Ordering the right amount of inventory is like Goldilocks choosing what porridge to eat. Too much wastes money, and too little leaves you short. You need a quantity that’s just right.
That’s where economic order quantity (EOQ) comes in. It helps you calculate the ideal restocking amounts to lower costs while keeping enough liquidity to adapt to shifting market conditions.
Here’s everything you need to know about EOQ, including how to calculate it and best practices.
What is EOQ?
The EOQ is the optimal number of units you should purchase to minimize inventory costs and avoid frequent ordering. You calculate it using a formula, including numbers like holding costs, demand rate, and setup costs.
The EOQ formula assumes a trade-off between inventory setup costs and holding costs. While buying large amounts of product at once is cost-effective, it’s not worth it if your holding costs are too high. But you need enough inventory to satisfy customer needs. EOQ balances these elements by discovering the most economical strategy for reducing total inventory costs — without sacrificing stock.
How to calculate EOQ
The EOQ formula is as follows:
EOQ = √[(2xSxD)/H]
“H” represents holding costs (per year or per unit), “D” represents the demand rate (quantity sold per year), and “S” represents your setup costs (per order). The setup costs include shipping, handling, and any other expenses related to receiving and preparing stock for sale.
Let’s look at an example of the EOQ formula in action for a coffee company selling beans.
Holding costs
Start with holding costs, which are sometimes referred to as carrying costs. Use the following formula to find this number:
Holding cost = (storage costs + employee salaries + depreciation costs + opportunity costs)/ total value of annual inventory
Let’s say the holding costs for the coffee company’s bags of beans are $2 per unit per year.
Demand rate
Next, determine the demand rate for the coffee bean bags. After examining sales data and historical order trends, the company finds the demand rate is 20,000 units per year.
Setup costs
Setup costs include shipping and handling, along with any other expenses associated with placing an order. In this scenario, per-order costs are $100.
EOQ example
According to the EOQ formula, the first calculation is 2xSxD. In this scenario, the calculation is 2x100x20,000, which equals 4,000,000. Then, divide the figure by the holding costs of $2 per unit per year. The result is 2,000,000.
After calculating the square root of that figure, the result is 1,414 units per order. This means that to minimize the total costs associated with ordering and holding inventory, the company should aim to order 1,414 bags of organic coffee beans each time it restocks.
The importance of EOQ: 4 benefits
Inventory is a form of working capital, which means it’s an asset required for your daily operations. But too much working capital cuts into profit margins and leads to missed opportunities.
By learning how to calculate EOQ, you unlock the following benefits.
1. Increase agility
By avoiding overstocking, you maintain some wiggle room in your warehouse. Instead of overflowing with products, storage areas have space for more, which means you can adjust stock levels easily if demand or market conditions suddenly change.
2. Decrease costs
EOQ drives down inventory costs. It minimizes holding expenses while keeping setup costs as low as possible, leading to stronger profitability and less waste.
3. Promote better liquidity
Overordering can leave you with too little cash to capitalize on new opportunities or handle emergencies. The EOQ formula ensures you have enough cash and inventory to quickly adapt to any situation.
4. Reduce the likelihood of spoilage
EOQ is essential for businesses in the food and beverage sector that deal with perishable goods. Holding extra stock won’t just drive up storage costs — it can also lead to spoilage and lost revenue. With the EOQ formula, your business minimizes risk to make sure more goods reach customers.
4 limitations of EOQ
While the formula is valuable to an inventory management strategy, it has some limitations.
1. Inventory shortages
The EOQ approach tends to generate smaller orders, which opens the door for shortages.
Let’s revisit the coffee example. In that scenario, the company had an annual demand of 20,000 bags. To meet that projected demand, it would have to place 14 separate orders of 1,414 units throughout the year. But since that number is so exact, any spikes in demand or delivery delays could easily lead to a shortage.
2. Outdated systems
Outdated inventory systems or incomplete data could negatively impact your calculations, leading to stock outs or overordering. Upgrading to a cloud-based inventory management software, like Fishbowl, gives you more accurate visibility into your stock levels.
3. Seasonality
One of the EOQ formula’s biggest shortcomings is that it assumes static demand. It doesn’t account for seasonality. If you sell products that experience large seasonal spikes, you have to adjust your ordering strategy to prepare for these surges.
4. Inaccurate data
The garbage in, garbage out rule applies to all inventory management calculations — including the EOQ formula. Inaccurate holding cost, demand, or setup cost data leads to inaccurate final calculations. Even seemingly slight inaccuracies in your inputs create major discrepancies on the back end.
3 alternative ways to optimize inventory
Here are several great alternatives to the EOQ formula to help you better understand customer needs and optimize stock levels.
1. Safety stock measurements
Safety stock is extra inventory beyond projected demand, and it’s a buffer against sudden or unexpected surges in product interest. If you expect to need 1,000 units of a particular SKU in April, ordering 1,100 units gives you a safety stock buffer.
Keep in mind that this is a limited example. Calculate safety stock thresholds using historical sales data and demand projections. And like EOQ, safety stock levels may need adjustments throughout the year, especially during busy seasons such as the holidays.
2. Reorder points
A point-based reordering strategy uses real-time stock data and average delivery lead times to help you decide when to make an order. But instead of manually checking stock levels to guide your reordering efforts, set predetermined thresholds or reorder points. Your inventory system arranges a replenishment shipment when stock hits these thresholds.
Combine reorder points with other inventory management strategies, such as safety stock calculations. This ensures you receive replacement stock before cutting into your reserves.
3. Real-time stock tracking
Modern software solutions provide real-time insights into your stock levels, precisely tracking your inventory turnover ratio and any other metrics that need attention. This way, you can predict future demand and tailor stock levels to align with what your customers need. Real-time tracking also lets you continuously review your stock management strategy’s efficacy — whether you use EOQ or an alternative.
Inventory management software takes the guesswork out of ordering stock, setting the stage for cost savings and greater efficiency.
Maximize inventory efficiency with Fishbowl
Implementing EOQ principles requires quality data and real-time insights. Fishbowl inventory management software delivers both.
The Fishbowl platform offers unparalleled control, efficiency, and precision, supporting your organization’s growth goals on every level. It has a powerful and ever-expanding suite of software integrations, including a QuickBooks integration that unifies financial and inventory data. Streamline bookkeeping, invoicing, expense tracking — whatever your business needs.
Schedule a Fishbowl demo today to learn more about its intuitive inventory management solutions.