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Economic Order Quantity and Procurement for Beginners

August 23, 2018 0ProcurementSupply Chain

Have you ever stocked your shelves and wondered, “Why am I always ordering this product?” This is why Economic Order Quantity (EOQ) is a key aspect of procurement. Economic order quantity is basically a formula to ensure you are ordering the proper amount of stock at the right point in time.

Some people new to the role may purchase an amount of product that they feel a company requires now. However, experienced purchasers also anticipate and predict demand. They will purchase items that are required over a year to three years. On average companies tend to save about 5 to 10% in this area. By doing purchasing this way companies can also save up to 50% on their sourcing

Economic Order Quantity Simplified:

What does economic order quantity account for?

EOQ = √(2*K*D / H)

Above is the economic order quantity formula used. For some, myself included, this looks like an entirely new language.

To make this formula even easier for you we made an excel template that will calculate EOQ for you. To download our EOQ excel template please click here.

So let’s break it down:

First is the yearly demand (D). This is how much of a specific product your company will need. Now you may not want to do it over a yearly basis as some companies do it over 2 to 3 years, depending on perishability and depreciation.

The next factor is setup cost (K). K stands for a number of factors, but mostly shipping and handling.

Next is holding cost (H), or how much it costs to warehouse and store the product. For a full understanding of what this may cost you read our article here.

Q tells us exactly how many we should order of the specific product.

How can I start to implement this in my business?

Part of this exercise is finding the re-order point, or the stock level that triggers the need to order more of said product/supply. In the EOQ model, one assumption is that no safety stock is held. This can be risky because if demand is not constant backorders/shortages may occur. However, if demand is very consistent there is no need to hold safety stock, which is a lean concept. Below is the formula to calculate the reorder point.

Reorder Point

RO Point = D * ( L / WD )

Demand (D) (see above for elaboration – how much of a specific product your company will need)

L equals the lead time, measured in days. One of the things economic order quantity also accounts for is the time it takes to receive a product. This is important for timing, but also so that product doesn’t sell out, which leads to lost revenue. Many customers will not wait for backorders to be filled.

WD equals working days in a year.

Understanding Economic Order Quantity is Vital for Business

EOQ is a key part of cost accounting, but it also affects procurement and logistics. To download our EOQ excel template please click here.

For more insight into logistics, operations, and procurement planning; submit your requirements and TQS will build you a business plan.


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