Economic Order Quantity (EOQ) can help ensure you have enough products on hand to meet demand. Too much of one product can increase storage costs and reduce available cash flow. Too little of a product, and you’ll damage the customer experience and miss out on sales opportunities.
In fact, only 37% of shoppers return to a retailer’s website or store after an item goes out of stock. Most shoppers head to another store or do not bother buying the product at all.
Understanding your business’s EOQs is crucial for creating a positive customer experience and saving your company money on inventory costs.
It’s clear that EOQ is an important retail metric to track. This guide explains how to calculate EOQ, how it affects your bottom line, and examples and challenges to look out for.
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What is economic order quantity (EOQ)?
Economic order quantity (EOQ) is a model used to establish optimal inventory levels. It helps retailers find their ideal order quantity to maximize inventory, lower holding costs, and avoid stockouts.
Also known as “optimum lot size,” economic order quantity refers to the number of units you should add to inventory with each purchase order.
It helps purchasers answer two critical questions for optimizing stock levels:
- How much to order?
- When to order?
The goal is to help retailers minimize the total costs of inventory. Originally appearing in 1913, it describes a simple inventory planning model showing the tradeoff between holding costs and ordering costs.
EOQ acts as a continuous review system, monitoring inventory nonstop and ordering a fixed quantity once inventory levels reach a specific reorder point. It gives retailers instant replenishment without any shortages or stockouts.
EOQ is a valuable inventory management tactic for small businesses because it helps you decide:
- How much inventory to keep on hand
- How many items to order each time
- How often to reorder to keep costs low
However, the EOQ model requires underlying assumptions in order to work:
- A SKU number demand is constant.
- Inventory is depleted at a fixed rate until it reaches zero.
- Lead time from suppliers is known and constant.
- There are no discounts for bulk ordering.
- All replenishments are received in a lump sum.
The cost of inventory using the EOQ model involves a tradeoff between holding costs and order costs. It helps a small business find the optimal order quantity to minimize the sum of both costs.
Alvaro continues, “If you order a large number of products at one time, it will increase your business’s holding costs. But if you order fewer items, more frequently, it will reduce holding costs but increase order costs.”
The EOQ model helps you plan an inventory system so you never run out of stock and keep customers happy with your brand.
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Importance of calculating EOQ
Retailers miss out on $1 trillion every year due to stockouts alone. Selling out of a popular product could result in lost sales and lost shoppers, because they’ll go to another store to find the desired product. Determining EOQ is one of the most efficient ways to guarantee you’ll have enough stock available.
💡 PRO TIP: Ship-to-customer order fulfillment is the easiest way to prevent stockouts from hurting revenue. Rather than being limited to selling products you have in stock, you can sell products in-store and ship them to customers from your warehouse or another store location that has inventory.
EOQ determines your business’s reordering point. When the stock drops below a certain level, your EOQ formula — when applied correctly — triggers the order for more units. That way, you avoid running out of inventory and can continue fulfilling orders.
Overstocking is having more products than you can sell. Over-ordering inventory leaves you with too much product — a financial drain on your business.
Storage fees are rising every year, so you need to optimize your inventory processes. The longer you hold stock, the higher the holding costs you’ll pay. EOQ, however, determines the middle ground between overstocking and understocking inventory. You’ll know exactly how much product will be ordered at certain inventory levels.
If you have more inventory than you need, you are wasting money, space, and personnel dedicated to caring for that inventory.
Improve cash flow
EOQ not only helps you better plan inventory buys, it also increases cash flow for your business. Inventory is a retail business’s largest asset, other than labor, and you need ample inventory to meet customer demand. The EOQ formula keeps cash out of your inventory balance and in other productive areas.
For example, if you run out of inventory, there’s a shortage cost, which equals revenue loss because you can’t fill orders. If EOQ can minimize inventory levels and lower holding costs while keeping stock constantly available, the extra cash can be used in areas like product development or marketing.
The economic order quantity formula
The EOQ formula is the square root of: [2(setup costs)(demand rate)] / holding costs
Q= √2DS / H
- Q = The number of EOQ units
- D = Annual demand you get for a product
- S = Order cost, or “setup cost,” which is how much one order costs per purchase
- H = Holding costs, or “carrying costs,” which is the total cost of holding inventory
To properly determine EOQ, you’ll need to determine holding costs. These costs refer to all costs involved in storing unsold inventory, including:
- Employee salaries
- Opportunity costs
- Related inventory expenses
Use the following formula to determine inventory holding costs:
Cost of Storage / Total Annual Inventory Value X 100
Example of calculating EOQ
Let’s say you run an electronics store called Geeky Gadgets. You need to purchase 10,000 drones per year to meet demand (D). You incur an order fee of $100 (S) and a holding cost of $15 (H) per drone.
If you want to know your EOQ, you’ll plug those numbers into the formula:
Q= √2DS / H
EOQ = √2 X 10,000 X 100/15 = √133,333
EOQ = 365.14
So whenever Geeky Gadgets orders drones, they should order 366 of them, rounded up to the nearest whole unit.
Challenges with economic order quantity
A business must have the right data to make accurate calculations. EOQ assumes there’s a steady demand for products, and that you can replenish products immediately. It also assumes fixed costs for:
- Inventory units
- Order fees
- Holding fees
This makes it hard, or nearly impossible, for businesses to account for changes in consumer demand or seasonality. If you don’t have correct, real-time data on holding or order costs, you’ll have the wrong amount of inventory, which can quickly lead to a stockout.
Determining the correct amount of inventory requires you to estimate needs based on historical demand. This can be time-consuming if you’re using spreadsheets and have no tracking in place. Inventory management software, however, can pull this information together in a few clicks, so you can apply the right data to your EOQ formula.
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Seasonality and changing demand
The EOQ model is a simple model for products with consistent demand throughout the year. But this isn’t always the case.
Newly launched products may have higher demand in the beginning that decreases over time. Products with seasonal demand — in which sales fluctuate throughout the year — could invalidate EOQ calculations. You can’t simply measure EOQ at the beginning of the year and expect it to hold true. This could lead to periods of stockouts or excess inventory because of inconsistent reordering.
“Every product you have on hand will have a unique EOQ depending on its demand, so there is no blanket order quantity that you can apply across your inventory,” explains Hodge. She continues,
“Seasonality will play a role and demand often shifts over time, so maintaining accurate EOQs requires constant demand and turnover rate monitoring.”
Hodge has managed a storefront for several years, working in merchandising, buying, and sales analysis. She describes a common issue faced by many retailers: “In my boutique, we had a best-selling top that we sold in large quantities for years,” she says.
“However, it was long-sleeved, so it was never as popular during the summer months, and it tended to sell better in neutral as opposed to bright colors. Using sales and inventory data from our point-of-sale (POS) system, we were able to pick up on these trends quickly and adjust our order quantities accordingly.”
Hodge says that nailing down when and how demand for her best-selling top “fluctuated with our customer base allowed us to determine the ideal EOQ of our bestseller, ensuring we always had it in stock for our customers and weren't left with excess in our stock rooms in slower seasons.”
Another limitation of the EOQ model is potential inventory shortages. Some businesses new to using EOQ can be conservative in their reordering, which results in smaller orders and being left understocked in your store.
Calculate EOQ for your store
Mismanaged inventory is a supply chain nightmare for any retailer. It can lead to understocked stores, lost revenue, and — worst of all — unhappy customers who never return.
Use the EOQ model to order the ideal amount of inventory for your store. Run the formula on your in-demand SKU numbers, and check predictions against previous ordering data. You’ll soon start to see the benefits of more cash flow and fewer stockouts using the EOQ model.
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