Economic Order Quantity (EOQ)

Every time a fresh purchase order is placed, the business incurs an ordering cost (paperwork, follow-up, inspection, etc.), and every unit of material kept in store for a period of time incurs a carrying cost (storage, insurance, interest on capital locked up, obsolescence risk). Ordering material too often keeps carrying cost low but pushes up total ordering cost; ordering in very large lots keeps ordering cost low but pushes up carrying cost. The Economic Order Quantity is the order size that strikes the best balance between these two opposing costs.

Formula for EOQ (in words): EOQ equals the square root of "2 × Annual Usage (in units) × Ordering Cost per Order", the whole of that divided by the Carrying Cost per unit per annum.

Named more simply: EOQ = √(2 × A × O ÷ C), where A = Annual usage/consumption in units, O = Ordering cost per order (₹), and C = Carrying cost per unit per annum (₹).

A useful property of the EOQ, worth remembering for numerical problems, is that at the EOQ, the Total Ordering Cost for the year exactly equals the Total Carrying Cost for the year — this equality is what makes the combined total cost lowest at that particular order quantity, and it is a good way to check that an EOQ answer is correct.

Advantages of ordering at the EOQ:

• Minimises the combined total of ordering cost and carrying cost for the year.
• Avoids both very frequent small orders (which raise ordering cost) and very large infrequent orders (which raise carrying cost and lock up working capital).
• Provides an objective, calculable basis for deciding order size, rather than an arbitrary guess.
• Helps in planning storage space and working-capital requirements more accurately.

Limitations of the EOQ formula:

• It assumes annual usage, ordering cost, and carrying cost stay constant throughout the year, which is rarely exactly true in practice. …