Economic Order Quantity (EOQ)

Economic Order Quantity (EOQ) Explained

By Team TranZact | Published on May 28, 2023

What is EOQ, and in what aspects does it help your business? The EOQ full form is Economic Order Quantity. EOQ is also referred to as optimum lot size and inventory management economic order quantity.

Economic order quantity (EOQ) refers to a formula used to determine the optimal quantity of goods to order, minimizing the total cost of storing and maintaining inventory. Every manufacturer and trader wants to buy the optimum quantity of items to keep their inventory costs under control. And this is where EOQ plays a key role. Let's understand the Economic Order Quantity Formula, the importance of economic order quantity, the relevance of inventory management and economic order quantity, and find out how manufacturers can leverage EOQ for their benefit.

Every small manufacturer wants to buy the optimum quantity of items to keep their inventory costs under control. Let's find out how manufacturers can leverage EOQ for their benefit.

TranZact - Best Inventory Management Software

What Is Economic Order Quantity (EOQ) and Its Formula?

Economic Order Quantity refers to the optimum quantity of inventory items companies must purchase at any time. EOQ is the ideal quantity of inventory that can minimize inventory costs, including shipping and storage costs.

Using the EOQ formula, inventory managers can meet their production demand without exceeding their inventory spending. Here is the Economic Order Quantity formula:

EOQ=2DSH

Where: D is the annual demand for an inventory item (or unit) S is the ordering cost for each purchase order H is the annual holding cost for each unit

In short, the EOQ formula is the square root of twice the annual demand for any inventory item, multiplied by the incremental cost to process each purchase order, and divided by the incremental cost to hold an inventory item in the company's inventory.

Here is the use of the EOQ formula with an example: A small apparel company sells around 10,000 T-shirts every year. The company incurs an annual cost of Rs. 500 to place an order for these t-shirts. The cost of storing the received t-shirts in the inventory lot is Rs. 200. Here is the EOQ calculation:

EOQ=2x10,000x500200=223.60

This means the company must order 223.60 or 224 units per purchase order to maintain an optimum cost. If the company orders more than 224 units, it will increase its carrying or holding costs. If the company orders less than 224 units, the ordering costs will increase.

Next, let's discuss the importance of EOQ.

Why Is EOQ Important?

With the EOQ model, small manufacturers can reduce the cost of ordering and holding their inventory items. Whenever there is an increase in inventory volume:

  • There is a corresponding drop in the cost of ordering inventory.
  • There is a corresponding increase in the cost of holding inventory.

EOQ is also known as reorder quantity and it works as the exact measure that can minimize both of the above costs. The EOQ formula is calculated to reduce the total cost of each purchase order for inventory. Having seen the importance of economic order quantity, next, let's discuss the role of EOQ in inventory control.

What Is EOQ in Inventory Control?

EOQ in inventory control determines the ideal order size to maximize the company's profits and minimize its inventory costs. Be it for finished products or raw materials; proper inventory management is a major cost factor for any small business.

Economic Order Quantity is also known as ideal order quantity. It provides the optimum order size that can prevent situations like over-ordering inventory items or running out of stock. EOQ in inventory control can improve operational efficiency and increase profits and cash flow in the organization.

Here is how inventory management economic order quantity is beneficial for any organization:

  • To identify the right number of inventory units to purchase.
  • To minimize the costs of purchasing, shipping, and storing inventory units.
  • To improve the cash flow or cash tied in the inventory balance.
  • To determine the exact reordering point for every inventory item.
  • To prevent loss of revenue due to insufficient inventory levels.

Next, let's discuss the importance of Economic Order Quantity in cost accounting.

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What Is EOQ in Cost Accounting?

EOQ in cost accounting is the optimum level of inventory levels that can prevent both overstocking and understocking. Why is EOQ important in cost accounting? This is because understocking can lead to lost sales opportunities, while overstocking can add to the overall costs and wastage, and reduce the cash flow.

EOQ meaning the order quantity that is ‘just right' not less nor more, is an important accounting metric.

EOQ in cost accounting comprises multiple components used to calculate the cost of ordering and holding inventory items. Here is a detailed look at the components of the EOQ formula including the ordering cost formula:

Ordering cost

In any cost accounting system, the total number of annual orders is calculated by dividing the yearly demand (D) by the quantity per order (Q). Each purchase order has a fixed cost (S) that is independent of the number of ordered units. Based on this, the annual ordering cost is then calculated in the following manner:

Ordering cost= DQ x S

Holding cost

The holding cost is the direct cost incurred by the inventory financing or the opportunity cost of holding the inventory stocks. Hence, the holding cost per unit (H) is calculated as the cost per unit (C) multiplied by the interest rate (i). Here is the formula:

Holding cost=i x C

The annual holding cost is calculated as the product of the available inventory (at any time) with the holding cost per unit. Here is the formula:

Annual holding cost= Q2 x H

The annual total cost of orders (TC) is calculated by adding these two costs (as shown in the following formula):

TC= DQ x S+ Q2 x H

To calculate the EOQ, the annual total cost of the order (TC) is differentiated from Q, as shown in the following formula:

EOQ= dTCdQ

In the next section, let's look at some of the challenges of EOQ in inventory management.

