As a manufacturer or distributor you always want to keep your inventory as low as possible, but at the same time be able to supply the current demand. In order to do that, you want to make sure you don’t run out of stock but you do not want to hold unnecessary inventory that eats up your cash flow and takes up space in your warehouse.
The question most companies are asking themselves is: How much should I order to minimize my cost of carrying the inventory and minimizing the cost to order the inventory.
In order to make this determination Economic Order Quantity (EOQ) comes into place.
EOQ is essentially an accounting formula that determines the point at which the combination of order costs and inventory carrying cost are the least. The result is the most cost effective quantity to order.
If you are having repetitive purchasing or planning on an item, you should consider applying EOQ. Some obvious examples using EOQ would be purchase-to-stock and make-to-stock. Repetitive buy maintenance, repair, and operating (MRP) inventory is also a good application for EOQ.
The basic EOQ formula is as follows:
SQRT(2 * (Annual usage in units) * (Order Cost) / (Annual Carrying cost per unit))
Annual Usage = 10,000
Cost per order = $2
Cost per unit (CU) = $8
Carrying cost percentage (percentage of CU)= 0.02
Carrying cost per unit = $8*0.02=$0.16
EOQ = SQRT (2*2*10,000 / 0.16) = 500