Economic Order Quantity – EOQ

Economic order quantity (EOQ) is the ideal order quantity a company should purchase for its inventory as
per a given set of cost of production, a certain demand rate, and other variables. EOQ takes into account
the timing of reordering, the cost incurred to place an order and costs to store merchandise. For example,
if a company is constantly placing small orders to maintain a specific inventory level, the ordering costs
get too higher, negatively affecting the income earned by the company.
1. Objectives of EOQ
 To minimize inventory holding costs, order-related costs including shortage costs. For example if
the company runs out of inventory, there is a shortage cost, which is lost revenue because the
company fails to fulfill an order.
 To calculate a company's inventory reorder point i.e. a specific level of inventory that triggers the
need to place an order for more units. By determining a reorder point, the business avoids running
out of inventory and is able to fulfill all customer orders.
 To avoid losing the customer or the client orders in the future owing to shortage of inventory.
2. EOQ formula
 Formula: Following is the formula for the Economic Order Quantity (EOQ):

Where Q = optimal order quantity

D = units of annual demand

S = cost incurred to place a single order

H = carrying cost per unit

 Assumptions:
This formula is derived from the following cost function:

Total cost = purchase cost + ordering cost + holding cost

This formula assumes that demand, ordering, and holding costs all remain constant.

 Application of EOQ formula: For example, a retail clothing shop carries a line of men’s jeans and
the shop sells 1,000 pairs of jeans each year (D). It costs the company $5 per year to hold a pair
of jeans in inventory (H) and the fixed cost to place an order is $2 (S).
By substituting the values in the EOQ formula, it is the square root of (2 x 1,000 pairs x $2 order
cost) / ($5 holding cost) which come to 28.3 with rounding. Thus the ideal order size to minimize
costs and meet customer demand is slightly more than 28 pairs of jeans.
3. Advantages of EOQ
 Reduce Holding Costs: The biggest advantage of EOQ is that it helps the company in reducing the
holding cost of inventory because when the company has EOQ system in place then it does not
need to have a big warehouse to store goods as company orders goods in limited quantity so that
current production of goods does not come to a halt. In simple words, if the company does not
follow this method then it has to incur unwanted warehouse expenses besides increased holding
costs related to inventory.
 Reduce Ordering Costs: In case of EOQ while ordering goods companies order goods on fixed
date which may be fortnightly or monthly which results in reduction in ordering costs because if
 company orders 10 times in one month then company will have to pay more transportation costs,
packing costs and other costs 10 times but if company orders goods only 1 time in a month then
all costs will incur one time only.
 Better Inventory Management: Another benefit of EOQ is that it is a key to better inventory
management and when the company can manage its inventory in an effective way then it can
reduce substantial operational costs which in turn will lead to more profits for the company.
 Cash savings: EOQ is an important cash flow tool for management to minimize the cost of
inventory and the amount of cash tied up in the inventory balance. If EOQ can help minimize the
level of inventory, the cash savings can be used for some other business purpose or investment.
4. Disadvantages of EOQ
 Environmental dynamics ignored: The EOQ formula assumes that consumer demand, both
ordering and holding costs remain constant, which makes it difficult or impossible for the formula to
account for changing consumer demand, seasonal changes in inventory costs, lost sales revenue
due to inventory shortages etc.
 Exact demand forecast not possible: The biggest disadvantage of EOQ is that it is based on the
assumption that demand for company’s products can be forecast accurately which in real life is not
possible because demand for company’s product never remain static rather it keeps changing and
if demand for good produced by the company rises or decreases substantially then having EOQ
system in company is of no use.
 Immediate Availability of Products with Suppliers: Another problem with EOQ is that it may be
possible that supplier does not have raw materials and if the company needs immediate raw
material for meeting unexpected demand then it can lead to problems. In simple words, if the
company has good relationships with multiple suppliers then it is not much of a problem, however,
if the company is dependent on only 1 or 2 suppliers for its raw material then the company may
face trouble following EOQ method.
 Requires Continuous Monitoring: Companies in case of EOQ have to constantly monitor reorder
levels as the moment, level of raw materials reaches reorder level, company has to order goods
from suppliers. Hence company will need to employ staff to monitor stock levels which again is a
time consuming as well as an expensive process.
Reorder level

Reorder level is also known as Reorder point which enables a company to reorder the stock at the right
time. Reorder level is the inventory level at which a company would place a new order and it depends on
company’s work-order lead time and the safety stock maintained by the company.

 Work-order lead time: Work-order lead time is the time the company’s suppliers take in
manufacturing and delivering the ordered units.
 Safety stock: Safety stock is simply extra inventory beyond Reorder level. Safety stock is
essential to prevent a stock out situation which may lead to loss of revenue, loss of customers
and loss of market share.
 Significance of Reorder level: Identifying correct Reorder level is important. If a company places a
new order too soon, it would have to bear storage costs. If the company places an order too late,
it may result in stock-out situation. Hence Reorder level or Reorder point is a significant aspect in
purchase management.
 Formula for Reorder level:
Reorder level = (Average daily unit sales X Average Delivery lead time) + Safety stock
Where Average daily unit sales = Total sales in unit time

Total no. of days in unit time

Total no. of orders

Then Reorder level for ABC Ltd. = (500 X 7) + (5 X 500)

= 3500 + 2500

= 6000 units

Price analysis for determining Right price

The main objective of any buyer is to procure the material items at the right price. It is that price which
brings the best ultimate value of the money invested in purchasing the materials. Deciding the right price
of a product requires Price analysis which is nothing but an evaluation of the price offered by one vendor
relative to the prices being offered by other vendors for a similar item. The essential factors considered
during a Price analysis are as follows:
 PRICE COMPARISON: When two or more competitive bids are received then the lowest price
offered is concluded to be fair and reasonable. It is noted that generally where the difference in
prices between the two offers differs by less than 15%, then price competition is said to exist. A
price that is very low must be checked to assure that the seller understands what is being asked
for and has made no errors. 
Example: Seller A proposes a price of $2,592.00; Seller B, a price of $2,550.00 and Seller C, a
price of $1,400.00. Seller C is low but the difference is too great. This must be checked to see if
Seller C is proposing the same item(s) and has made no errors in the proposed pricing.
 CATALOG PRICE: Where only one offer is received and the seller has a published price catalog,
available to the general public, then it can be used to find whether the price is reasonable or not.
The catalog should be current (within one year, generally). Provide a dated page from the catalog
along with the page where pricing is identified (this could be a printout of an online catalog).
 MARKET PRICE: Where an item has an established market price, verification of an equal or lower
price also establishes the price to be fair and reasonable. Example: the purchase of metals such
as lead, gold, silver, or commodities such as grains.
 HISTORICAL PRICES: If the buyer has a history of the purchase of the item over several years,
this information, taking into account inflation factors, can be used to determine a price fair and
reasonable. The historical pricing summary must be supported by appropriate documentation over
a computing system for proper analysis.
 COMPARISON OF BASE PRICE AGAINST VALUE ADDED PRICE: If an item has added features
then the Seller can provide the price of the base item, by a catalog, and then state the costs of the
additional features. The buyer can then find the price reasonability based on the information
provided with the help of technical personnel.
 SALES OF THE SAME ITEM TO OTHER PURCHASERS: If the Seller has no catalog but has
sold the same item to others in the recent past, the price can be determined to be fair and
reasonable by verifying with those other purchasers what price they paid. This must be noted in
the written documentation with name, telephone number, date of confirmation and price paid. A
copy of another customer’s invoice will suffice.