What is Economic Order Quantity (EOQ)?
Economic order quantity (EOQ) is the optimum inventory size at which annual total costs of ordering and holding are minimum.
The major problem that comes while inventory management is how much inventory should be added when inventory is replenished. If the firm is buying raw materials, it has to decide lots in which it has to be purchased on replenishment. In addition to this, if a firm is planning a production run, the issue is how much production to schedule. These problems are known as order quantity problems.
The task of the firm is to determine the optimum or economic order quantity (economic lot size).
In order to determine an optimum inventory level involves two types of costs –
- Ordering costs
- Carrying costs
Ordering cost includes the entire costs of acquiring raw materials. It include costs involves in following activities –
- Purchase ordering
Ordering costs increase in proportion to the number of orders placed. It increases with the number of orders. Thus the higher the inventory size, higher will be ordering costs. On the other hand, if the firm maintains large inventory levels, order size will be small and hence the ordering costs will be relatively small. Thus ordering costs decrease with increasing size of inventory.
Costs incur in maintaining a certain level of inventory refers to carrying cost of inventory. They include storage, insurance, taxes, deterioration and obsolescence. The storage cost comprise cost of storage space, stores handling costs and clerical and staff service costs. It varies with inventory size. This behavior is contrary to that of ordering costs which decline with increase in inventory size. The economic size of inventory thus depend on trade off between carrying cost and ordering costs.
Economic order quantity = √2×quantity required×ordering cost/carrying cost
Example of Economic Order Quantity
Total quantity requirement is 1200 units, ordering cost per order is Rs. 37.50 and carrying cost per unit is Rs. 1. Compute EOQ.
EOQ = √2×1200×37.5/1
= 300 units