Economic Order Quantity (EOQ): Definition, Formula, Calculation, Examples & Applications

 

1. Definition

Economic Order Quantity (EOQ) is the optimal order quantity a business should purchase to minimize the total cost of inventory. It balances ordering costs (costs of placing orders) and holding costs (costs of storing goods) to achieve maximum cost efficiency.

2. Meaning in Detail

The EOQ model helps businesses decide how much stock to order at one time. Ordering too frequently increases ordering costs (administration, shipping), while ordering in large quantities increases holding costs (storage, insurance, depreciation). EOQ finds the sweet spot where total inventory costs are the lowest.

Developed by Ford W. Harris in 1913, EOQ is still widely used in inventory management, supply chain planning, and manufacturing.

It assumes constant demand, fixed ordering costs, and stable holding costs.

3. Components of EOQ

1. Ordering Cost (Co) – The expense of placing a single order (e.g., admin costs, supplier charges).

2. Holding Cost (Ch) – The annual cost of storing a single unit of inventory.

3. Demand (D) – The total number of units required per year.

4. Purchase Cost – Cost of acquiring inventory (not directly used in EOQ formula but relevant for overall cost).

4. EOQ Formula

$$EOQ=\sqrt{\frac{2\times D\times Co}{C\mathrm{h}}}$$

Where:

• D = Annual Demand (units)

• Co = Ordering Cost per Order

• Ch = Annual Holding Cost per Unit

5. Example Calculation

Example:
A company sells 10,000 units per year.

• Ordering Cost (Co) = ₹500 per order

• Holding Cost (Ch) = ₹2 per unit per year

$$EOQ = \sqrt{\frac{2 \times 10,000 \times 500}{2}}$$$$EOQ = \sqrt{\frac{10,000,000}{2}}$$$$EOQ = \sqrt{5,000,000}$$

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$$EOQ \approx 2236 \ \text{units per order}$$

Interpretation:
The company should order 2,236 units at a time to minimize total inventory costs.

6. Key Features of EOQ

• Cost Optimization – Minimizes total ordering and holding costs.

• Simple Calculation – Based on a mathematical formula.

• Inventory Balance – Prevents overstocking and stockouts.

• Demand-Driven – Requires accurate demand forecasting.

• Static Model – Works best in stable, predictable demand scenarios.

7. Importance in Business

• Cost Control – Reduces overall inventory expenses.

• Cash Flow Efficiency – Frees up working capital.

• Operational Planning – Ensures smoother production cycles.

• Supplier Coordination – Aligns ordering schedules with supply chain capacity.

8. Advantages & Disadvantages

Advantages:

• Simple and effective model.

• Improves decision-making.

• Reduces waste and storage costs.

Disadvantages:

• Assumes constant demand and lead time (not always realistic).

• Ignores bulk discount benefits.

• May be inaccurate during seasonal demand changes.

9. Usage in Business

EOQ is used by:

• Manufacturers – To plan raw material purchases.

• Retailers – To restock goods efficiently.

• Wholesalers – To manage large-scale inventory.

• E-commerce stores – To balance warehouse costs and fast delivery needs.

10. Case Studies

Case Study 1 – Amazon Warehouse Management
Amazon uses modified EOQ models to determine order batches for millions of SKUs, balancing quick delivery with minimal storage time.

Case Study 2 – Toyota Production System
Toyota applies EOQ-based principles in its Just-In-Time system to order only what is needed, reducing holding costs significantly.

11. Practical Example (With Table)

Parameter	Value
Annual Demand (D)	10,000 units
Ordering Cost (Co)	₹500 per order
Holding Cost (Ch)	₹2 per unit
EOQ	2,236 units

This means the business should place about 5 orders per year (10,000 ÷ 2,236 ≈ 4.47).

12. Common Mistakes / Misunderstandings

• Assuming EOQ works for fluctuating demand without adjustments.

• Ignoring seasonal trends.

• Forgetting to update holding and ordering costs regularly.

• Using EOQ without considering supplier discounts.

13. Real-Life Applications

• Retail chains like Walmart use EOQ to keep shelves stocked without excess storage.

• Pharmaceutical companies use EOQ to prevent expiration of medicines.

• Food industry uses EOQ to avoid spoilage.

14. FAQs

Q1: Is EOQ relevant in modern supply chain systems?
A: Yes, especially for stable demand products. Many companies modify EOQ to adapt to dynamic markets.

Q2: Can EOQ be used in e-commerce?
A: Absolutely, especially for standard products with steady sales patterns.

Q3: What happens if we order less than EOQ?
A: It increases ordering costs and can lead to stockouts.

15. Expert Tip from Learn with Manika

“EOQ is not a one-time calculation. Reassess your ordering quantity periodically to adapt to market changes, cost fluctuations, and demand trends.”

16. Related Terms

• Inventory Turnover Ratio
• Reorder Point (ROP)
• Just-In-Time (JIT) Inventory
• Safety Stock
• Lead Time