What is Economic Order Quantity (EOQ) and How Does It Reduce Inventory Costs?

What is Economic Order Quantity?

Economic Order Quantity (EOQ) is an inventory management method used to calculate the most economical quantity of material to order at one time.

It balances two important costs:

• Ordering Cost – Cost incurred every time a purchase order is placed.
• Holding Cost – Cost of storing and maintaining inventory.

In simple terms

Ordering materials in very small quantities means placing purchase orders frequently.

Ordering in very large quantities means keeping more inventory in storage.

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EOQ helps identify an order quantity that minimizes the combined annual ordering and holding costs.

Simple Manufacturing Example

An electronics factory uses 10,000 terminal connectors annually.

Assume:

• Annual demand (D) = 10,000 units
• Ordering cost (S) = ₹500 per order
• Annual holding cost (H) = ₹4 per unit

EOQ Formula:

[EOQ=\sqrt{\frac{2DS}{H}}]

Substituting the values:
EOQ=\sqrt{\frac{2\times10,000\times500}{4}}
[EOQ=\sqrt{2,500,000}]

EOQ = 1,581 units approximately

The factory should order approximately 1,581 connectors per order under these assumptions.

What Does This Mean?

Annual orders:

10,000 ÷ 1,581 ≈ 6.3 orders

So the factory would place approximately 6–7 orders per year.

Important Insight

EOQ does not automatically determine when to place an order.

• EOQ: How much should we order?
• Reorder Point: When should we order?

Both are important for effective inventory management.

Factors to Consider

1️⃣ Annual material demand

2️⃣ Purchase order processing cost

3️⃣ Storage and inventory holding cost

4️⃣ Supplier minimum order quantity (MOQ)

5️⃣ Available warehouse space

6️⃣ Supplier lead time

Benefits

• Reduced inventory-related costs
• Better purchasing decisions
• Improved inventory planning
• Less unnecessary stock accumulation
• Better balance between ordering and storage

Practical Insight

A supplier may offer a discount for purchasing 5,000 units at once.

But is that really economical?

Consider the purchase price, storage cost, cash tied up in inventory, and actual consumption before deciding.

The cheapest purchase quantity is not always the quantity that gives the lowest total inventory cost.