Economic Order Quantity(EOQ): A Deep Dive into the Science of Inventory Management
Over many years, I've seen firsthand how crucial effective inventory management can be. One tool that started the science of modern inventory management is the Economic Order Quantity (EOQ) formula. Since I received an enquiry about it last week, I thought I would explore the concept and show how it can benefit retailers.
The Origins of EOQ
A bit of history: in 1913, a mathematician named Ford W. Harris was pondering a theoretical shop stock control. He wasn't thinking about colourful products or bustling aisles. Instead, Harris was fixated on a more fundamental question: How often should a shop order its stock to keep costs down and do inventory optimization?
He derived his formula called EOQ, and modern inventory management was born.
Breaking Down the EOQ Formula
The formula he derived is this:
EOQ = Sqr(2 x D x K / h)
Where:
- D = is how much you sell in a period.
- K = Cost per order
- h = Holding cost per unit (how much it costs you to have the stock sit in your shop for a period)
Generally, it's over a year, so let's break this down with a real-world example and see what it can tell us.
A Real-World Example: The Stationery Shop
So I took a stationery shop that uses our POS System. Here's how we would use the EOQ formula to find how many times we should order to give us the best profit.
Annual Demand (D)
It sold 60,575 items last year in the shop. That's a lot of pens and paper!
Cost per Order (K)
I asked the woman who was in charge of the stationery order, and she told me that each order there was about
- 3 hours to place an order @ $25/hour
- 4 hours to pick up the order @ $25/hour
- $10 for petrol
- $20 for delivery fees
Total: $205 per order
Annual Holding Cost per Unit (h)
This is where things got eye-opening. We included:
- Bank fees and overdraft: 2.5%
- Shrinkage (a polite way of saying 'theft'): 1.5%
- Portion of rent: $15,000 a year
- Other costs from profit and loss: $10,000
When we crunched the numbers, it came to $1.08 per item per year. That's a lot if you think about it.
Let us do the calculation.
Now we have the figures, let us calculate the following:
EOQ = √[(2 x 60,575 x 205) / 1.08]
Let's break down the calculation step by step:
- First, multiply 2 x 60,575 x 205 = 24,835,750
- Then, divide this by 1.08: 24,835,750 / 1.08 = 23,014,583.33
- Finally, take the square root: √23,014,583.33 = 4,797.35
Rounding to the nearest whole number, we get 4,797. That is a lot of ordering.
Interpreting the Results
When we plugged all this into our EOQ formula, it suggested ordering 4,779 times a year. That's many times every day!
I don't know about you, but I've never met a retailer who wants to place orders daily. It's just not practical.
Practical Tips from EOQ
While the EOQ formula does not here give you a perfect ordering schedule, it does highlight some crucial points:
-
Holding stock is expensive: $1.08 per item per year adds up quickly. Our total inventory of 60,575 items is $65,421 annually, just in holding costs!
-
Frequent, smaller orders can be cost-effective. This approach aligns with many successful retailers' formula of order to do its' "little and often" philosophy.
-
One size doesn't fit all: What works for our stationery shop might not work for a pet shop or a newsagency.
How do you derive your figures using POS Solutions?
Calculating a simple EOQ requires three variables, which I will discuss point by point, quoting two departments as an example for you to work with as an example of stationery that I used above.
The demand quantity (D)
This is the quantity of goods moved.
There are two ways of doing this: the top sales report will give you this figure.
Cost of ordering (K)
I just asked about the procedure used in the shop and then costed it.
Holding costs (h)
Your profit and loss will help you here. If you are doing it by department, take a reasonable percentage of the total costs.
I got the average stock holding to calculate my holding costs. So I went to the stock turn report in the stock reports.
The Bottom Line
Executive summary
Here are some practical tips:
-
Calculate your holding costs: You might be surprised at what you find. Include all inventory costs, such as warehouse space, insurance, and potential depreciation. Your profit and loss will tell you most of this.
-
Review your ordering process: Write a typical order scenario in your shop. While doing so, I suggest you streamline this process to reduce costs. Maybe bulk ordering certain items could lead to discounts that offset increased holding costs.
-
Consider a mix of strategies: Perhaps you should place frequent orders for fast-moving items and less frequent orders for others. Use EOQ as a starting point, but adjust based on your business's unique needs.
-
Use technology to your advantage: Our POS system can help you track inventory and make smarter ordering decisions frequently and accurately.
EOQ does not offer a flawless ordering plan. It indeed confirms certain crucial aspects of inventory management.
Over the years in retail, I've seen that the most prosperous retailers use data and their gut feelings. So, while you should crunch the numbers, don't discount the value of your gut feelings.
Frequently Asked Questions (FAQ)
What is Economic Order Quantity (EOQ)?
Economic Order Quantity is an analytics formula for determining the optimal number of times to order stock to maximize profit.
How is EOQ calculated?
The EOQ formula is: EOQ = √[(2 x D x S) / H], where D is annual demand, S is setup cost per order, and H is holding cost per unit per year.
What are the benefits of using EOQ?
EOQ is a theoretical construction that helps balance ordering and holding costs, minimise total inventory costs, and optimize stock levels.
Can EOQ be used with seasonal products?
Probably not. EOQ becomes less effective if, over some time, you have fluctuating demand.
What's the difference between EOQ and reorder point?
EOQ determines the best number of times to order, while the reorder point is an inventory management system that concerns inventory levels. The EOQ may help you to derive this reorder point.
How can I implement EOQ in my business?
Your profit and loss statement and your POS System will give you the information you need to calculate your shop's EOQ. If you do so, please let me know what you get.
