Economic order quantity

What it means

Economic order quantity, or EOQ, is a classic model of inventory management. It looks for the size of a single order at which the sum of two opposing costs is lowest: ordering costs, which fall as orders get larger, and holding costs, which rise with order size.

Ordering costs include the buyer's work, transport, receiving and checking goods, and processing the invoice. Holding costs are tied-up capital, space, insurance, energy, losses and the risk of obsolescence. The basic formula is the square root of twice the annual demand multiplied by the cost per order, divided by the annual cost of holding one unit.

The model assumes steady demand, a constant price and instant replenishment, which holds only roughly in practice. It is still a useful starting point: it shows that ordering very often and very rarely are both expensive, and that the optimum is usually surprisingly flat, so small deviations from it do not raise costs much.

How it works in practice

The model makes most sense for high-volume items with regular consumption, which can be picked out with ABC analysis and XYZ analysis. For items with irregular demand it is better to combine EOQ with safety stock and a reorder point that reflects lead time and fluctuations in usage.

In practice the result must be adjusted for real constraints: minimum pack size, warehouse capacity, volume discounts, shipping in full pallets or truckloads, and shelf life. If a supplier offers a discount for larger orders, the price saving is compared with the extra holding costs.

The effect of the setting shows in inventory turnover and working capital. Orders that are too large tie up cash; orders that are too small raise transport costs and the risk of stock-outs. When moving to just-in-time the logic changes, since the aim is to minimise stock even at the cost of more frequent deliveries.

What to watch out for

The most common mistake is underestimating holding costs. Companies count only warehouse rent and forget tied-up capital, insurance, stocktake differences and goods that become obsolete. With holding costs understated, the model recommends orders that are too large.

Model parameters need regular updating. Changes in transport prices, interest rates or demand shift the optimum. If order quantities set once in the warehouse system go unchanged for years, the company is ordering on conditions that ceased to apply long ago.