Show DefinitionEconomic order quantity or EOQ model is the equation that helps compute order quantity of inventory accompanied by the minimum total holding and ordering costs. FormulaThe economic order quantity is derived from the total cost equation,
where p is a unit price, D is annual demand quantity, K is ordering cost, H is holding cost per unit, and Q is order quantity. To find order quantity with the minimum total cost, we should calculate the derivative of the total cost function with respect to variable “Q” and set it equal to zero assuming that other variables are constant. Solving the equation with respect to variable “Q” will give the economic order quantity. Assumptions of EOQ modelIf the economic order quantity model is applied, the following assumptions should be met:
Holding cost vs. ordering costThe holding or carrying cost is the total cost for keeping and maintaining inventories in storage. Common examples are a rent fee for the storage space, depreciation, labor cost to operate storage, materials, equipment and its maintenance cost, shrinkage of stock, security expense, insurance, cost of capital, and other direct costs. Ordering cost refers to the cost related to shipping and handling a new order, e.g., communication and transportation cost, and insurance. Please note that ordering cost doesn’t include cost of goods! Holding cost and ordering cost move in opposite directions. To reduce ordering cost per unit, we should increase order quantity, but such a scenario leads to an increase in holding cost; in turn, reducing holding costs requires a smaller order quantity, which leads to an increase in ordering cost. This relationship is shown in the graph below. Economic order quantity calculation exampleA company manufacturing building materials has an annual demand in concrete of 150,000 tons. The price is $425 per ton, the ordering cost is $3,750, and the annual holding cost per ton is $48.25. Let’s put all the data available in the formula above. Thus, the economic order quantity of 4,829 tons provides the minimum total holding and ordering cost. To prove this, we calculate the total cost for EOQ and order quantity of 4,500 tons and 5,500 tons using the total cost equation above.
As we can see, the EOQ model is always the best solution. GraphIf basic assumptions of the model are met, the graph of inventory consumption and restocking looks as follows: The maximum stock balance equals the economic order quantity, and it is consuming at a constant rate until reaching zero. At this time, restocking is made by the whole batch. If this article was helpful for you please thank our authors! $ DONATE
Home » Economics » Economic Order Quantity: Meaning, Formula, Assumptions, & Advantages Economic order quantity is also popularly known as EOQ. It is defined as a production scheduling concept as it is used to determine the frequency and volume of orders that are needed to satisfy a specific demand while reducing the cost per order to minimum levels. Economic order quantity is necessary to minimize the order-related and holding costs of merchandise and raw materials inventory. It is the perfect order quantity that should be bought by an organization for its inventory. The economic order quantity is also known as the optimal order quantity and optimal order size. This measurement tool is applicable in the fields of supply management, logistics, and operations and is computed by merchandising as well as manufacturing companies. The merchandising organizations use it for computing the optimal order size of inventory related to ready-to-use merchandise, whereas the manufacturing companies for an optimal order size of inventory related to raw materials. Understanding ordering cost and holding costs in an economic order quantityThe EOQ is the level at which the combined holding and ordering cost is at its minimum level. It is important to gather information about the two most important factors of EOQ as there is an inverse relationship between both the ordering cost and holding cost. Ordering costs – Whenever a company places an inventory order with the supplier the cost which incurs is known as ordering costs. The total will vary as it is dependent upon the frequency of placing orders. If the number of orders that have been placed increases in a given year then the annual ordering cost will also increase, and the same applies if the company places small number o orders because then the ordering cost will be lower. Some ordering costs are delivery charges, telephone expenses, payment processing charges, and invoice verification charges. Holding costs – Holding costs are also known as carrying costs as it is incurred while holding the inventory in a warehouse or a store. The total cost is dependent upon the size of the order, and larger the order the higher is the annual holding cost and vice versa. It includes storage space rent, property tax, and insurance. The formula of economic order quantityThe economic order quantity equation takes into account inventory holding costs like shortage costs, ordering costs, and storage. It is based on the assumption that it is holding costs, order, and demand remain constant over time. The formula of economic order quantity is Q = Q = Economic order quantity D = Demand in units S = Order cost H = Holding costs The goal of this formula is to identify the maximum number of units so that an organization can minimize its costs in terms of storing, taking delivery, and buying the units. The formula is easily modified to gather information about varying production levels. It has become a cash flow tool that can minimize the amount of cash and the cost of inventory that is integrated into the inventory balance. The formula also calculates inventory reorder point of an organization. This helps the company as it avoids running out of inventory so that it can fulfill all the orders promptly. Assumptions of economic order quantityThe computation of economic order quantity is possible because of certain assumptions for instance
Advantages of economic order quantityThe advantages of economic order quantity are as follows
DisadvantagesThe disadvantages of economic order quantity are as follows
|