Economic Order Quantity
Written by Andrew Goldman for Gaebler Ventures
The economic order quantity is a tool used in Operations Management to determine the most cost-effective purchase quantity. The variables within the formula are discussed in the article below.
The economic order quantity is used when goods or materials are purchased periodically.
The economic order quantity determines the appropriate number of product to order based on a number of different variables. The economic order quantity is the amount to purchase that will minimize the overall cost to the company. Small businesses do not have to compute this number on a regular basis, but understanding the logic behind the calculation can help your company make better purchasing decisions.
To begin, the different variables in the EOQ formula are; the annual demand of the product, the purchase cost per individual unit, the fixed cost per order, the order quantity and the holding cost of the product. By analyzing each of these variables, we can understand how it affects our purchasing habits and ultimately, our bottom line.
The annual demand for the product is an important piece to the puzzle. If it's a product that you use once or twice a year, you're probably not going to order it frequently or in large numbers. If it is a product that you use often, you may want to purchase in larger amounts to obtain a discount or arrange for frequent small deliveries with your supplier.
The purchase cost for individual unit is pretty straightforward. If an item cost thousands of dollars, we would expect to purchase it less frequently than an item that cost ten dollars. If the purchase price a unit increases, you may want to order it less frequently or wait until you have a customer commitment that requires the part.
The fixed cost per order is another key element, but it is often ignored in the purchasing process. Each time you place an order, it requires a fixed cost. You need to have an employee take the time to place the order. This may result from another employee taking the time to count the inventory and let your personnel know they need to order a product. Once an order is placed, there is the cost of tracking the order and receiving the order.
If these costs are high, you would want to order less frequently and in larger amounts. If your system is smooth, this fixed cost may be low and have a minimal impact on your purchasing habits.
The order quantity can be fixed or determined by your purchasing department. Sometimes lot sizes are fixed due to your supplier, and other times you have multiple pack sizes to choose from. If the order quantity is flexible, this is not too big of an issue. If the order quantity is large, depending upon your usage it can be costly to store. Understanding the order quantity versus your demand can greatly impact your purchasing decisions.
Finally, you need to consider the holding cost of the product. This can be difficult to calculate, especially for small businesses. The holding costs include the space the material is occupying as well as the labor to move it and count it in inventory. If your space is limited, your holding cost is high. As a result, you wouldn't want to have excess of a product that only gets used once or twice a year.
The EOQ formula can be easily found on the web. While it is not necessary for the small business to try and crunch these numbers, it is important that the small business understand the different variables and how they affect your company. If you understand the implications of the variables, you can find a nice balance that works best for your business.
Andrew Goldman is an Isenberg School of Management MBA student at the University of Massachusetts Amherst. He has extensive experience working with small businesses on a consulting basis.
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