Economic Order Quantity (EOQ)
This article covers meaning, importance & example of Economic Order Quantity (EOQ) from operations perspective.
What is Economic Order Quantity (EOQ)?
Economic order quantity (EOQ) is the quantity of a product that should be ordered so as to minimize the total cost that includes ordering costs and inventory holding costs. EOQ the optimum amount of inventory which should be orders by a production company so that the cost of ordering as well as holding the inventory is reduced, and making it an efficient process.
Importance of Economic Order Quantity
For any production company, one of best ways to reduce costs and improve margins is to have an efficient process in terms of ordering raw materials, holding additional inventory and generating output. For maximum efficiency, a company should reduce inventory holding costs, order optimum raw materials and maximize output production. This is where Economic Order Quantity (EOQ) is useful. Using EOQ model, a company can focus on reducing the volume of inventory which is on hold, and thereby avoid blocking capital on the stored inventory.
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Formula for Economic Order Quantity (EOQ)
The basic model of EOQ gives the equation to calculate EOQ as follows,
Economic Order Quantity (EOQ) = √((2* Annual Demand*Co)/Ci)
where, Co = fixed cost per order or the ordering cost & Ci= Inventory holding cost per unit
This is deduced by differentiating and finding the minima for the equation for the total annual cost, which comprises of the variable purchase cost, the ordering cost and the inventory holding cost. But the EOQ does not depend on the purchase cost as it remains constant for the same annual demand whatever be the order quantity. With increasing order quantity, the number of orders to be placed in the year decreases and thus the ordering cost decreases but at the same time the inventory holding cost goes on increasing. At the EOQ value, the total cost comprising of both these costs is at its minimum value.
Example of Economic Order Quantity
An example of EOQ can be understood from the following scenario. Consider a company manufacturing mobile phones. It sells 10,000 phones a year. It costs around $50 per phone as holding cost and fixed cost is $20.
Using the formula for EOQ, we see
EOQ = √((2* Annual Demand*Co)/Ci )
= √((2* 10000*20)/50 )
= √(8000) = 89.4
Thus, EOQ = 89.4, which means the ideal size of order should be 89 mobile phones to reduce costs as well as meet customer demand.
Hence, this concludes the definition of Economic Order Quantity (EOQ) along with its overview.
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