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written by | April 19, 2022

EOQ - Relevance of Economic Order Quantity in a Business

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An EOQ formula functions on the premise that the requirement for products is continuous in an industry. It assumes that stocks are sold at fixed rates until the inventory is exhausted. The EOQ formula is implemented in most organisations known for the large storage of inventory. With EOQ, every commercial enterprise seeks to understand the maximum stock quantity. It helps to reduce storage and logistic expenses, among various other costs. EOQ effectively determines a practical ordering point and serves as a valuable guideline. EOQ ensures that your business never faces a shortage of stocks without you having to maintain a large volume of the same. 

If you have always been challenged with the amount of inventory you need to maintain and how much you need to order, this article will answer all your questions. EOQ is the perfection calculation technique that commercial enterprises resort to as it reflects the accuracy in the order size. It enables businesses to cater to the demands of their clients successfully without having to maintain inventory in excess.

Did you know?

McDonald’s Corporation, a renowned global organisation, implements the EOQ technique to maintain a healthy inventory at nominal costs.

EOQ - An Insight

Every organisation, big or small, has to maintain additional quantities of stocks to cater to the demands of their clients. Maintaining a large volume of inventory creates an unnecessary burden on your finances. However, maintaining a low volume of stocks can also impact your overall sales. The Economic Order Quantity enables you to understand the most feasible quantity you can maintain at minimal costs without affecting your profit levels. EOQ considers the annual costs of your orders, the sales of those stocks, and the expenses on warehouse storage. 

It then makes a very practical, cost-effective measurement to arrive at the ideal inventory storage you need to maintain. It has made EOQ in inventory management an indispensable technique used by all commercial enterprises known to stock inventory. This technique enables you to make informed and invaluable decisions that assist you in reducing expenses while smoothly conducting your business.

Also Read: Learn About Safety Stocks

Why Use EOQ?

Every trade transaction involves a variety of inventories. Sellers are adept at offering discounts to attract purchases to buy large quantities. Most businesses are at crossroads when it comes to understanding of the quantity of inventory that needs to be stored. EOQ helps you understand the exact inventory levels to enhance your business profits.

You save a lot of money on storage which can be utilised in other departments like research, promotional activities, marketing or even training. Fast-moving goods imply the necessity of re-ordering. EOQ helps a business set up timely levels of re-ordering stocks so that you don’t face a scarcity of stocks in the event of increased demand.

EOQ Formula and EOQ Factors

You need to be well-versed with all your inventory details to calculate the EOQ for your business. The various factors involved in the EOQ formula are

  • The cost of holding, which is better known as the carrying cost - H
  • The demand on an annual basis - D
  • The cost of placing the order - S

EOQ formula involves the following steps, you need to:

  1. Understand the exact quantity or demand which is required
  2. The total costs to place an order for the same (including the processing costs as well)
  3. Get exact details on the holding expenses (additional cost for storing a single unit)
  4. You now multiply the demand by 2. You then multiply the answer by the costs involved in placing an order
  5. You now find out the square root of (2xDxS/H).

In this formula, the alphabet D indicates the demand of the number of additional units you require of a specific stock. The alphabet S indicates the cost of setting up the demand and the alphabet H indicates the cost of storage of an additional unit of the said item.

The EOQ formula sets the exact point for reordering your inventory. This reorder point keeps you constantly updated about:

  • The timing of placing an order of the inventory.
  • The quantity that needs to be ordered.
  • Your inventory management becomes organised to the extent that you do not maintain unsold stocks and neither do you face a shortage of stocks when required.

Example of EOQ Formula

Let’s take the example of the TVS Motor Company.

Suppose the TVS Motor company is keen to get an insight into the economic order quantity that will assist it in reducing inventory storage costs and help it to maintain a healthy cash flow at all times.

Ordering cost on an annual basis

₹25 crores

Units in demand

₹1 crore

Costs of holding

₹10 crore

EOQ for TVS Motor will be

EOQ formula  → √(2SD/H)

EOQ = √2 [(25,00,00,000) (1,00,00,000) / (10,00,00,000)]

Thus, EOQ is √5 which is 2.2360.

Also Read: Economic Survey 2022: GDP to grow at 8-8.5% in FY23; See highlights here

EOQ Formula Calculators

Many online EOQ calculators and apps provide you with accurate results. You can explore a few varieties before actually using them. Some calculators demand very distinct inputs. You need to have all the correct numbers of demand for units and various costs involved before using the formula.

Benefits of Economic Order Quantity

One of the key advantages of using the EOQ technique is that it helps to improvise the profit levels of your business. Some of the other key advantages are as follows:

If a customer requirement for a specific product arises on the spur of the moment, the optimal EOQ technique assures that the item is available and ready for sale. This type of service increases your goodwill, sales and profit margins.

EOQ gives you an exact timeline of your inventory requirements. It protects you from indulging in the excess ordering of goods which keeps your cash tied up in inventory.

Since EOQ provides optimal schedules for placing inventory orders, you will be spared from losses that occur due to stocks that become obsolete. It reduces a lot of wastage, especially in the case of perishable products.

EOQ helps to maintain the perfect balance between placing orders on demand. It reduces the necessity of unnecessary stocking of products. You stand to gain fewer payments for storage, security, and insurance, among other costs.

Conclusion

The details of this article help you understand everything about the economic order quantity formula and its important role in the inventory management of businesses. 

Follow Khatabook for the latest updates, news blogs, and articles related to micro, small and medium businesses (MSMEs), business tips, income tax, GST, salary, and accounting.

FAQs

Q: In what way does EOQ help a business?

Ans:

It aids in enhancing the volume of orders according to the demand and thereby helps increase your profit margins. It ensures you always

  • Have optimum inventory levels to meet customer demand, 
  • Minimise wastage, 
  • Reduce cash being tied up in inventory,
  • Lowering stocking requirements and liabilities.

Q: What is another term for Economic Order Quantity?

Ans:

It is also referred to as ‘lot sizing’.

Q: Why is it necessary to implement the EOQ technique in a business?

Ans:

It serves as a very practical metric that boosts the performance of your business.

Q: What does the Economic Order Quantity formula determine?

Ans:

It helps to determine the most feasible quantity of stocks across products that need to be stored at a given time.

Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.
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Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.