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Challenges of Economic Order Quantity (EOQ)

Among its major limitations, EOQ analysis assumes constant consumer demand throughout the year. Hence, it is calculated based on the assumption that inventory ordering and holding costs will remain the same. Here are some of the challenges for small businesses to calculate the exact EOQ and order size:

Manual data systems

Manual data systems like Excel spreadsheets often provide inaccurate or outdated numbers, leading to errors in calculating EOQ.

Outdated systems

Similarly, an outdated inventory or legacy system can provide incomplete numbers, which can also impact the accuracy of EOQ.

Changing seasonal demands

Economic order quantity in cost accounting is challenging in industries where there is a change in customer demand across the year. For example, in fashion retail. Additionally, there can be seasonal changes in inventory costs based on demand.

Inventory shortage

To save costs, small businesses often end up placing smaller orders. This can result in understocking, which can impact your sales revenue.

Assumes consistency

Organizations can increase or decrease their inventory levels depending on the markets. However, an economic order quantity model assumes that the business will have consistent or the same inventory levels.

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Simplify Calculation of EOQ With TranZact

EOQ meaning Economic Order Quantity can benefit small businesses in optimizing their inventory costs. Accurate EOQ analysis in small companies can improve profitability, reduce wastage, and improve order fulfillment.

With its advanced and automated inventory management system, TranZact can help organizations calculate accurate EOQ by providing them with correct inventory-related numbers. It enables businesses to save time and streamline recording processes for higher business growth!

FAQs on EOQ

1. What is economic order quantity?

Economic Order Quantity (EOQ) is an inventory analysis calculation used to determine the ideal order quantity that helps to reduce overall inventory costs. It takes into account factors such as demand rate, ordering costs, and holding (carrying) costs and finds the optimal balance between these costs.

2. What is the importance of EOQ in inventory management?

The importance of Economic Order Quantity (EOQ) in inventory management comes forth in its ability to optimize inventory levels, minimize maintenance and ordering costs, and ensure efficient inventory replenishment. By finding the optimal order quantity, EOQ helps businesses strike a balance between inventory carrying costs and ordering costs, leading to improved cash flow.

3. How do you calculate holding cost in EOQ

The process of calculating holding cost in EOQ is fairly simple. The formula for holding cost in Economic Order Quantity (EOQ) is derived by multiplying the holding cost per unit by the EOQ quantity, divided by 2. This formula represents the cost incurred for storing and holding inventory, taking into account the quantity ordered and the concerned holding cost per unit.

4. What is the EOQ model?

The EOQ model in inventory management is the mathematical model used to know the optimum quantity of items companies must purchase at any time. An economic order quantity model is necessary to help business owners control inventory costs without overstocking or understocking.

5. What is the formula for EBQ?

The formula for Economic Batch Quantity (EBQ), also known as production batch quantity or economic lot size, is calculated by dividing the total production or setup cost by the cost per unit of production, multiplied by the demand rate per unit of time. The EBQ formula helps determine the optimal batch size for production that minimizes total production and inventory costs while meeting demand efficiently.

6. What are the 3 components of Economic Order Quantity?

The three components of Economic Order Quantity (EOQ) are the demand rate or usage rate of the inventory item, the ordering cost per order, and the holding cost per unit per year. These components are used in the EOQ formula to calculate the optimal order quantity, in order to improve inventory control and reduce inventory costs.

7. How does Economic Order Quantity work?

Economic Order Quantity or EOQ is based on the annual demand of any inventory item and its ordering and holding cost per year. EOQ calculation and analysis can be automated using an efficient inventory management system.

8. How is EOQ calculated?

EOQ is the square root of twice the product of the annual demand rate and ordering costs – divided by the annual holding costs. This formula helps determine the optimal order quantity that ensures low inventory costs based on the trade-off between holding and ordering costs.

9. What is the main objective of EOQ?

The main objective of the Economic Order Quantity (EOQ) model is to determine the optimal order quantity that minimizes the total costs associated with inventory management. By balancing the costs of holding inventory and the costs of ordering, EOQ aims to find the ideal quantity that maximizes efficiency and minimizes expenses in inventory control.


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TranZact

TranZact is a team of IIT & IIM graduates who have developed a GST compliant, cloud-based, inventory management software for SME manufacturers. It digitizes your entire business operations, right from customer inquiry to dispatch. This also streamlines your Inventory, Purchase, Sales & Quotation management processes in a hassle-free user-friendly manner. The software is free to signup and gets implemented within a week.