Economic order quantity is also popularly known as EOQ. It is defined as a production scheduling concept as it is used to determine the frequency and volume of orders that are needed to satisfy a specific demand while reducing the cost per order to minimum levels.
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Economic order quantity is necessary to minimize the order-related and holding costs of merchandise and raw materials inventory. It is the perfect order quantity that should be bought by an organization for its inventory. The economic order quantity is also known as the optimal order quantity and optimal order size.
The merchandising organizations use it for computing the optimal order size of inventory related to ready-to-use merchandise, whereas the manufacturing companies for an optimal order size of inventory related to raw materials.
Understanding ordering cost and holding costs in an economic order quantity
The EOQ is the level at which the combined holding and ordering cost is at its minimum level. It is important to gather information about the two most important factors of EOQ as there is an inverse relationship between both the ordering cost and holding cost.
Ordering costs – Whenever a company places an inventory order with the supplier the cost which incurs is known as ordering costs. The total will vary as it is dependent upon the frequency of placing orders.
If the number of orders that have been placed increases in a given year then the annual ordering cost will also increase, and the same applies if the company places small number o orders because then the ordering cost will be lower. Some ordering costs are delivery charges, telephone expenses, payment processing charges, and invoice verification charges.
Holding costs – Holding costs are also known as carrying costs as it is incurred while holding the inventory in a warehouse or a store.
The total cost is dependent upon the size of the order, and larger the order the higher is the annual holding cost and vice versa. It includes storage space rent, property tax, and insurance.
The formula of economic order quantity
The economic order quantity equation takes into account inventory holding costs like shortage costs, ordering costs, and storage. It is based on the assumption that it is holding costs, order, and demand remain constant over time. The formula of economic order quantity is
Q = Economic order quantity
D = Demand in units
S = Order cost
H = Holding costs
The goal of this formula is to identify the maximum number of units so that an organization can minimize its costs in terms of storing, taking delivery, and buying the units. The formula is easily modified to gather information about varying production levels.
It has become a cash flow tool that can minimize the amount of cash and the cost of inventory that is integrated into the inventory balance. The formula also calculates inventory reorder point of an organization.
This helps the company as it avoids running out of inventory so that it can fulfill all the orders promptly.
Assumptions of economic order quantity
The computation of economic order quantity is possible because of certain assumptions for instance
- The total ordering cost in an EOQ remains constant
- The total units that are to be consumed are certain
- The ordered inventory is delivered in one attempt
- The inventory costs are assumed constant
- The maximum quantity for every stock item is computed on a separate basis
- No availability of any discount on quantity or cash
- There is no fluctuation of lead time
Advantages of economic order quantity
The advantages of economic order quantity are as follows
- The economic order quantity helps in reducing the holding costs of inventory. The company does not have to order excess stocks that need to be stored in warehouses and thus saves money that would have to be spent on rent and other expenses related to storage.
- The economic order quantity equation helps an organization to determine the number of units and the number of units it needs to purchase. This reduces the ordering costs as the company orders in fewer times and saves on costs related to transportation, packing, etc.
- The EOQ helps the organization to manage its inventory in a better manner. It is now able to minimize its operational costs, and this ultimately leads to profits.
- It makes restocking an easy process as the formula helps to determine how often you should be placing orders.
- The EOQ model helps the company to find the best deal because now you are py=urchasing only what you require and not any excess that can become a waste
The disadvantages of economic order quantity are as follows
- The economic order quantity needs several assumptions to survive and operate
- As per the formula of economic order demand, the consumer demand is constant, and this makes it impossible to calculate during seasonal changes
- Forecasting the demand accurately is simply not possible because the demand is not static. It continues to rise and fall substantially and thus changes the equation every time
- Sometimes the company places an order with the supplier, but he does not have the required raw materials. This can cause problems as the organization is unable to meet the unexpected and high demand for the product. The EOQ model states that the demand is constant, and this can cause a loss for the firm.
- It is important to monitor the reorder levels if it is following the economic order quality formula. This is a time-consuming and expensive process because you will have to hire a team to do so regularly.