Economic Order Quantity (EOQ)

Economic order quantity (EOQ) is the order quantity of inventory that minimizes the total
cost of inventory management.

Two most important categories of inventory costs are ordering costs and carrying costs.
Ordering costs are costs that are incurred on obtaining additional inventories. They
include costs incurred on communicating the order, transportation cost, etc. Carrying
costs represent the costs incurred on holding inventory in hand. They include the
opportunity cost of money held up in inventories, storage costs, spoilage costs, etc.

Ordering costs and carrying costs are quite opposite to each other. If we need to minimize
carrying costs we have to place small order which increases the ordering costs. If we want
minimize our ordering costs we have to place few orders in a year and this requires
placing large orders which in turn increases the total carrying costs for the period.

We need to minimize the total inventory costs and EOQ model helps us just do that.

Total inventory costs = Ordering costs + Holding costs

By taking the first derivative of the function we find the following equation for minimum
cost

EOQ = SQRT(2 × Quantity × Cost Per Order / Carrying Cost Per Order)

Example
ABC Ltd. is engaged in sale of footballs. Its cost per order is $400 and its carrying cost
unit is $10 per unit per annum. The company has a demand for 20,000 units per year.
Calculate the order size, total orders required during a year, total carrying cost and total
ordering cost for the year.

Solution

EOQ = SQRT(2 × 20,000 × 400/10) = 1,265 units

Annual demand is 20,000 units so the company will have to place 16 orders (= annual
demand of 20,000 divided by order size of 1,265). Total ordering cost is hence $64,000
($400 multiplied by 16).

Average inventory held is 632.5 ((0+1,265)/2) which means total carrying costs of $6,325
(i.e. 632.5 × $10).
Reorder Level

Reorder level (or reorder point) is the inventory level at which a company would place a
new order or start a new manufacturing run.

Reorder Level = Lead Time in Days × Daily Average Usage

Lead time is the time it takes the supplier or the manufacturing process to provide the
ordered units.

Daily average usage is the number of units used each day.

If a business is holding a safety stock to act as buffer if daily usage accelerates the
reorder level would increase by the level of safety stock.

Reorder Level = Lead Time in Days × Daily Average Usage + Safety Stock
Examples

Example 1: ABC Ltd. is a retailer of footwear. It sells 500 units of one of a famous brand
daily. Its supplier takes a week to deliver the order.

The inventory manager should place an order before the inventories drop below 3,500
units (500 units of daily usage multiplied with 7 days of lead time) in order to avoid a
stock-out.

Example 2: ABC Ltd. has decided to hold a safety stock equivalent to average usage of 5
days. Calculate the reorder level.

Safety stock which ABC Ltd. has decided to hold equals 2,500 units (500 units of daily
usage multiplied by 5 days).

In this scenario reorder level would be 6,000 units (2,500 of safety stock plus 3,500 units
based on 7 days of lead time).

Safety Stock

Safety stock is the stock held by a company in excess of its requirement for the lead time.
Companies hold safety stock to guard against stock-out.

Safety stock is calculated using the following formula:

Safety Stock = (Maximum Daily Usage − Average Daily Usage) × Lead Time
Lead time is the time which supplier takes in ordering the items

Example
ABC Ltd. is engaged in production of tires. It purchases rims from DEL Ltd. an external
supplier. DEL Ltd. takes 10 days in manufacturing and delivering an order. ABC's requires
10,000 units of rims. Its ordering cost is $1,000 per order and its carrying costs are $3 per
unit per year. The maximum usage per day could be 50 per day. Calculate economic order
quantity, reorder level and safety stock.

Solution

EOQ = SQRT (2 × Annual Demand × Ordering Cost Per Unit / Carrying Cost Per Unit)

Maximum daily usage is 50 units and average daily usage is 27.4 (10,000 annual demand
÷ 365 days).

Safety Stock = (50-27.4) × 10 = 226 units.

Reorder Level = Safety Stock + Average Daily Usage × Lead Time

Reorder Level = 226 units + 27.4 units × 10 = 500 units.