Economic Order Quantity (EOQ): order the right amount

What is Economic Order Quantity?

Economic Order Quantity, or EOQ, is the order quantity that minimises the combined cost of ordering and carrying inventory.

Small, frequent orders keep average inventory low but create more administrative and receiving costs. Larger, less frequent orders reduce the number of orders but tie up more capital and require more storage. EOQ identifies the balance between these two costs.

The EOQ formula

Where:

• D = annual demand in units
• S = cost of placing and receiving one order
• H = annual inventory holding cost per unit

Holding cost can include the cost of capital, warehouse space, insurance, handling, shrinkage and obsolescence. If you use a holding-rate percentage, multiply it by the item value to obtain the annual cost per unit.

EOQ calculation example

Based on these assumptions, the company should order approximately 707 units at a time, or about 14 orders per year. The result is a decision aid and may need to be rounded to match pack sizes, pallet quantities or a supplier's minimum order quantity.

When is EOQ useful?

The model is most useful for items with relatively stable demand and known costs. It can help you:

• reduce working capital without creating unnecessary orders,
• compare current order quantities with a cost-based target,
• create consistent replenishment rules for recurring items,
• find products with disproportionately high ordering or carrying costs.

Limitations to consider

The basic EOQ model assumes steady demand, constant lead time and stable costs. Real supply chains also involve seasonality, quantity discounts, supplier risk and limited warehouse capacity. EOQ should therefore be used alongside forecasting, safety stock and reorder-point calculations.

A lower EOQ is not automatically better. Consider the supplier's minimum order quantity, transport efficiency and the operational cost of a stockout.

EOQ, safety stock and reorder point

These concepts answer different questions. EOQ determines how much to order. The reorder point determines when to place the order. Safety stock provides protection against variation in demand and lead time. Together they form a more complete inventory policy.