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Formula and Calculation of Economic Order Quantity (EOQ)
Formula and Calculation of Economic Order Quantity (EOQ)
Q=H2DSwhere
:Q=EOQ units
D=Demand in units (typically on an annual basis)
S=Order cost (per purchase order)
H=Holding costs (per unit, per year)
EOQ is an important cash flow tool. The formula can help a company control the
amount of cash tied up in the inventory balance. For many companies, inventory is
its largest asset other than its human resources, and these businesses must carry
sufficient inventory to meet the needs of customers. If EOQ can help minimize the
level of inventory, the cash savings can be used for some other business purpose or
investment.
Assume, for example, a retail clothing shop carries a line of men’s jeans, and the
shop sells 1,000 pairs of jeans each year. It costs the company $5 per year to hold a
pair of jeans in inventory, and the fixed cost to place an order is $2.
The EOQ formula is the square root of (2 x 1,000 pairs x $2 order cost) / ($5
holding cost) or 28.3 with rounding. The ideal order size to minimize costs and
meet customer demand is slightly more than 28 pairs of jeans. A more complex
portion of the EOQ formula provides the reorder point.
Holding Costs
Another important strategy to minimize holding costs and other inventory spending
is to calculate a reorder point, or the level of inventory that alerts the company to
order more inventory from a supplier. An accurate reorder point allows the firm to
fill customer orders without overspending on storing inventory. Companies that
use a recorder point avoid shortage costs, which is the risk of losing a customer
order due to low inventory levels.
The reorder point considers how long it takes to receive an order from a supplier,
as well as the weekly or monthly level of product sales. A reorder point also helps
the business compute the economic order quantity (EOQ), or the ideal amount of
inventory that should be ordered from a supplier. EOQ can be calculated using
inventory software.
Ordering Cost
The number of orders that occur annually can be found by dividing the annual
demand by the volume per order. The formula can be expressed as:
For each order with a fixed cost that is independent of the number of units, S, the
annual ordering cost is found by multiplying the number of orders by this fixed
cost. It is expressed as:
TOPIC: Reorder level
Reorder level of stock (also known as reorder point or ordering point) in a
business is a preset level of stock or inventory at which the business places a new
order with its suppliers to obtain the delivery of raw materials or finished goods
inventory.
Every business has to maintain a certain level of raw materials or finished goods in
its store. This is done in order to sustain the continuity of production in case of raw
materials and the continuity of sales in case of finished goods. For this purpose, the
business must set a specific level at which it should place a new order with the
suppliers of inventory.
Formula:
The two formulas used to calculate the re-order level are given below:
Maximum demand or usage (in days, weeks or months) × Maximum lead time (in
days, weeks or months)
[Maximum demand or usage (in days, weeks or months) × Maximum lead time (in
days, weeks or months)] + Safety stock
The David IT Store sells 500 laptops on an average in a week. The maximum
demand in a week is 523 laptops. If, the lead time is 4.5 week then the reorder
level would be:
It means that every time the number of laptops decreases to 2,354, the David IT
Store must place a new order.
A business manufactures tires. The average demand for the business is 645
tires/week and the maximum demand is 670 tires/week. To manufacture one tire 3
kilos of rubber is required as raw material. So, the production department of the
business requires a maximum of 2,010 (= 670 × 3) kilos of rubber per week. If the
lead time to get rubber from the supplier is 1.5 weeks then re-order level would be:
The production department must place a new order when the raw material (rubber)
reaches 3,015 kilos.
Usage or demand
Lead time
Minimum lead time: 1.2 months
Average lead time: 1.5 months
Maximum lead time: 1.75 months
Solution