Saturday, 14 February 2015

What is Economic Order Quantity and its application in Finance management

What is Economic Order Quantity?
Economic Order Quantity or EOQ is that quantity of any purchase order that is placed at each indent so as to add optimum units to the inventory at minimum overall costs. It is that ordering quantity which reduces the over all costs of inventory like ordering costs, holding costs and shortages or losses. 

What are the Inventory Costs?
Before studying How to calculate EOQ, let us know about the Inventory cost components. Inventory cost is made up of these following components.

  • Unit cost: This is the purchase price per unit of the item purchased.
  • Order Cost: This is the cost incurred in placing an order. It includes the transportation or shipment cost, handling charges and any other payments like octroi and toll tax, etc. incurred per each order.
  • Holding Cost: This is the storage cost incurred in keeping the stock like rent of the building or godown, insurance, interest paid or lost due to capital invested, salaries paid to stores staff and any other costs like refrigeration, maintenance, etc. incurred in storing the inventory.
  • Losses: This element of cost is due to shortages, damages to items during handling, or loss due to tear and wear of stocks. All these losses are to be borne by the business. So, they are included to the cost of stocks by increasing their unit cost.

How to calculate Economic Order Quantity?
EOQ is calculated using a formula EOQ = square root of {(2*D*S)/H}
Q is the Economic Order Quantity
D is the annual demand for quantity
S is the cost for placing an order known as order cost (some put is as K also)
H is the holding cost per unit and losses can be added to this holding cost

Let us consider an example.
Suppose, your business enjoys an annual demand of 1,000,000 bags of cement
Placing one order, say, costs $10 and let holding cost be $2 per 1000 bags or .002 per bag

Now, according to above formula, EOQ = the square root of {2*1000000*10 / .002}= square root of 
20,000,000/0.002 = square root of 20,000,000*1000/2 = square root of 10000, 000,000 = 100,000 bags
So EOQ is 100, 000 bags. You need to place orders for 100, 000 bags each time to maintain your inventory costs at lowest levels. So you will place total 10 orders in a year each being of 100,000 bags. 

The above is a sample for calculating Economic Order Quantity in a more or less reasonable sense. But there are some factors that may affect the accurate calculations in actual circumstances.

Factors affecting EOQ calculation
  • Employing EOQ formula assumes that prices are constant at a given period during the gap between calculation and its application.
  • It is assumed that orders are placed at exhaust of present inventory and it gets replenished immediately through immediate deliveries from suppliers.
  • It also assumes that interest rates and rentals do not change during the period.
  • It further assumes that demands are constant and there is no variation in the demanded quantity for that goods during that period.
A more prudent way of applying this EOQ method for better management
As we can not guarantee or get assured of changes in tastes and prices or any of the factors governing EOQ calculation, it will be more advisable for a good finance manager to check the calculations at frequent intervals to ensure its efficient application to manage inventories. If the initial calculations prove to be wrong or of no more feasible, you can change the calculations according to present circumstances and modify your orders to achieve minimal negative impacts due to the variations in factors controlling your Economic Order Quantity calculations.

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