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Economic Order Quantity

Economic order quantity is a simple inventory management model that many companies and software programs utilize to determine the point at which the combination of inventory order costs and inventory carrying costs are the least - thus most profitable to the company. The result is the most cost effective quantity to order. When you have repetitive purchasing/ sales of an item, EOQ can prove beneficial. Though EOQ is generally recommended where usage is constant, items with demand variability such as seasonality can still use the model by going to shorter time periods.

The Equation:

S = Annual Usage (sales) in units
O = Order cost per order
C = The carrying cost per unit per period
Q = The order quantity

Annual Usage.

Expressed in units, this is generally is based on prior year unit sales, forecasted unit sales, a combination of both, or even last 6 months unit sales extrapolated based on current market conditions - thing is you can pick and choose what is best in your situation.

Order Cost.

This is the sum of the costs that are incurred each time an item is ordered. These costs are associated with physical activities required to process the order as well as the costs charged to ship and receive the stock. The typical costs are: typical ABC functions (cost to enter the purchase order, cost to communicate with the vendor, the cost to process the receipt, incoming inspection, invoice processing and vendor payment), inbound freight and insurance associated with shipment.

Carrying cost.

Carrying costs are the variable costs PER UNIT of holding an item in inventory. Below are the primary components of carrying cost.

Interest: If you borrow money to pay for your inventory, the interest charged should be part of the carrying cost. If not - you should compute an opportunity cost at a rate that you could otherwise earn on the funds tied up in inventory.

Insurance: Since insurance costs are directly related to the total value of the inventory, you would include this as part of carrying cost.

Taxes: If you are required to pay any taxes on the value of your inventory they would also be included.

Storage Costs: Storage costs should only include costs that are variable based upon inventory levels.

Example:

Annual unit sales of product = 1,600
Order cost                        =    $50
Carrying cost / unit / year   =      $1

If sales do not fluctuate then you would order 400 units every 91 days - 365 days / (1,600 annual unit sales / 400 units to order)