Economic Order Quantity (eoq)

The economic order quantity (EOQ) method of inventory control is a procedure for balancing ordering costs and carrying costs so as to minimize total inventory costs. Ordering costs are administrative, clerical, and other expenses incurred in initially obtaining inventory items and placing them in storage. There also is the carrying, or holding, cost, the expenses associated with keeping an item on hand (such as storage, insurance, pilferage, breakage). Finally, there are stock out costs. They include the loss of customer goodwill and possibly sales because an item requested by customers is not available.

In order to determine the EOQ, calculus is used in the development of the mathematical model. The method uses an equation that includes annual demand (D), ordering costs (O), and holding costs (H). The basic equation for EOQ is presented below:

EOQ = square_root[(2 * annual_demand * ordering_costs) / holding_costs]

EOQ=square_root[(2*annual_demand*ordering_costs)/holding_costs]

The EOQ equation helps managers decide how much to order. However, managers also need to determine the reorder point (RIP), the inventory level at which a new order should be placed. To determine the reorder point, managers estimate lead time (L), the time between placing an order and receiving it. In the formula for ROP, lead time is multiplied be average daily demand:

Reorder level = Average daily usage rate * lead-time in days

Reorder level=Average daily usage rate *lead-time in days

The model described is one of the simplest to develop. The sophistication level of the model depends on the actual need of the company and demands of the environment.


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