With economic order quantity, companies can reduce their inventory costs and optimise their profitability. Here you will find information on what EOQ means and how you can use it to make your business more cost-effective.
What is economic order quantity?
Economic order quantity - EOQ for short - is a business purchasing method used to improve a company's profitability. The method, also known as the Wilson formula, is a type of inventory strategy that aims to balance the costs of existing inventory and ordering against demand.
EOQ improves profitability and reduces costs
For companies that have some form of warehousing materials management is of great importance. You need to have enough stock at home to meet demand from customers and deliver quickly, but not so much that you are left with poor stock turnover and too much capital tied up in products.
With EOQ, you as a business can calculate exactly how much you need to order at a time to match demand, while minimising inventory costs. The aim is to have an inventory level as close to zero as possible to avoid tying up too much capital. Calculating the economic order quantity also helps to reduce the company's taxes, as the inventory value is the basis for taxation.
Reading tips: FIFO method and Just in time.
How to calculate your company's economic order quantity
The formula for economic order quantity is a so-called square root formula. The value for optimal EOQ is obtained by taking the square root of the order cost and the annual demand divided by the current annual cost of inventory per product.
The EOQ formula itself looks like this:
Q = √ 2KD / H
Q stands for the economic order quantity you get, while K represents the order cost and D stands for the demand in quantity per year. H is the current inventory cost per year and product.
In addition to the standard formula, there is also a variant that includes unit price and inventory interest:
Q = √ 2NP / UB
Also in this formula, Q corresponds to the optimal economic order quantity you want to obtain. N stands for the number of products and P for the order cost per unit. These values are divided by U which represents the inventory holding rate and B which stands for the unit price.
What is required for economic order quantity to work?
Economic order quantity is a useful method when you want to streamline your company's flow of goods and reduce the inventory value to a minimum - without having to place orders too often. Both warehousing and ordering are associated with costs, so finding a good balance is important.
However, for the method to work, certain variables must be correct. The EOQ requires in particular that
- you know what the annual demand is. It is also possible to use a different time unit - for example month or quarter - but the demand per selected time unit must be known. Since the formula calculates an ideal order quantity for the entire time period you choose, it's also good if demand is fairly steady.
- no material shortages or logistical problems arise.
- stock is replenished immediately when the need arises.
Of course, unforeseen events can always happen. As the approach is to keep inventories as low as possible and the flow of goods as efficient as possible, large changes in demand, material shortages and replenishment backlogs can quickly cause delays in deliveries to customers.
In short, you want to strive to keep lead times as unchanged as possible. In practice, of course, this may be easier said than done, but the ambition should be there.
Using EOQ in your company? 5 things to keep in mind
If you run a business in trade and sales, the economic order quantity method can bring a lot of good to your business. Here are some tips to keep in mind when considering implementing the method in your company.
- Get to know how EOQ works and how to do the calculation. Enlist the help of someone with financial management skills if necessary.
- Make sure the conditions are right in terms of demand, lead times, production and logistics.
- Ensure that the optimal purchasing frequency proposed by EOQ works in practice. Among other things, it is important to take into account the capacity of the warehouse staff - the method must be feasible.
- The EOQ does not take into account goods that are within the same warehouse network, but in different warehouses. New orders don't always have to be the best even if EOQ suggests it. Sometimes a reallocation of existing stock may be better.
- Do you have certain products that sell better than others? In this case, it may be useful to calculate the EOQ for each individual product type rather than for the stock as a whole.
Advantages and disadvantages of economic order quantity
There are several advantages and disadvantages to EOQ. Before you start using economic order quantity, it is important that you know both aspects.
Benefits of EOQ
- Decreases the inventoried stock value.
- Makes it possible to find an optimal balance between stocks and orders in relation to customer demand.
- Beneficial from a tax point of view - a low inventory value results in a lower tax base.
Disadvantages of EOQ
- Requires certain conditions to work - including steady demand and unchanging lead times.
- A small stock makes the business vulnerable to problems such as material shortages or delays from suppliers.
Assess the conditions for EOQ with PostNord's innovative business services
At PostNord, we're as passionate about entrepreneurship as we are about great postal and logistics services. We love to see businesses succeed and to do what we can to help.
As a business customer with us, you get access to lots of smart tools and services specifically designed for businesses. Several of these can be usefully used to complement the EOQ and to facilitate the method. These include our integrations, with which you can, for example, connect your e-commerce system to PostNord and thus gain access to automatic freight solutions for faster and smoother order processing.
We also offer complete 3PL services with both warehouse management and efficient shipping solutions. Ideal if you want to use EOQ in your business, but wish to leave all logistics to a reliable and market-leading partner.
Would you like to know more about how PostNord can assist you in using the EOQ? Contact us and we will help you!
