Economic Order Quantity (EOQ)

E.O.Q. Definition: Economic Order Quantity (EOQ) is a production formula used to determines the most efficient
amount of goods that should be purchased based on ordering and carrying costs. In other words, it represents the
optimal quantity of inventory, accompany should order each time in order to minimize the costs associated with
ordering and holding inventory.

EOQ is the order size that minimizes the sum of ordering and holding costs related to raw materials or merchandise
inventories. In other words, it is the optimal inventory size that should be ordered with the supplier to minimize the
total annual inventory cost of the business.

Other names used for economic order quantity are

 optimal order size and

 Optimal order quantity.

The economic order quantity is computed by both manufacturing companies and merchandising companies.

 Manufacturing companies compute it to find the optimal order size of raw materials inventory and
 Merchandising companies compute it to find the optimal order size of ready to use merchandise inventory.

The ordering and holding costs

The two significant factors that are considered while determining the economic order quantity (EOQ) for any
business are

 The ordering costs and

 The holding costs.

Ordering costs The ordering costs are the costs that are incurred every time an order for inventory is placed with
the supplier. Examples of these costs include telephone charges, delivery charges, invoice verification expenses and
payment processing expenses etc. The total ordering cost usually variesaccording to the frequency of placing
orders.

The holding costs (also known as carrying costs) are the costs that are incurred to hold the inventory in a store or
warehouse. Examples of costs associated with holding of inventory include occupancy of storage space, rent,
shrinkage, deterioration, obsolescence, insurance and property tax etc.

The total holding cost usually depends upon the size of the order placed for inventory. Mostly, the larger the order
size, the higher the annual holding cost and vice versa.

The total holding cost is some time expressed as a percentage of total investment in inventory. The economic
order quantity is the level of quantity at which the combined ordering and holding cost is at the minimum level.

Economic order quantity(EOQ) formula

The following formula is used to determine the economic order quantity (EOQ):

Where,

 D = Demand per year

 Co = Cost per order
 Ch = Cost of holding per unit of inventory
Example

The material DX is used uniformly throughout the year. The data about annual requirement, ordering cost and
holding cost of this material is given below:

Annual requirement: 2,400 units

Ordering cost: $10 per order
Holding cost: $0.30 per unit

Required: Determine the economic order quantity (EOQ) of material DX using above data.

Solution

The economic order quantity for material DX is 400 units. Now, we can compute the number of orders to be placed
per year, annual ordering cost, annual holding cost and combined annual ordering and holding cost as follows:

Number of orders per year

= Annual demand/EOQ
= 2,400 units/400 units
= 6 orders per year
Ordering cost
= Number or orders per year × Cost per order
= 6 orders × $10
= $60

Holding cost

= Average units × Holding cost per unit

= (400/2) × 0.3
= $60
Combined ordering and holding cost at economic order quantity (EOQ):
= Ordering cost + Holding cost
= $60 + $60
= $120
Notice that both ordering cost and holding cost are $60 at economic order quantity. The holding cost and ordering
cost at EOQ tend to be the same.

Maximum Level of Stock

The maximum level of stock is the level above which a business does not or cannot hold stock in its premises. The
maximum level of inventory could be described as the maximum capacity of a business to stock goods (inventory or
raw material) in its store, which may be due to reasons like demand limitation of goods (in production or sales), the
storage capacity of business, rationed funds etc.
The ‘maximum level of stock’ is usually achieved when those goods arrive which were ordered at the ‘re-order
level’ of the stock. This stock is then used in the production process (in case of raw materials) or sold (in case of
finished goods) and then re-ordered again at the re-order level which again fills up the stock to the ‘maximum
level’. This is an on-going process.

Formula:

Maximum Level = Re-order level + Re-order quantity – (Minimum usage × Minimum lead time)

Minimum Level of Stock

The minimum level of inventory is a kind of a precautionary level of inventory which indicates that the delivery of
raw materials or merchandise may take more than the normal lead time. Lead time is the expected time taken by
the supplier to deliver goods at the warehouse or at the point of consumption.

If the level of stock strikes the minimum level, the management of the company must make sure that they
corroborate with the supplier and take other necessary measures to make the goods (inventory or raw materials)
available in time so that the business operations are not disturbed or delayed.

Formula:

Minimum Level of Inventory = (Maximum usage × Maximum lead time) – (Average usage × Average lead time)
OR, Minimum Level of inventory = Re-order level – (Average usage × Average lead time)

Both the formulas are equivalent and produce the same result.

