The economic order quantity or EOQ by the acronym of its name in English (Economic Order Quantity) is a mathematical model used to calculate the optimal size of each raw material order. This, seeking the highest efficiency.
In other words, this tool is a way of estimating the amount of supplies that we must request, each time we place an order with the supplier. This, minimizing costs.
The economic order quantity is a model that allows companies to reduce their inventory costs. In this sense, we must remember that the products that remain unused generate a cost for the space they occupy and for which the store owner must be paid.
Economic Order Quantity Formula
The formula for the economic order quantity is as follows;
Q: Optimal quantity for each order.
K: Cost of each order.
D: Annual demand for the product or raw material.
G: Storage cost per unit.
To better understand this formula, we break down each of these concepts:
G=i*C, where i is the maintenance rate and C is the unit cost of the product.
Now, let’s say I want to calculate the annual cost of ordering from the supplier. For this, I first divide the annual demand by the size of each order, with which I would obtain the number of orders that I must make in the year. I multiply this by the cost of each order (K):
Advantages and disadvantages of the EOQ model
Among the advantages of the EOQ model we can mention:
- It is a simple formula to apply.
- It allows to optimize the costs of the company.
- Helps prevent overstock circumstances from being generated.
However, it also has some disadvantages:
- It has limitations because it assumes that the cost of the raw material, the demand that the company has and the maintenance costs are known and constant.
- It does not consider eventual discounts for volume or order size. Leaving this variable aside, the possibility of increasing the quantity of the order to take advantage of a price reduction is obviated.
- Taking into account its rigid assumptions, it is not useful for companies that have seasonal increases in demand.
Suppose a company has an annual demand for 7,000 units of lumber. The cost of each order is 100 euros. Also, the annual cost of storage of each table is 40 euros. With these data, we can find the economic order quantity:
Therefore, the optimal order size is approximately 187 units.
Now, we can also calculate the annual cost of orders. First, the number of orders would be:
So, the annual cost of the orders would be: