by D. Victor

Created on: March 03, 2010   Last Updated: March 06, 2010

Inventory management requires classification and determination of inventory costs and measurement of stock levels. In maintaining adequate levels of inventory, it is necessary to order the right amount of inventory at the right time to maximize the benefits of holding inventory against its costs. As such, the Economic Order Quantity (EOQ) determines the "order quantity that minimizes inventory costs."

The EOQ is a function of demand, holding costs and ordering costs. It can be calculated using a formula (that uses the aforementioned variables), table or graph. According to the formula, the Economic Order Quantity is the square root of the quotient of [2 X Ordering Cost of a consignment X Demand/Holding Cost per unit). The graph of the EOQ demonstrates the relationship in a more lucid manner. The EOQ is where the holding cost line intersects the ordering cost curve.

If you refer to how costs are classified in cost accounting, you would realize that holding costs are variable costs and ordering costs are fixed per order. Therefore, total ordering costs are higher with smaller inventory levels while total holding costs rise with the inventory level. The graph demonstrates the relationship between a Total Fixed Cost (Ordering) and Total Variable Cost (Holding). This also explains why the "ordering costs" line is a curve and the holding costs are a straight line.

The aim of the Economic Order Quantity is to minimize Total Inventory Cost. This occurs where the total holding costs are equal to the costs of ordering. This is logical because there is a trade-off between holding costs and ordering costs. If you have no inventory, your ordering costs would be exponential—your suppliers would charge for delivery each time, bulk discounts would not be available and staff would be very active in receiving regular orders. However, if you maintain too much inventory you would incur significant holding costs. This is because the business might need more staff, equipment and storage space to handle high inventory levels.

Going back to the concept of inventory levels, recall that the reorder level is: maximum usage X maximum lead time. The maximum level is: Reorder level + reorder quantity – (minimum usage X minimum lead time). Using these, the EOQ dictates how much to reorder when the reorder level is reached. However, by definition, whatever quantity is the optimum amount should not take stock levels past the maximum level. This is because the maximum level serves as a warning when inventory levels are too high for the business to manage properly (and where holding costs are significant).

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