Reorder Level of Stock

Reorder level of stock (also known as reorder point or ordering point) in a business is a preset level of stock or
inventory at which the business places a new order with its suppliers to obtain the delivery of raw materials or
finished goods inventory.

Every business has to maintain a certain level of raw materials or finished goods in its store. This is done in order to
sustain the continuity of production in case of raw materials and the continuity of sales in case of finished goods.
For this purpose, the business must set a specific level at which it should place a new order with the suppliers of
inventory.

Illustration 1:Purchase Manager has been given an estimated annual purchase requirement of 2000 units of
material. Unit price of material is Rs20. Annual cost of carrying inventory is 25% of cost of material. Ordering cost
for an order is Rs50. What order size would you recommend to the Purchase Manager

Solution:
Illustration 3: A producer has estimated annual requirements of a material as 7200 units. Cost of placing an order is
estimated as Rs 50/order and annual storage cost/unit of material is Rs. 5. Calculate the optimum order quantity or
EOQ. Also show that at EOQ level, total ordering cost is equal to total storage cost.

Total ordering Cost = No. of orders × ordering cost per order.= Total annual requirements × Ordering cost per order
Order size

=Number of orders × Ordering cost per order

= 72000 × 50
1200
= 6 ×50 = 3000
Total Storage Cost = Average Stock x Annual Storage Cost per unit.
= Ordering Size × S.
2
= 1200 × 5 = 3000
2
Therefore, at EOQ = Total Storage Cost = Total Ordering Cost 3000 = 3000

Illustration 5:A company uses 3000 units of material per month. Cost of placing an order is Rs. 200.The Cost per
unit is Rs. 20. The reorder period is 4-8 weeks. The minimum consumption of raw material is 100 units to 350 units
whereas the average consumption is 275 units. The Carrying cost of inventory is 20% per annum. Calculate:

1. EOQ/ Re-order quantity

2. Re-order level.
Solution:

Or reorder quantity
Where:
A = Annual Usage of Inputs in units
O = Ordering Cost / Order
C = Carry Cost / Unit / annum
EOQ= Economic Order Qty.
Illustration 8:A company manufactures 5000 units of a product per month. The cost of
placing an order is Rs. 100. The purchase price of a raw material is Rs. 10/kg. The re-order
period is 4 to 8 weeks. The consumption of raw material units is 100kg to 450 kg / week. The
average Consumption is 275 kg. The carrying cost inventory is 20% / annum. You are required
to calculate:
1. Re-order quantity
2. Re-order Level
3. Maximum Level
4. Minimum Level
5. Average Stock Level

Solution:
Annual Requirement of Material = 275×52 = 14300

2AO
EOQ =
C
2x 14,300 x 100
= √ 10 x 20%

= 1196 units

Re-order Level= Maximum weekly Consumption × Maximum Delivery Period.

= 450 ×8 =3600 Kg.

Maximum Level= Re-order Level + Re-order quantity- (Minimum weekly Consumption

× Minimum Delivery period)
= 3600+1196 – (100×4)
= 4396kg
Average Delivery Period= (4+8)
2 = 6 weeks.
Minimum Level = Re-order Level - (Average Weekly consumption × Average
Delivery period)
= 3600- (275×4) =2500kg.
 Average Stock Level = (Minimum Level + Maximum Level)/2
= (439+2500)/2
= 3448kg

Knec July 2022

Knec July 2023

Reorder quantity is the total number of product units you request from a manufacturer or supplier on an inventory
replenishment purchase order. The precise number shouldn’t be too high so that you have too much capital
invested in inventory and subsequent increased storage costs but it also shouldn’t be too low so that there isn’t
enough safety stock and you have the danger of running out of inventory before you can order the next batch.

Average Daily Use (ADU) × Average Lead Time (ALT).

Let’s have a look at how to determine the reorder amount for a specific product:
-ADU is 25
-ALT is 30 days
Your reorder quantity using the reorder quantity formula will be:

=ADU X ALT
=25 X 30
=750
Average Daily Usage (ADU) is the total units of your product sold per day.

Your Average Lead Time (ALT) is the time(in days) taken between placing a purchase order and receiving the
inventory.

To know your reorder qty, all you need to do is multiply ADU and ALT. The result gives you the amount of inventory
you need to reorder. Here’s an example:

ADU = 10 units

ALT = 29 days

Your reorder quantity is equal to 290 units.