EOQ formula and EOQ factors

The EOQ formula is as follows.

EOQ = Square root of [(2 x demand x ordering cost) / carrying cost]

Demand

The demand remains constant according to the assumptions made by EOQ. The demand is how
much inventory is used per year or how many units are sold per year.

Ordering cost

The EOQ formula contains the ordering cost which is a fixed cost. This is how much you spend
on placing and then receiving your order. This cost includes all the resources you need to put into
receiving the order. For instance, making calls, sending reminder emails, and taking delivery-
related costs are used to calculate the ordering cost. It includes the time it takes for the order to
reach you as well. Ordering cost can be calculated by dividing the demand per year by volume
per order. When you have to pay a fixed amount for the order regardless of order quantity, you
can calculate ordering cost per year by dividing demand per year by volume per order multiplied
by set cost.

Carrying cost

The carrying cost is also known as the storage cost or holding cost of inventory. It is what you
need to spend to store your inventory in a warehouse. The carrying cost includes warehouse fees
and opportunity costs. If the inventory is destroyed or stolen from the warehouse then it can be a
part of the carrying cost. If you are paying interest to purchase inventory, then the amount you
are paying to the bank should be made part of the carrying costs. The insurance costs with regard
to the inventory are also taken into account in carrying cost calculation. Carrying costs are
variable costs as they will depend on your inventory.

EOQ formula example

EOQ formula is best understood with a simple example. Let us say that you are a dog products
retailer. You sell leashes, muzzles, brushes, treats, collars, chews, bowls, dog food, and more.
You want to know how much inventory of designer collars you should keep. You sell each
designer collar for $7. In a month you sell 30 collars which equate to 360 collars per year. The
ordering cost is $10 per order because you are taking into account the processing time and people
who work for you. The carrying cost for collars is $2 per unit and this includes the opportunity
cost.

Here is how the economic order quantity is calculated for this scenario.

EOQ = Square root of [(2 x demand x ordering cost) / carrying cost]

EOQ = Square root of [(2 x 360 x 10) / 2]

EOQ = Square root of [3600]

EOQ = Square root of [3600]

EOQ = 60

This means you need to have at least 60 collars in the inventory to ensure you are rightly stocked
at any given time. You can use the same EOQ formula to calculate how many leashes, muzzles,
treats, and chews you should keep so you avoid understocking and overstocking.