Managing stock and inventory effectively is a challenge every retail and e-commerce operation faces. With so many variables at play – availability, lead times, market competition, seasonal demand fluctuations, and more – getting it right requires careful planning.
For businesses, especially smaller ones, the costs of overstocking or understocking can be significant. These decisions are too important to rely on guesswork, which is why determining the right amount of stock to order at the right time is essential.
This is where the EOQ formula – Economic Order Quantity – comes in. In this guide, we’ll break down the EOQ formula, explain how to calculate economic order quantity, and explore why EOQ is a critical tool for inventory management, from the shelves to the warehouse and beyond.
What is the EOQ formula?
The EOQ formula may look complicated at first glance, but it’s easier to understand than it may seem. The formula is:
EOQ = square root of 2SD/H
In simple terms, here is what each variable stands for:
- D: Demand – The total number of units required to meet customer demand
- S: Ordering Cost – The cost associated with placing an order for one unit
- H: Holding Cost – The cost of storing one unit in inventory for one year
Why is EOQ in inventory management important?
The EOQ formula plays a more significant role than it might seem, influencing not only operational efficiency behind the scenes but also sales and revenue.
Optimising costs
Making the right stock-ordering decisions is crucial for controlling costs. Overordering can lead to excessive holding costs, while underordering risks lost sales and unhappy customers. By maintaining a steady flow of inventory – bringing in stock regularly and selling it promptly – businesses can maximise profitability while minimising storage expenses.
Right-sizing inventory to capital
Excess inventory ties up valuable capital, limiting cash flow and potentially straining business operations. Maintaining a balanced level of stock ensures that working capital remains available for other priorities and supports a healthier overall balance sheet.
Informing forecasting
Accurate EOQ calculations play a key role in improving forecasting. By using this data, retailers can plan confidently for future demand, aligning inventory management with known variables such as seasonal peaks and shifts in customer behaviour.
Maximising resource efficiency
Accurate stock and demand forecasting benefits manufacturers as well as retailers. By providing clear insights into how many items are needed, manufacturers can streamline their operations, avoid overproduction or shortages, and cut costs. This efficiency can ripple through the supply chain, with manufacturers passing on savings to retailers, creating a win-win scenario.
Enabling smoother operations
A predictable and well-managed supply chain ensures everything runs like clockwork. When suppliers and logistics providers know exactly how many units to expect and when, it minimises disruptions. This consistency allows shipping and warehousing needs to be planned more effectively, avoiding unnecessary costs and bottlenecks while improving overall operational efficiency.
Supporting stronger supplier relationships
The EOQ formula doesn’t just improve processes – it strengthens partnerships. By placing consistent, predictable orders, retailers build trust with their suppliers. Over time, this reliability can lead to better relationships, opening the door to more favourable terms, faster lead times, or even volume discounts.
Satisfying more customers, more often
By avoiding understocking, businesses can ensure customers receive the products they want, when they want them. In today’s highly competitive, digital-first marketplace, where consumers can easily shop elsewhere, reliable fulfilment is crucial. Meeting customer expectations consistently not only boosts satisfaction but also helps build trust and loyalty, creating a strong foundation for long-term success.
How do you calculate economic order quantity?
To calculate EOQ, start by defining the key variables in the formula:
- Demand (D): Estimate the total annual demand for the product. Use historical sales data or forecast future demand based on market trends and consumer behaviour
- Ordering cost (S): Add up all the costs involved in placing an order, such as wholesale prices, administrative costs, and shipping fees. If purchasing in bulk, divide the total cost by the number of units to get a per-unit cost
- Holding cost (H): Calculate the annual cost of storing one unit of the product, including warehousing, insurance, and the opportunity cost of tied-up capital
Once you’ve defined these values, use the EOQ formula:
EOQ = Square root of [(2 × D × S) ÷ H]
EOQ example calculation
Let’s calculate the EOQ for a beauty product with the following data:
- Annual demand (D): 5000 units
- Ordering cost (S): £40 per order
- Holding cost (H): £5 per unit per year
Here is the calculation step-by-step:
- Multiply demand (D) by ordering cost (S):
5000 × 40 = 200,000
- Multiply the result by 2:
200,000 × 2 = 400,000
- Divide by holding cost (H):
400,000 ÷ 5 = 80,000
- Find the square root of the result:
√80,000 ≈ 282.84
The EOQ for this product is approximately 283 units per order.
