Economic Order Quantity (EOQ)
Economic Order Quantity EOQ, or Economic Order Quantity, is defined as the optimal quantity of orders that minimizes total variable costs required to order and hold inventory.
Every company worries about two things when deciding how to manage their inventory. How much should we order? And how often should we order? These represent variables that come with their own changing costs. The Economic Order Quantity, or EOQ, is that magic number that represents the optimal quantity of orders that minimizes total variable costs required to order and hold inventory. The EOQ helps us to determine the appropriate amount and frequency when ordering and holding inventory.
How EOQ Works
The Principles Behind EOQ: The Total Cost Curve
In box (a) we see the inventory carrying costs, or the costs associated with holding inventory. These costs increase as you hold more and more inventory.
In box (b) we see the order processing costs, also known as the procurement costs. The costs decrease as the order quantity increases.
In box (c) these two graphs are combined to reflect the total variable costs associated with the order quantity. This new graph is called the Total Cost Curve. By looking at the minimum cost per unit on the graph, we can determine what is the proper order quantity, or Economic Order Quantity.
The Principles Behind EOQ: The Holding Costs
The Holding Costs, as we saw before are variable. They increase the cost per unit as the order quantity grows, such as:
Keeping inventory on hand
Interest
Insurance
Taxes
Theft
Obsolescence
Storage Costs
The Total Cost Formula
Total Cost = Purchase Cost + Order Cost + Holding Cost
The first thing we want to look at is the total cost formula. While this formula does not tell us the EOQ, the derivative of this formula will. The equation for total cost is simply the constant purchase cost, PR, plus the order costs (CR over Q), plus the holding costs (PFQ over 2).
PR represents unchanging fixed
Every company worries about two things when deciding how to manage their inventory. How much should we order? And how often should we order? These represent variables that come with their own changing costs. The Economic Order Quantity, or EOQ, is that magic number that represents the optimal quantity of orders that minimizes total variable costs required to order and hold inventory. The EOQ helps us to determine the appropriate amount and frequency when ordering and holding inventory.
How EOQ Works
The Principles Behind EOQ: The Total Cost Curve
In box (a) we see the inventory carrying costs, or the costs associated with holding inventory. These costs increase as you hold more and more inventory.
In box (b) we see the order processing costs, also known as the procurement costs. The costs decrease as the order quantity increases.
In box (c) these two graphs are combined to reflect the total variable costs associated with the order quantity. This new graph is called the Total Cost Curve. By looking at the minimum cost per unit on the graph, we can determine what is the proper order quantity, or Economic Order Quantity.
The Principles Behind EOQ: The Holding Costs
The Holding Costs, as we saw before are variable. They increase the cost per unit as the order quantity grows, such as:
Keeping inventory on hand
Interest
Insurance
Taxes
Theft
Obsolescence
Storage Costs
The Total Cost Formula
Total Cost = Purchase Cost + Order Cost + Holding Cost
The first thing we want to look at is the total cost formula. While this formula does not tell us the EOQ, the derivative of this formula will. The equation for total cost is simply the constant purchase cost, PR, plus the order costs (CR over Q), plus the holding costs (PFQ over 2).
PR represents unchanging fixed