A company's profitability will suffer if it has too much or too little inventory. If it has too much inventory, it is holding obsolete inventory which drags down the inventory turnover ratio. If the company has too little inventory, then it is subject to stockouts and loss of customer goodwill. In order to maximize company profit, it has to minimize the costs of ordering and storing inventory. That means it has to have some sort of financial metric to calculate the optimal quantity of inventory to order and store. That metric is economic order quantity or EOQ.
The Inputs to the Economic Order Quantity Formula
Carrying costs, also called holding costs or storage costs, go up in direct proportion to the amount of inventory you have on hand. This is why you don't want to have too much inventory on hand. If you do, carrying costs of inventory will eat you up. If you have to borrow any money to buy inventory, the interest charges you pay on that inventory is part of carrying costs. Since you probably pay insurance on the value of your inventory, that is also part of carrying costs as are any taxes you have to pay on the value of your inventory.
Other possible costs of carrying inventory are possible theft and destruction of that inventory and opportunity cost, or the profits you lose because your money is tied up in inventory. You should also consider obsolescence and deterioration of the inventory.
All carrying costs, as part of the economic order quantity formula, should be variable costs since they change with the amount of inventory you are holding.
Ordering costs in the economic order quantity model are the costs of placing and receiving an order. Where carrying costs are usually variable costs, ordering costs are often fixed costs. They include the time and resources spent sending email or memos about the order, telephone calls, and taking delivery of orders of inventory.
It is often best to divide ordering costs into orders for purchased items and orders for manufacturing. Orders for purchased items would have costs that include initiation of the purchase order, the approval steps, processing the receipt, and inspection. For manufacturing, the cost of the ordering process is a little different. Costs would include initiate the work order, production scheduling time, and inspection time. These lists for costs for purchased items and manufacturing are not all-inclusive.
The last input to the economic order quantity formula is your company's annual usage of inventory. This is the easy portion of the EOQ formula. Estimate the amount of annual inventory you use and you have this input.
How to Calculate Economic Order Quantity
Economic order quantity is really a simple concept. Here is a graph showing how EOQ works. It can be calculated by using a financial or accounting formula that arrives at the point at which the combination of ordering costs and carrying costs are the least. This is what is essentially meant by lowering inventory costs.
Here is the EOQ formula:
Here's an example. Let's say that XYZ, Inc. uses 4,800 units of inventory each unit and their order cost is around $2 per order. They have calculated their carrying cost per unit to be $6 per unit. Calculate the EOQ for XYZ, Inc.:
EOQ = (2)(4800)(2)/(6)....now take the square root and you have EOQ = 57 units
This means that if you order 57 units of inventory every time you place an order you will minimize your inventory costs - both your ordering and your carrying costs.
Here is an online calculator for EOQ that you can use for your convenience.