Economic Order Quantity Model (EOQ)

Managing inventory is an important task for every business that holds it. There are
many costs that occur because of inventory that need to be minimized, while still
providing enough inventory to operate without losing customer business. The EOQ
Economic Order Quantity model is used to minimize these inventory related
costs. You will find the EOQ Economic Order Quantity formula above, as well as the
EOQ Economic Order Quantity calculator.
Inventory can be expensive, and money is a precious commodity to any
business. Using a large amount of capital to carry inventory comes at a cost of
opportunity for the business. This capital could have been used in other ways to
improve business, such as marketing or leasehold improvements, so it is important that
this cost be minimized.
The cost of carrying inventory can be calculated by multiplying the cost of carrying a
unit of inventory by the average number of units carried, usually for a year. If
inventory is used at a steady pace, and restocked when empty, then the average
number of units held would be the order size divided by 2.

C=Carrying cost per unit of inventory

Q=Inventory order size (quantity)

We can see by the equation above that the carrying cost of inventory can be
reduced by reducing the size of Q. This is usually achieved by reducing the amount
of capital invested in inventory, as well as the space and expense required to store
it. However, every time inventory is ordered, a transaction and shipping cost usually
occurs. This is important since typically reducing the size of inventory held by a
company will usually mean an increase in the frequency of orders. If this increase in
ordering cost is larger than the savings from the reduced inventory size, then the total
cost of inventory is increased.

We can determine the ordering cost by calculating the number of orders in a year,
and multiply this by the cost of each order. To determine the number of orders we
simply divide the total demand (D) of units per year by Q, the size of each inventory
order.

D=Total demand (units)

Q=Inventory order size (quantity)
We then multiply this amount by the fixed cost per order (F), to determine the ordering
cost.

The total inventory cost for a year for a business is simply the sum of the carrying cost
and the ordering cost. The total inventory cost formula is below.

C=Carrying cost per unit of inventory

Q=Inventory order size (quantity)
D=Total demand (units)
F=Fixed cost per order

This total inventory cost value can be expressed graphically, and will have a minimum
value. Using calculus to determine the minimum point, where the slope equals zero,
will provide us with the optimal order quantity to reduce total inventory cost over the
year. This is known as the Economic Order Quantity.

EOQ Economic Order Quantity Formula