Calculating the economic order quantity, or EOQ, helps businesses order the right amount of inventory. It represents the optimal number of units you should restock to meet demand, but not go overboard.
The EOQ formula is one of several inventory calculations that can help make your operations more efficient.
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What is the EOQ formula?
To calculate the economic order quantity, you can use the following formula:
![EOQ = √ [ (2 x D x S) / H ]](https://www.nerdwallet.com/assets/blog/wp-content/uploads/2022/03/eoq-formula-320x92.png)
Here’s what those variables mean:
- D refers to the annual demand for your product, or how many units you sell per year.
- S refers to the setup cost per order, or how much it costs to place each order.
- H refers to the holding cost per unit on an annual basis.
When you put that all together, the EOQ is the square root of [(2 x Demand x Setup cost) / Holding cost].
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Why do businesses use the EOQ?
The EOQ tells a business the number of items it should order. It's designed to balance two specific inventory expenses: setup costs and holding costs.
- The setup cost, or ordering cost. This is how much a business spends to create and process each purchase order. But it does not include the cost to buy the goods themselves. Some setup cost examples include shipping and handling fees and the salaries you pay to employees who stock the items.
- The holding cost, or carrying cost. This refers to how much a business pays to store its unsold inventory. These costs can include depreciation, rent for warehouse storage space, insurance and security.
These two types of expenses are competing costs. By placing a large batch order at once, you would be able to save on your setup cost. But if you order more than you can sell, you will start to rack up holding costs. Businesses use the EOQ formula to help them reduce their overall inventory costs.
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Example of EOQ formula calculation
For example, let’s say you own a successful business that sells duffel bags. Based on your historical data, you know the following information:
- Units sold per month: 250.
- Setup cost per order: $45.
- Annual holding cost per unit: $3.
Here’s how you would take that information to calculate your EOQ for duffel bags:
- Find your annual demand: 250 duffel bags x 12 months = 3,000 duffel bags.
- Plug your numbers into the formula: EOQ = √ [ (2 x 3,000 x 45) / 3 ] = √ [90,000] = 300 units.
🤓 Nerdy Tip
Round up to the nearest whole number. Because the EOQ formula deals with square roots and division, it’s likely your result will include decimals or fractions. Drawback of the EOQ formula: The annual timeline
The EOQ formula requires information on an annual timeline. That’s because it assumes that demand, setup costs, holding costs and goods prices are always constant.
In reality, that's not the case. The formula doesn't account for things like seasonality trends or bulk order discounts. The same goes for supply chain disruptions. It's not a perfect solution, but you can always make tweaks to the inputs based on your own situation.
How do you use the EOQ formula in your business?
Pair it with another inventory formula. You can pair the EOQ formula with the reorder point formula. This equation helps you figure out when to order more inventory. Using these calculations together can help you avoid running out of stock and carrying more than you need to.
Set reorder points with your POS system. Many POS systems let you set reorder points, or inventory thresholds that indicate when to order more stock. When your product inventory levels reach their reorder points, you’ll be prompted to place another order.
POS systems, such as Square, can use reorder points to help automate purchase order forms for you. This makes it simple for you to use the EOQ. Some systems, such as Lightspeed Retail, will even let you set your desired inventory levels ahead of time.
