Economic Order Quantity (EOQ)
Definition
Economic Order Quantity (EOQ) is an essential tool in inventory management that helps businesses determine the most cost-effective amount of inventory to order at any given time. The primary goal of EOQ is to minimize the total cost associated with ordering and holding inventory, which includes order costs (costs incurred in issuing purchase orders) and holding costs (costs associated with storing inventory).
\[ EOQ = \sqrt{\frac{2DS}{H}} \]
- D: Demand rate (units per period)
- S: Ordering cost per order
- H: Holding cost per unit per period
Examples
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Example 1: A retail company sells 24,000 units of a specific product annually. The cost to place one order is $100, and the holding cost per unit per year is $12. Applying the EOQ formula:
\[ EOQ = \sqrt{\frac{2 \times 24000 \times 100}{12}} \approx 200 \text{ units} \]
Hence, the company should order 200 units at a time.
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Example 2: A manufacturer requires 12,000 units of raw material every year. The cost of placing one order is $50, and the holding cost per unit per year is $5. Using the EOQ formula:
\[ EOQ = \sqrt{\frac{2 \times 12000 \times 50}{5}} \approx 346 \text{ units} \]
Thus, the manufacturer should order approximately 346 units per order.
Frequently Asked Questions (FAQs)
Q: What happens if the order quantity is larger than the EOQ?
A: Ordering more than the EOQ can lead to higher holding costs, which might not be economical in the long term as it increases the overall cost of inventory.
Q: Can EOQ be used for perishable goods?
A: EOQ can be adapted for perishable goods, but it requires considering additional factors such as shelf-life and spoilage costs, which are not typically included in the basic EOQ model.
Q: How does lead time affect EOQ?
A: Lead time does not directly affect the EOQ formula but plays a crucial role in determining the reorder point. The reorder point ensures that new stock arrives before the existing stock runs out.
Q: Is EOQ applicable to all types of inventory?
A: EOQ is most effective for items with steady demand and stable holding and ordering costs. It may be less effective for items with highly variable demand or significant demand seasonality.
- Reorder Point (ROP): The inventory level at which a new order should be placed to replenish stock before it runs out.
- Holding Costs: The costs associated with storing and managing inventory, such as warehousing, insurance, and spoilage.
- Ordering Costs: The costs related to placing and receiving orders, including administrative costs, shipping, and handling.
- Safety Stock: Extra inventory carried to reduce the risk of stockouts due to unexpected demand or supply delays.
Online References
Suggested Books for Further Studies
- “Inventory Management and Production Planning and Scheduling” by Edward A. Silver, David F. Pyke, and Rein Peterson
- “Operations Management: Processes and Supply Chains” by Lee J. Krajewski, Manoj K. Malhotra, and Larry P. Ritzman
- “Principles of Inventory Management: When You Are Down to Four, Order More” by John A. Muckstadt
Accounting Basics: Economic Order Quantity (EOQ) Fundamentals Quiz
### What is the primary goal of computing Economic Order Quantity (EOQ)?
- [x] To minimize the total costs of ordering and holding inventory.
- [ ] To maximize sales volume.
- [ ] To reduce order lead time.
- [ ] To calculate profit margins.
> **Explanation:** The primary goal of EOQ is to determine the most cost-effective quantity of inventory to order at one time, minimizing both ordering and holding costs.
### Which of the following is NOT a component considered in the EOQ formula?
- [ ] Ordering costs
- [ ] Holding costs
- [x] Sales revenue
- [ ] Demand rate
> **Explanation:** The EOQ formula considers ordering costs, holding costs, and demand rate, but it does not take sales revenue into account directly.
### Which factor remains constant in the basic EOQ model assumptions?
- [x] Demand rate
- [ ] Holding costs
- [ ] Ordering costs
- [ ] Lead time
> **Explanation:** In the basic EOQ model assumptions, the demand rate remains constant to simplify the calculation. Variability in demand rate requires a more complex model.
### In the EOQ formula, what does the variable "D" represent?
- [ ] Holding cost per unit per period
- [ ] Ordering cost per order
- [x] Demand rate
- [ ] Discount rate
> **Explanation:** In the EOQ formula, "D" represents the demand rate, which is the number of units required per period.
### What would happen if an order quantity is smaller than the EOQ?
- [x] More frequent orders and higher ordering costs.
- [ ] Lower holding costs and overall costs.
- [ ] Reduced demand and higher lead times.
- [ ] Increased sales revenue.
> **Explanation:** Ordering quantities smaller than the EOQ results in more frequent orders, thereby increasing ordering costs even though it might reduce holding costs.
### How frequently should a company place orders according to the EOQ calculation?
- [ ] Whenever inventory is low.
- [ ] Based on supplier availability.
- [x] At intervals determined by dividing annual demand by EOQ.
- [ ] Once per year.
> **Explanation:** Companies should place orders at intervals determined by the quantity calculated by dividing the annual demand by the EOQ to maintain optimal inventory levels.
### Which cost does EOQ aim to minimize?
- [ ] Only ordering costs
- [ ] Only holding costs
- [x] The total of ordering and holding costs
- [ ] Marketing costs
> **Explanation:** EOQ aims to minimize the combined total of ordering and holding costs to find the most cost-efficient order quantity.
### What is the impact of reduced holding costs on EOQ?
- [x] EOQ decreases.
- [ ] EOQ increases.
- [ ] EOQ remains unchanged.
- [ ] Holding costs do not impact EOQ.
> **Explanation:** If holding costs decrease, EOQ also decreases because the cost of storing inventory is lower, thus more frequent smaller orders become more economical.
### EOQ is primarily beneficial for which type of demand pattern?
- [x] Regular and stable demand.
- [ ] Highly seasonal demand.
- [ ] Completely unpredictable demand.
- [ ] Sporadic demand.
> **Explanation:** EOQ is primarily beneficial for managing regular and stable demand patterns, as it simplifies ordering by balancing costs effectively for predictable demands.
### What kind of inventory items are least suitable for the EOQ model?
- [ ] Items with predictable demand.
- [ ] Non-perishable goods.
- [x] Perishable goods with short shelf lives.
- [ ] High-value items.
> **Explanation:** Perishable goods with short shelf lives are least suitable for the EOQ model as it doesn’t typically take into account the perishability factor.
Thank you for learning about Economic Order Quantity (EOQ). Taking on challenging accounting concepts and quizzes helps to strengthen your knowledge base and prepares you for practical applications in the field of inventory management. Keep up the excellent work!
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