What is Economic order quantity

Economic Order Quantity
What is Economic Order Quantity?
Economic order quantity (EOQ) refers to an order quantity that is considered ideal for an organisation. This is a good economic order quantity definition. When an organisation purchases it, it results in the minimisation of inventory costs. The inventory costs can be like order costs, shortage costs, and holding costs. Ford W. Harris is credited with developing the EOQ model in 1913. As time has passed, the experts have refined this model.

Assumptions of Economic Order Quantity
EOQ is dependent on certain assumptions, without which its computation would not be possible.
These assumptions are as follows:

• The inventory costs are assumed in EOQ to be constant.
• The delivery of the ordered inventory takes place in one go.
• The total ordering cost shall remain constant.
• The total units, whose consumption is to take place, are certain.
• Any type of discount is not available in EOQ, whether it is on cash or on quantity.
• The computation of every stock item’s maximum quantity takes place on a separate basis.
• Lead time does not fluctuate in EOQ.

Economic Order Quantity Formula
The calculation of the Economic Order Quantity formula takes place by reducing the total cost per order. This is done by adjusting the first-order derivative to 0.
The key aspects in the EOQ formula are as follows:

• Holding Cost
• Annual Quantity Demanded
• Ordering Cost
• Volume per Order
• Unit Cost
• Carrying Cost

Aspects in Economic Order Quantity
Now let us discuss the various aspects in Economic Order Quantity one by one briefly.
Annual demand (D):
It refers to the amount of demand an organization gets for its product each year. This can be determined by looking into the historical order data.

Volume Per Order:
It refers to the amount of volume an organization goes for per order. This can be determined by analyzing historical inventory or sales data.

Ordering cost (S):
Ordering cost means the cost of an order per purchase. Experts also refer to it as the ‘setup cost’. This particular cost is inclusive of both the shipping and handling costs.

Unit Cost (Variable Cost):
Unit or Variable costs are those that are subject to change in accordance with the volume change. It includes

• Credit card fees
• Packaging supplies
• Delivery costs
• Production supplies
• Piece-rate labour
• Raw materials
• Commissions

Holding costs (H):
Holding cost refers to the totality of the cost of holding inventory. Reducing these costs is a key supply chain management strategy.

Carrying Cost (Interest Rate):
This refers to the costs a business pays for holding inventory in stock in the form of interest rate.

Significance of Economic Order Quantity
The significance of Economic Order Quantity can be understood with the following points:

• It helps in the identification of the optimal number of product units to order. With the help of EOQ, an organization can significantly reduce storing unit costs, delivering costs, and purchase costs.
• One can determine various levels of production by modifying the EOQ formula.
• EOQ can help an organization manage its cash flow efficiently. It can efficiently maintain an appropriate inventory balance.
• The inventory reorder point of an organisation can be determined by EOQ. This way an organisation prevents a situation where it runs out of inventory. Hence, EOQ prevents loss of sales and customer satisfaction.

What is the limitation of Economic Order Quantity?
The limitations of EOQ are as follows:

• Economic order quantity operates on the basis of the assumption of constant values. So the concept assumes that demand will remain constant throughout the year. Real world is not like this as some of the associated costs are uncontrollable and can vary.
• Another problem with EOQ is that it assumes that every time restocking of the inventory will take place in one go. Once again, this is not the case in the real world as the delivery period can vary.

Why EOQ is important to any business organization?
Economic order quantity allows a business organisation to conduct efficient management of its inventory. Without EOQ, business organisations would develop a tendency to hold either excessive or deficient amounts of inventory. This would result in missed opportunities and high inventory costs.

How does EOQ improves the profitability of any organisation?

• EOQ improves the profitability of an organisation in the following ways:
• It improves order fulfilment.
• It results in less over-ordering for the organisation.
• It results in lesser wastage due to optimised order schedules.
• Lower storage costs are also possible due to EOQ.
• All of these result in enhancing an organisation’s profitability.

What is meant by maximum inventory level?
Maximum inventory level refers to the maximum possible quantity of materials an organisation holds. Beyond this point, there must not be any exceeding of the organisational stocks. This excessive stock condition is known as overstocking. If overstocking happens, the material costs of the organisation would become high.

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