While you can’t always meet this exact figure, rounding to the nearest convenient quantity (e.g., 300 units) ensures smoother inventory management.
What should I do once I’ve established the EOQ figure for a particular product?
If you were to order in too much stock too soon, then you’ll rack up unnecessary storage and warehousing costs. But if you don’t order in enough, then you’ll be unable to meet demand and miss out on sales and revenue to your competitors.
What the EOQ formula does is strike the perfect balance, establishing not only how much stock you should buy in per order, but also how often you should place your orders.
To summarise how this would work, let’s return to the example above. We’ve established that demand (D) is 5000 units per year, and that the EOQ (the ideal number of units that should be ordered at a time is 282.84.
Dividing 5000 by 282.84 gives us 17.677 – this means that the retailer should be placing orders 17.677 times per year. If we then divide 365 (the number of days in a year) by 17.677, we get 20.648.
This suggests that one order should be placed every 20.648 days – rounding up to 21, this means the retailer now knows that they should be placing a new order once every three weeks.
What are the challenges around implementing the EOQ formula and calculation?
Economic Order Quantity (EOQ) calculations rely on fixed values for demand (D), ordering costs (S), and holding costs (H). However, these variables can change frequently, requiring recalculations to maintain accuracy. Regularly updating EOQ can be time-consuming, particularly for businesses dealing with fluctuating demand and costs.
Technology solutions, such as inventory management software, can help automate these calculations by integrating real-time data for D, S, and H. However, these tools can be expensive or overly complex for smaller e-commerce businesses. In such cases, alternative approaches—such as simpler forecasting models or outsourcing to expert logistics providers—may offer a more practical solution.
Here are the key factors that can impact EOQ variables:
Variations in demand
Demand for products rarely stays static. Seasonal peaks, such as Christmas or Chinese New Year, and trends driven by social media can significantly influence how much stock is needed.
Variations in order and holding costs
Ordering and holding costs are influenced by a variety of factors, including:
- Warehousing and staffing costs
- Insurance premiums
- Shipping and delivery rates
- Supplier pricing
- Administrative expenses in procurement
These fluctuations can impact the total cost of managing inventory, directly affecting the EOQ.
Interlinked demand
Demand for one product often influences demand for another. For instance, a spike in paint sales could lead to an increase in demand for paintbrushes. These dependencies add complexity to EOQ calculations, especially when both products are subject to their own variations.
What should I do if I need help with inventory management?
Managing stock effectively goes beyond calculating a formula – it’s about having the right systems, expertise, and support in place to keep your operations running smoothly. At ILG, we specialise in helping e-commerce businesses optimise their inventory and logistics processes, ensuring you always have the right stock in the right place at the right time.
Our services include seamless inventory management, forecasting advice, and advanced warehousing solutions, all designed to give you a competitive edge. Whether you’re looking to improve efficiency, reduce costs, or adapt to changing demand, our team is here to help.
Join the many e-commerce businesses already partnering with us to streamline their logistics and achieve long-term success. Contact us today to find out how we can do the same for you.
FAQs
Are there any types of goods where EOQ may not be suitable?
The EOQ formula is most effective for goods with stable demand and long shelf lives. Perishable items, such as food and beverages, are not ideal for EOQ calculations due to their limited holding time. Similarly, items with highly unpredictable demand may not benefit as much from EOQ-based inventory planning.
How often should I calculate Economic Order Quantity?
There’s no fixed schedule for recalculating EOQ – it depends on how frequently the underlying variables change.
- For products with consistent demand and costs, EOQ may only need recalculating every few months
- In industries with frequent demand fluctuations or seasonal trends, monthly or even weekly recalculations may be necessary
Any significant changes in demand, ordering costs, or holding costs should prompt a review to ensure the EOQ remains accurate.
Are there circumstances that can result in unusually high or low EOQs?
- High EOQs: New businesses may see higher EOQ figures due to initial setup costs for ordering and holding inventory. While this can seem daunting, it helps establish a foundational stock level
- Low EOQs: High holding costs reduce the EOQ, as storing inventory for extended periods becomes less economical. In these cases, ordering smaller quantities more frequently can be more cost-effective
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