7.7: Economic Order Quantity

Commercial distributors often face a trade-off between ordering frequency and inventory holding. Ordering too often inflates administrative costs, while infrequent bulk orders tie up capital in storage and insurance. The Economic Order Quantity (EOQ) model provides a quantitative approach to striking this balance, allowing firms to identify the order size that minimizes the combined costs of ordering and holding inventory.

The EOQ formula can be simplified into plain language for easier understanding while still retaining its technical accuracy.

EOQ equals the square root of twice the annual demand (D) multiplied by the cost to place one order (S), then divided by the annual holding cost per unit (H).

While EOQ provides a useful baseline, its assumptions may not always hold in real business environments. It presumes constant demand and stable costs, which may not reflect seasonal fluctuations, bulk discount opportunities, or supply chain disruptions. For example, if a business experiences varying demand or suppliers offer significant discounts for larger purchases, EOQ should be adapted or supplemented with other models like Quantity Discounts or Just-in-Time (JIT) systems.

Additionally, incorporating safety stock to buffer against delivery delays or demand variability is often necessary, even when using EOQ as a foundation.

CleanPro, a commercial cleaning supplies distributor, faces rising inventory costs due to inefficient ordering practices.

Frequent small orders increase ordering expenses, while large bulk orders increase storage and insurance costs.

As a result, CleanPro faces higher overall inventory costs and decreased operational efficiency.

The company has decided to apply the Economic Order Quantity model or EOQ to address the issue.

This model determines the optimal order quantity that minimizes total inventory costs, including ordering and holding costs.

EOQ is calculated as the square root of two times the annual demand, multiplied by the ordering cost, divided by the annual holding cost per unit.

CleanPro sells ten thousand units of a product each year.

The cost of placing an order is one hundred dollars, and the annual holding cost per unit is two dollars.

Using the EOQ formula, the optimal order quantity is calculated to be one thousand units.

EOQ is most effective when demand is consistent, lead times are constant, and cost factors remain stable.