Economic Order Quantity (EOQ) is a term used in inventory management to refer to the ideal quantity of units a company should purchase to meet demand while minimizing inventory costs such as holding costs, shortage, or carrying costs. The EOQ formula is used to identify the optimal number of product units to order, and it assumes that the demand for a product is constant over the year and each new order is delivered in full when inventory reaches zero. The formula takes into account the fixed cost for each order placed, regardless of the number of units ordered, and the cost for each unit held in storage, commonly known as holding cost, sometimes expressed as a percentage of the purchase cost of the item.
EOQ is an important cash flow tool as it can help a company control the amount of cash tied up in the inventory balance. For many companies, inventory is its largest asset other than its human resources, and these businesses must carry sufficient inventory to meet the needs of customers. If EOQ can help minimize the level of inventory, the cash savings can be used for some other purposes.
The EOQ formula can be modified to determine different production levels or order intervals, and corporations with large supply chains and high variable costs use an algorithm in their computer software to determine EOQ. The main benefit of using EOQ is improved profitability, and it can help businesses make data-driven decisions to optimize their inventory levels and reduce costs.
