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Small Business Guide to Economic Order Quantity

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Last editedJan 20232 min read

Economic order quantity (EOQ) is a metric used to ensure companies have the right amount of stock proportional to demand. Having too much of a product can lead to unnecessarily high storage costs and have a negative effect on cash flow. Not having enough of a product, on the other hand, can cause businesses to miss out on sales opportunities as well as tarnish the customer experience.

The economic order quantity model is therefore a valuable metric to track. In this post, we’ll take you through how to calculate EOQ, as well as information on why it’s important to do so.

What is economic order quantity (EOQ)?

Economic order quantity (EOQ) is used to determine optimal inventory levels. It assists retailers in the task of determining the order quantity which best matches their needs with regards to inventory management, storage costs, and avoiding demand.

Sometimes referred to as “optimum lot size,” economic order quantity is the precise number of units that should be added to inventory when creating purchase orders. It is used to help retailers know how much to order and when to order it.

The aim of incorporating EOQ into the equation is to minimise inventory costs. It functions as a kind of review system, overseeing inventory and initiating reordering once inventory levels diminish to a certain level. It therefore provides retailers with instantaneous replenishment of stock, therefore avoiding issues such as stock-out.

For small businesses, EOQ has infinite value. This is because it can help you decide how much inventory to keep in stock, how much you should reorder, and how often you should reorder it.

Economic order quantity formula

Economic order quantity can be expressed using the following formula:

EOQ = square root of: [2(setup costs)(demand rate)] / holding costsQ= √2DS / H

To make this clearer, here is a definition of some of the representative values:

  • Q = Number of EOQ units

  • D = Annual demand for a product

  • S = Setup cost (cost of order per purchase)

  • H = Holding costs (total cost of holding inventory)

To ensure you receive an accurate EOQ value, you need to have accurate accounts of holding costs. Holding costs are basically all the costs involved in storing inventory, including equipment, warehouse and insurance costs.

To calculate inventory holding costs, you can use the formula below:

(Cost of storage/total annual inventory value) X 100

Why is an economic order quantity model important?

EOQ is crucial for businesses looking to establish optimal inventory levels. Below are some of the chief ways EOQ can help improve inventory management and business affairs as a whole:

Can reduce stock-outs

Calculating EOQ can prevent popular products running out of stock. This helps maximise sales, as well as boost customer retention and loyalty.

Additionally, as EOQ determines a business’s reordering level, restocking can be triggered automatically when stock drops to a certain threshold. This means you can avoid ever running into issues related to stock-out.

Can prevent overstocking

Overstocking is having more stock than can be sold. When a business over-orders, they can be left with too many products. This can cause financial difficulties as resources are required to store the stock, and returns will not be made on these orders by way of customer sales.

Effectively using EOQ calculations, however, can ensure you always order the right amount of stock to meet demand.

Can improve cash flow

EOQ is not only helpful when it comes to inventory ordering, it can also lead to improvements in cash flow management. For example, by optimising inventory planning, EOQ can prevent cash being used up in inventory and can be distributed to other areas.

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