Economic order Quantity (EOQ) is a popular model while determining optimum order quantity a firm must place on its suppliers.
There are advantages as well disadvantages of ordering either large quantity of small quantity.
There are two key elements of cost with ordering process:
Inventory carrying cost
Every time an order is placed, a certain fixed cost is incurred which is called Fixed ordering cost
Once a certain quantity has been ordered and that arrives at warehouse, it needs to be carried at warehouse till the full order quantity gets consumed over a period.
Assuming annual demand being fixed, making a large order quantity every time an order is placed, reduces number of orders in a year and therefore total annual cost of ordering. However, ordering large quantity every time an order is placed ensures more quantity is carried at a time in the warehouse resulting in higher inventory carrying cost.
Ordering Low quantity every time an order is placed yields opposite result i.e. higher annual ordering cost due to more number of orders annually and lesser inventory being carried resulting in lesser inventory carrying cost.
The key issue is therefore strike the right balance between annual ordering cost and annual inventory carrying cost through optimization. The best solution will be to minimize:
Total annual ordering cost + Total annual inventory carrying cost
The order quantity which minimizes total annual ordering plus annual inventory carrying cost is called EOQ
The standard formula for EOQ = Square root (2 x Co x D/Ch)
D = Annual demand for the item
Co = Ordering cost every time an order is placed
Ch = Annual unit inventory carrying cost
Companies can and should use EOQ model to effectively control its inventory management process. The high value items which are procured throughout the year which are popularly known as “A” class items under ABC / pareto analysis of inventory management can be sourced using EOQ model to optimize their cost of procurement.