Understanding Economic Order Quantity (EOQ)

Hi guys, Ian Johnson from DriveSuccess.com. Today we're going to talk about calculating economic order quantity. And we're going to use a very simple and straightforward formula. We're going to use what's called the Wilson EOQ formula. This is a formula that's been around for a hundred years. in 1913. There are some pros and cons to this formula, but it's important to note that a lot of things have changed in terms of business over the last 100 years. So what we're going to do today is we're going to go over exactly how the formula is used. I'm going to go through this example up here. on the board. I'm going to show you how to determine your economic order quantity, and then we'll just talk about some of the drawbacks and the benefits of using the formula in terms of identifying the ideal quantity in terms of purchasing raw materials or consumables, what have you. So what we're going to do today is we're going to go over these variables, and I'm going to show you how the calculation is done. Again, the calculation is very simple. It's not terribly difficult to understand. However, there are certain variables that go into the calculation that are quite... involved and they do take some analysis on your part in order to make sure that your calculation is accurate. Because one of the biggest mistakes companies make when it comes to calculating economic order quantity is they basically gloss over their costs to purchase those raw materials and their holding costs of inventory. So let's just basically go over these variables and I'll show you exactly how the calculation is done. And when we get to the cost of purchasing and the cost of holding inventory, I'll kind of delve into that a little bit further. So annual usage is the simple... portion, simplest portion of the calculation, you should know exactly how much you use of a given raw material, a consumable or finished good. That's fairly simple. In our example it's 3,000 units. So this is going to, we're going to call this A. Again, the price. It's fairly simple to understand how much are you paying for this part that you're buying. In this case it's $20. The cost to actually make the purchase. Now this is not a per unit cost. Rather this is the cost that is included in terms of actually going ahead and getting an approval, doing a purchase requisition, placing the order, sending the order out to your vendor, emailing or faxing, and receiving the incoming shipment, inspecting the parts, and putting them on the shelf in your warehouse, and then paying your vendor. Now, this may not seem like that much, but what you've got to take into consideration when you do this portion of the equation is that your cost of purchasing has to be taken across. all of the orders that you process. So it may not seem like a lot, but the fact is that it's really broken down in terms of how many orders you process and what those aforementioned costs are in terms of receiving, inspection, putting them on the shelf, and doing all those other things. Holding costs of inventory. This is critical. Now, a link just popped up above my head. This link is going to give you a sample Excel spreadsheet. It's going to allow you to determine your specific inventory carrying costs. or your specific holding cost of inventory. Now these are the costs to hold inventory without sales. Now the thing is is that the reason why you have to click on this link and go to my website in order to figure this out is because your holding costs as a company are always different from one company to the next. It's different for companies that operate in business to business markets. It's different for companies that operate in business to consumer markets. And it's not just your cost to finance inventory. A lot of companies think that their holding cost of inventory is nothing more than the cost of financing the inventory. There's so much more that's included in that. First of all, there's the cost of obsolescence, parts, finished goods, and obsolescence in terms of raw materials. There's the cost of pilferage, theft. It's a big issue in business-to-consumer markets. The cost of inventory damage, cost of insurance, the per-unit freight cost to get parts into your warehouse. So that... That aforementioned link that I mentioned earlier, it's going to allow you to determine your specific inventory holding costs by giving you a percentage of the inventory value on hand. In our example, we're just going to take 3% because once you do the calculation, you're going to probably come close to that 3%. Most companies apply 3% as a standard holding cost for the inventory value on hand. And that's made up of all those other things I mentioned. Cost of financing, obsolescence, damage, pilferage. insurance per unit freight cost, cost of counting, handling, all those things. So in this case, the holding cost of inventory, we're going to take the price of the unit, which is $20, multiplied by our holding cost of inventory, which is 3%, and it gives us $0.60. So let's put this all into the equation. So let's call cost of purchasing, I just don't want to forget about this, CP, and holding costs, we're going to call this HC, holding costs. Okay, so the calculation goes like this. You're going to take 2, okay, and you're going to multiply it by A, and then you're going to times this number times your cost to purchase, times CP, and you're going to divide everything by your holding costs, HC. Okay, so we're going to plug everything into the equation, EOQ. equals, it's going to be 2 times 3,000, it's going to be 6,000, multiplied by the cost of purchase, which is going to be 2, divided by 0.60, which is our holding cost. Okay? So this is going to be EOQ. is going to equal to 12,000, 6,000 times 2, divided by 0.60, and our EOQ is going to be square root of 20,000. Okay, so once you take 12,000 divided by 0.60, it's going to be 20,000. That means your EOQ... I'm sorry, I'll leave it there. make sure that's EOQ, is going to equal 141 units. Okay? 141 units. That is the ideal quantity where your costs to purchase and your costs of holding inventory are minimized. Now if you wanted to take this EOQ quantity and say how many orders are we going to place throughout the day, the year, you just take 3,000 units, 3,000 divided by 141, and you're going to get 21 orders. So throughout the year, you're going to place 21 orders, and you're going to buy 141 units at a time. And in this case, what you've done is you have minimized your cost of purchase and your holding cost of inventory. Now, this formula is very straightforward. It's not terribly difficult. However, as I mentioned earlier, the problems arise when you have to determine your specific costs to make the purchase and what your specific inventory holding costs are. You've got to calculate what this number is, okay? Because, as I said earlier, you know, your holding cost of inventory depend upon the type of market you operate. in, the type of customers you sell to, your business model. And, you know, again, you know, business to business markets, you know, issues of obsolescence and damage are maybe more prevalent than business to consumer markets where theft and pilferage is a bigger concern. So make sure you calculate your holding costs of inventory, okay? Again, this is a very simple and straightforward formula. We've used it all. We've determined that our economic order quantity is 141 units and we're going to place 21. orders throughout the year based on 3,000 units purchased in a given year. Now let's just talk about some of the drawbacks. First of all the EOQ formula again it's a hundred years old and it makes a lot of assumptions. The first thing is it assumes that the lead time from your vendors is constant and doesn't change. We know that doesn't happen. It also assumes that the price stays the same and again it doesn't account for any discounts or anything else like that. It also assumes that your ordering costs are constant and that they don't change and of course that's not the case. And it also assumes that your demand in terms of the units that you purchase in at the year is going to be constant as well. So there's a lot of drawbacks to the formula. It's a good formula and it's something you want to look at when you look in terms of you know when you're calculating safety stock. Another link just popped up above my head. This will show you how to do a proper calculation of safety stock and EOQ plays a role role in that in terms of when you hit your reorder point. So that's it, economic order quantity, simple calculation, more difficult parts, the cost of purchasing, holding cost of inventory. So that's it, economic order quantity, Ian Johnson, driversuccess.com. Bye bye.

