Economic Order Quantity inventory management

Written By

Jigar Dhaneja

Economical Order Qty is a basically concept related to Procurement of goods or Inventory management in warehouse or store, economically. We will discuss what is this, how to calculate EOQ also you will be able to download an Excel template to calculate EOQ easily.

Lets learn about inventory management.

You can download the below excel file for EOQ calculation.

Before we proceeding further to read this article you need to understand that, why it is important concept & purpose to write this article.

Now, as per current market trend & day by day increasing new products introduction to market, its very difficult to manage procurement, ordering & holding inventory economically.

The main purpose to write this article is, I have seen so many of the industries stores, retailers & wholesalers who procure goods on random basis rather than scientifically or mathematically followed EOQ Model, which is driven by Ford W. Harris in 1913.

If you want to optimize cost follow EOQ model & improve revenue generation based on inventory reduction follow Inventory Turnover Ratio model.

Before, we going towards calculation review certain assumption considered by EOQ model.

Assumption of EOQ Model

• Demand is constant during period of EOQ calculation.
• Ordering & Holding (carrying) cost is constant during period of EOQ calculation.

Now, after basic understanding EOQ model its time to go into EOQ formula

Where As,

d = Annual demand ( Consumption )

s = Ordering cost per order

H = Holding cost per unit

Now, we need to understand what is Annual demand, ordering cost & holding cost.

Annual Demand

To calculate annual demand, majority three ways as per listed below.

1. Annually Product Consumption Basis.
2. Forecasting Basis – based on new product introduction & and future capacity expansion.
3. Combined Approach. (Consumption & Forecasting)

In very easiest way to calculating demand is on consumption basis. But sometimes changes in regular practice of manufacturing & possibility to increase in demand, forecasting method can be used.

To calculate demand based on combined approach, take average of Consumption & Forecasting method.

Ordering Cost

Ordering cost is as simple as that the cost associated with procurement of material excluding direct material cost.

Examples – Transportation cost , Documentation cost, Inspection cost ( Its varies based on depend on usage )

Carrying Cost (Holding Cost)

Carrying cost is as simple as that the cost associated with the material in store or hold.

Example – Cost of Storage charges, Insurance on inventory charges, Cost of material defect during storage.

To Understand the concept of Ordering Cost, Carrying Cost & EOQ in detail refer graph attached below..

After review above graph three important parameters on demand qty concluded from this graph as per below listed.

Carrying Cost is directly proportional to Demand Qty.

Ordering Cost is In-directly proportional to Demand Qty.

EOQ is derived based on minimum level of ordering cost as well as carrying cost.

Example EOQ calculations

Example – 1

A Bicycle manufacturing company managing its warehouse. As per its manufacturing requirement & to fulfil its demand, they need to procure a product at a rate of 30000 units per year. Ordering cost per order including transportation & documentation is Rs.2400. Holding cost per unit is Rs.2, Calculate Economical Order Qty of the Product.

Given Data

d = 30000

s = 2400

H = 2

Solution

Put value in EOQ = SQRT (2 * 30000 * 2400 / 2)

                       EOQ = 8485.28 (Approx. 8486)

Conclusion: – Ordering Qty is 8486 at which ordering & carrying cost maintained at lower level. One of the important things is if product buying in full qty at one time & supplier gives a special discount on bulk buying, then you need to compare both the cases & choose lower one.

Example – 2

In a car manufacturing plant demand of tyre is 55000 nos annually, ordering cost per  order is 5% of  annually demand, carrying cost is 0.01% of annual demand per qty, calculate Economical order qty & no of order required per year.

Given Data

d = 55000 Nos.

s = 55000 * 5% = Rs. 2750 per order

H = 55000 * 0.01% = Rs. 5.5 per unit

Solution

Put above value in formula,  EOQ = SQRT (2 * 55000 * 2750 / 5.5) .

                                                      EOQ = 7416.19(Approx. 7417)

Ordering qty per order is 7417.

No. of order required per year = ( Annual Demand / EOQ )

                                                          = ( 55000 / 7417 )

                                                          =7.41 (Approx. 8 order per year )

Conclusion :- Total ordering cost & holding cost is minimum, where 8 order placement per year & ordering qty is 7417 which is economical.

Hope you got an idea to manage the inventory, in such a way to reduce the inventory cost, where demand is constant.

Thank You.

Jigar Dhaneja @jigardhaneja

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