How Does EOQ Help Companies Cut Cost?

EOQ helps in determining the ideal order size. One can manage your inventory or purchases efficiently for any other product you regularly buy. It also helps in finding a perfect balance between ordering too much and too little.

Table of Contents

• What is EOQ?
• Scenario-Based Explanation of EOQ
• Calculating Economic Order Quantity
• Uses of EOQ model
• How does EOQ help companies in cutting costs?

What is EOQ?

Economic Order Quantity (EOQ) helps companies figure out the ideal number of units of a product to order at once. It aims to minimise the total cost of ordering and storing inventory. This means finding the perfect balance between the cost of placing orders like paperwork or shipping and the cost of keeping products in stock like storage and the money tied up in unsold items. EOQ helps businesses save money by making sure they don't order too much or too little of a product.

Scenario-Based Explanation of EOQ

Imagine you have a favourite snack, like potato chips, that you buy regularly from the store. You don't want to run out of chips, but you also don't want to buy so many that they go stale before you can eat them. This is where EOQ comes in.

EOQ is a formula that helps you find the perfect balance between buying too many chips and buying too few. It considers two main costs: the cost of ordering more chips (like the time and effort it takes to go to the store) and the cost of holding onto the chips (like the space they take up and the risk of them going stale).

Here is how it works:

1. Demand: First, you figure out how many bags of chips you usually eat in a given period, let us say a month.
2. Ordering Cost: You also determine how much it costs you each time you go to the store to buy chips, including transportation costs and your time.
3. Holding Cost: You calculate how much it costs to store the chips at home, taking into account things like storage space and the risk of them going bad.
4. EOQ Calculation: Using a formula, you can find the ideal quantity of chips to buy each time you go to the store. This quantity is known as the Economic Order Quantity (EOQ).

EOQ helps you make sure you buy just the right amount of chips so that you do not run out too often (saving you extra trips to the store) and you do not end up with too many stale chips (saving you money and space). 

Calculating Economic Order Quantity

The Economic Order Quantity (EOQ) can be calculated using a simple formula. Here is the Economic Order Quantity formula:

EOQ = √((2 * D * S) / H)

Here are the components of the EOQ model:

• EOQ (Economic Order Quantity): This is the optimal order quantity you want to determine. It represents the ideal quantity of a product to order at one time to minimize the total inventory costs, including ordering costs and holding costs.
• D (Annual Demand): D stands for the annual demand for the product, which is how much of the product you expect to use or sell in a year. It is a measure of how frequently you will need to replenish your inventory.
• S (Ordering Cost per Order): S represents the ordering cost per order. This cost includes expenses associated with placing and receiving an order, such as paperwork, shipping, and any setup costs.
• H: Also known as Annual Holding Cost per Unit of Inventory, it represents the annual holding cost per unit of inventory. It accounts for the cost of holding or storing a single unit of the product in your inventory for a year. This cost includes expenses like storage space, insurance, capital tied up in inventory, and potential spoilage or obsolescence costs.

Now, let us walk through a scenario-based calculation of EOQ:

Let's say you run a small bakery, and you need to order flour regularly to make your delicious bread. You find that your annual demand for flour is 1,000 bags. The ordering cost for each order (including delivery) is $50, and the annual holding cost for each bag of flour (storage, spoilage, interest on tied-up capital, etc.) is $5.

Using the EOQ formula, you can calculate the optimal order quantity:

EOQ = √((2 * D * S) / H)

EOQ = √((2 * 1,000 * $50) / $5)

EOQ = √((100,000) / $5)

EOQ = √20,000

EOQ ≈ 141 bags (rounded to the nearest whole number)

So, in this scenario, the optimal order quantity (EOQ) for flour is approximately 141 bags. This means that you should order 141 bags of flour at a time to minimize your total inventory costs. Ordering more or less than this quantity could result in higher overall costs.

By using the EOQ, you can ensure that you order the right amount of flour to meet your bakery's demand while keeping your ordering and holding costs as low as possible which helps in improving your bakery's financial efficiency.

Uses of the EOQ Model

The EOQ model is used by businesses for several purposes:

1. Inventory Optimization: The primary purpose of the EOQ model is finding the optimal order quantity that minimizes the total inventory cost. By using this model, companies can determine how much of a product to order at a time to ensure that they don't hold excess inventory (which incurs high holding costs) or order too frequently (which incurs high ordering costs).
2. Cost Reduction: EOQ helps in reducing the overall costs associated with inventory management. It allows companies to save money by finding the right balance between ordering and holding costs.
3. Improved Cash Flow: By optimizing inventory levels, businesses can free up capital that might otherwise be tied up in excess inventory. This allows improved cash flow and more financial flexibility.
4. Efficient Replenishment: EOQ helps in scheduling and planning the replenishment of inventory, ensuring that products are available to fulfil customer demand without overstocking or understocking.
5. Minimized Stockouts and Overstock: EOQ helps in minimizing the risk of stockouts (running out of products) and overstock situations (holding excess inventory), which can be costly and impact customer satisfaction.

How Does EOQ Help Companies in Cutting Cost?

The Economic Order Quantity (EOQ) model helps in cutting costs by optimizing your inventory management in several ways:

1. Reducing Order Costs:

EOQ calculates the optimal order quantity, minimizing the number of orders you need to place, thus reducing the formula:

• Ordering expenses: Administrative costs like placing orders, processing invoices, and handling deliveries.
• Transportation costs: Fewer orders mean less frequent delivery charges.

2. Minimizing Holding Costs:

By ordering the optimal quantity, you hold less inventory on average, leading to:

• Reduced storage costs: Lower space rental, equipment, and personnel expenses for storing inventory.
• Minimized risk of spoilage, obsolescence, or damage: Less inventory sitting around means less chance of it expiring, becoming outdated, or getting damaged.

3. Balancing Order and Holding Costs:

EOQ finds the sweet spot between ordering too often and holding too much inventory. This balance helps:

• Optimize overall inventory costs: You're not spending too much on orders or holding unnecessary inventory.
• Improve cash flow: By reducing costs and optimizing inventory levels, you free up cash for other business needs.