Hi guys, Ian Johnson from DriveSuccess.com. Today we're going to talk about calculating economic order quantity. And we're going to use a very simple and straightforward formula.

We're going to use what's called the Wilson EOQ formula. This is a formula that's been around for a hundred years. in 1913. There are some pros and cons to this formula, but it's important to note that a lot of things have changed in terms of business over the last 100 years. So what we're going to do today is we're going to go over exactly how the formula is used. I'm going to go through this example up here.

on the board. I'm going to show you how to determine your economic order quantity, and then we'll just talk about some of the drawbacks and the benefits of using the formula in terms of identifying the ideal quantity in terms of purchasing raw materials or consumables, what have you. So what we're going to do today is we're going to go over these variables, and I'm going to show you how the calculation is done. Again, the calculation is very simple.

It's not terribly difficult to understand. However, there are certain variables that go into the calculation that are quite... involved and they do take some analysis on your part in order to make sure that your calculation is accurate.

Because one of the biggest mistakes companies make when it comes to calculating economic order quantity is they basically gloss over their costs to purchase those raw materials and their holding costs of inventory. So let's just basically go over these variables and I'll show you exactly how the calculation is done. And when we get to the cost of purchasing and the cost of holding inventory, I'll kind of delve into that a little bit further.

So annual usage is the simple... portion, simplest portion of the calculation, you should know exactly how much you use of a given raw material, a consumable or finished good. That's fairly simple.

In our example it's 3,000 units. So this is going to, we're going to call this A. Again, the price. It's fairly simple to understand how much are you paying for this part that you're buying. In this case it's $20.

The cost to actually make the purchase. Now this is not a per unit cost. Rather this is the cost that is included in terms of actually going ahead and getting an approval, doing a purchase requisition, placing the order, sending the order out to your vendor, emailing or faxing, and receiving the incoming shipment, inspecting the parts, and putting them on the shelf in your warehouse, and then paying your vendor.

Now, this may not seem like that much, but what you've got to take into consideration when you do this portion of the equation is that your cost of purchasing has to be taken across. all of the orders that you process. So it may not seem like a lot, but the fact is that it's really broken down in terms of how many orders you process and what those aforementioned costs are in terms of receiving, inspection, putting them on the shelf, and doing all those other things. Holding costs of inventory.

