other methods for ordering replenishment but you should always use a method that will keep your carrying costs and ordering cost to a minimum.