For any business that buys and holds inventory, it's essential to place orders in the amounts that best fit your needs. That's where economic order quantity (EOQ) comes in.
If your orders are too large, you could have too much money tied up in inventory and storage expenses. If you order too little, you won’t be able to meet your customers’ needs. Economic order quantity helps you find the sweet spot where your business makes the ideal order size and maximizes profitability.
What Is Economic Order Quantity (EOQ)?
Economic order quantity (EOQ) is a calculation companies perform that represents their ideal order size, allowing them to meet demand without overspending. Inventory managers calculate EOQ to minimize holding costs and excess inventory.
It doesn’t matter if your business sells jelly beans, appliances, furniture or airplanes. Finding the economic order quantity for every product you purchase is almost certain to impact the bottom line. Every business that manages inventory can benefit from measuring and following the EOQ.
- Economic order quantity is a metric that represents the ideal order size to minimize costs for the business.
- Economic order quantity is a useful formula for businesses of all sizes and types that order and hold inventory.
- Inventory management systems and ERP systems can automate economic order quantity calculations, so your business makes the best, most informed decisions regarding orders and inventory management.
Economic Order Quantity (EOQ) Explained
Economic order quantity is a useful metric for businesses that buy and hold inventory for manufacturing, resale, internal use or any other purpose. Businesses that follow EOQ look at all costs related to purchasing and delivery while also factoring in demand for the product, purchase discounts and holding costs.
Experienced business owners and managers understand that purchasing and finding the ideal inventory levels can be complex. When your vendors offer volume discounts and other incentives to purchase more, EOQ can help you decide on the right place to draw the line.
EOQ relies on the economic order quantity formula (found below). That gives you a data-driven result to help optimize business profitability.
Why Is Economic Order Quantity (EOQ) Important?
Economic order quantity is a key metric for your organization’s sustainability because ordering too much can lead to high holding costs and take resources away from other business activities, like marketing or R&D, that could further boost sales or reduce costs.
Inventory is a type of working capital. Working capital represents business assets needed for regular operations. But too much working capital can eat into your profits, and it also represents a big opportunity cost.
EOQ may not be extremely helpful when managing your office supply closet. It's most important when looking at large, high volume or expensive purchases. As your orders and inventory grow and scale, EOQ has a greater impact on profits.
What Does Economic Order Quantity (EOQ) Tell Businesses?
Economic order quantity tells businesses the ideal order size for every product they buy. The EOQ formula assumes annual demand for a product is relatively flat. If you are in a growing business, EOQ may not be the best way to calculate your order size, as those numbers could change frequently.
Once you work through EOQ, you should know the optimal number of orders per year and the ideal order size. You may adapt the EOQ model to factor in pricing discounts, backorders, defective items and more.
With your EOQ results, you should have an optimal supply chain order schedule for the entire year.
Benefits of Economic Order Quantity (EOQ)
The main benefit of using EOQ is improved profitability. Here’s a list of benefits that all add up to savings and improvements for your business:
- Improved Order Fulfillment: When you need a certain item or something for a customer order, optimal EOQ ensures the product is on hand, allowing you to get the order out on time and keep the customer happy. This should improve the customer experience and may lead to increased sales.
- Less Overordering: An accurate forecast of what you need and when will help you avoid overordering and tying up too much cash in inventory.
- Less Waste: More optimized order schedules should cut down on obsolete inventory, particularly for businesses that hold perishable inventories that can result in dead stock.
- Lower Storage Costs: When your ordering matches your demand, you should have less products to store. This can lower real estate, utility, security, insurance and other related costs.
- Quantity Discounts: Planning and timing your orders well allows you to take advantage of the best bulk order or quantity discounts offered by your vendors.
Challenges of Economic Order Quantity (EOQ)
While many businesses want to use EOQ to determine order sizes, it isn’t always easy to achieve. When determining EOQ, you may run into these challenges:
- Poor Data: One of the biggest challenges of determining EOQ is access to accurate and reliable data. Manual or spreadsheet-driven systems may provide low-quality or outdated information, which can lead to inaccurate calculations.
- Outdated Systems: Old and outdated systems may have incomplete data and lead to missing out on potential savings. An inventory management system or cloud-based ERP can solve this problem.
- Business Growth: The EOQ formula is ideal for businesses with consistent inventory needs. With a fast-growing business, relying on EOQ can lead to inventory shortages.
- Inventory Shortages: If you’re just starting to use this method, it often generates smaller orders. If you are too conservative with your calculations, you could wind up under-ordering.
- Seasonal Needs: Seasonality can make EOQ more challenging, but not impossible. This is because there could be major changes in customer demand throughout the year.
Calculating Economic Order Quantity (EOQ)
Calculating economic order quantity requires high school-level algebra. Once you get the variables from your inventory management system, it’s easy to plug in the numbers and calculate EOQ. When you use a robust ERP, these calculations may all be handled for you, including order costs like inventory ordering costs, holding costs and stock out costs.
Three Variables (or Inputs) Used to Calculate EOQ
There are several variations of the formula used to calculate EOQ. One popular EOQ formula is based on these variables, also called inputs:
- D = Demand in units (annual)
- S = Order cost
- H = Holding costs (per unit, per year)
Economic Order Quantity (EOQ) Formula
EOQ = √ [2DS/H]
To best understand how economic order quantity works, here’s an example. Let’s say a business uses its ERP platform to determine demand, order cost and holding costs per unit, per year over the last year and expects similar demand next year.
Demand from last year was 10,000 units. The average order cost was $5,000. The holding cost is $3 per unit, per year.
EOQ = √ [2 x D x S / H]
= √ [ (2 x 10,000 x $5,000) / $3]
= √ [33,333,333.33]
= 5,774 units
Based on this company’s results, the economic order quantity is 5,774 units per order, roughly twice per year.
How to Use EOQ to Improve Inventory Management
When you calculate EOQ, you know the ideal order size to maximize profits for your organization. It prevents guessing, and there’s less cause for concern about overordering or running out of stock. You can follow the data and the numbers to make the best long-term decision for your business’s inventory needs.
If you run a large business, a business that requires expensive inventory, or a business with high inventory holding costs, EOQ could have a significant impact on your business, improving operational efficiency, cash flow and profits for years to come.
Free Economic Order Quantity (EOQ) Template
While NetSuite can calculate EOQ for every product your business sells automatically and display the results on a handy dashboard that automatically refreshes, you can also run the numbers yourself. Try out this spreadsheet template to calculate EOQ for specific products:
Gain Control of Your Inventory With NetSuite
While businesses 60 or 70 years ago had few options to automate and improve their order and supply chain management practices, businesses today can fully automate much of the inventory planning, ordering and payment process with software. These tools can help them optimize inventory management and facilitate their growth.
Don’t leave your business future to chance or in the hands of antiquated systems. Consider an upgrade to NetSuite, a robust ERP system that handles your inventory, orders, financials and a whole lot more.
Economic Order Quantity (EOQ) FAQs
EOQ is short for economic order quantity, the ideal order size for any product-driven business. The EOQ formula is often stated as
EOQ = √ [2DS/H]
Economic order quantity helps your business determine the ideal order size for any product. For example, if you run a retail, restaurant, wholesale or manufacturing business, EOQ can help you optimize order sizes to maximize profits. For a more detailed example, see above.
EOQ is calculated using the annual product demand, order cost and holding cost per unit, per year. This calculation can be automated with an inventory management system that’s often part of a larger ERP platform.
Economic order quantity helps businesses find the best order size to maximize profitability. If you want to improve business performance, EOQ could be an important metric.