This is critical. Now, a link just popped up above my head. This link is going to give you a sample Excel spreadsheet. It's going to allow you to determine your specific inventory carrying costs. or your specific holding cost of inventory.

Now these are the costs to hold inventory without sales. Now the thing is is that the reason why you have to click on this link and go to my website in order to figure this out is because your holding costs as a company are always different from one company to the next. It's different for companies that operate in business to business markets. It's different for companies that operate in business to consumer markets. And it's not just your cost to finance inventory.

A lot of companies think that their holding cost of inventory is nothing more than the cost of financing the inventory. There's so much more that's included in that. First of all, there's the cost of obsolescence, parts, finished goods, and obsolescence in terms of raw materials. There's the cost of pilferage, theft. It's a big issue in business-to-consumer markets.

The cost of inventory damage, cost of insurance, the per-unit freight cost to get parts into your warehouse. So that... That aforementioned link that I mentioned earlier, it's going to allow you to determine your specific inventory holding costs by giving you a percentage of the inventory value on hand.

In our example, we're just going to take 3% because once you do the calculation, you're going to probably come close to that 3%. Most companies apply 3% as a standard holding cost for the inventory value on hand. And that's made up of all those other things I mentioned. Cost of financing, obsolescence, damage, pilferage.

insurance per unit freight cost, cost of counting, handling, all those things. So in this case, the holding cost of inventory, we're going to take the price of the unit, which is $20, multiplied by our holding cost of inventory, which is 3%, and it gives us $0.60. So let's put this all into the equation.

So let's call cost of purchasing, I just don't want to forget about this, CP, and holding costs, we're going to call this HC, holding costs. Okay, so the calculation goes like this. You're going to take 2, okay, and you're going to multiply it by A, and then you're going to times this number times your cost to purchase, times CP, and you're going to divide everything by your holding costs, HC. Okay, so we're going to plug everything into the equation, EOQ. equals, it's going to be 2 times 3,000, it's going to be 6,000, multiplied by the cost of purchase, which is going to be 2, divided by 0.60, which is our holding cost.

Okay? So this is going to be EOQ. is going to equal to 12,000, 6,000 times 2, divided by 0.60, and our EOQ is going to be square root of 20,000.

Okay, so once you take 12,000 divided by 0.60, it's going to be 20,000. That means your EOQ... I'm sorry, I'll leave it there. make sure that's EOQ, is going to equal 141 units. Okay?

141 units. That is the ideal quantity where your costs to purchase and your costs of holding inventory are minimized. Now if you wanted to take this EOQ quantity and say how many orders are we going to place throughout the day, the year, you just take 3,000 units, 3,000 divided by 141, and you're going to get 21 orders.

So throughout the year, you're going to place 21 orders, and you're going to buy 141 units at a time. And in this case, what you've done is you have minimized your cost of purchase and your holding cost of inventory. Now, this formula is very straightforward.

It's not terribly difficult. However, as I mentioned earlier, the problems arise when you have to determine your specific costs to make the purchase and what your specific inventory holding costs are. You've got to calculate what this number is, okay?

Because, as I said earlier, you know, your holding cost of inventory depend upon the type of market you operate. in, the type of customers you sell to, your business model. And, you know, again, you know, business to business markets, you know, issues of obsolescence and damage are maybe more prevalent than business to consumer markets where theft and pilferage is a bigger concern. So make sure you calculate your holding costs of inventory, okay?

Again, this is a very simple and straightforward formula. We've used it all. We've determined that our economic order quantity is 141 units and we're going to place 21. orders throughout the year based on 3,000 units purchased in a given year. Now let's just talk about some of the drawbacks.

First of all the EOQ formula again it's a hundred years old and it makes a lot of assumptions. The first thing is it assumes that the lead time from your vendors is constant and doesn't change. We know that doesn't happen. It also assumes that the price stays the same and again it doesn't account for any discounts or anything else like that.

It also assumes that your ordering costs are constant and that they don't change and of course that's not the case. And it also assumes that your demand in terms of the units that you purchase in at the year is going to be constant as well. So there's a lot of drawbacks to the formula.

It's a good formula and it's something you want to look at when you look in terms of you know when you're calculating safety stock. Another link just popped up above my head. This will show you how to do a proper calculation of safety stock and EOQ plays a role role in that in terms of when you hit your reorder point.

So that's it, economic order quantity, simple calculation, more difficult parts, the cost of purchasing, holding cost of inventory. So that's it, economic order quantity, Ian Johnson, driversuccess.com. Bye bye.

Transcript for:Understanding Economic Order Quantity (EOQ)

Transcript for:
Understanding Economic Order Quantity (EOQ)