Too much or too little inventory can lead to significant external costs, from loss of sales to excess warehousing fees. By managing economic order quantity (EOQ), ecommerce companies can stay on top of their logistics and fulfillment needs while minimizing expenses.
Economic order quantity (EOQ) is the number of units a business orders at one time to meet customer demand without overspending on excess inventory or warehouse space. Ecommerce businesses use EOQ to minimize their holding costs and reduce excess inventory. Proper use of EOQ also helps prevent backorders, which could drive customers to competitors.
The EOQ model looks at purchasing costs and delivery costs as well as product demand, discounts, and holding costs like warehouse management expenses. EOQ can help you determine the optimal order size to place with vendors, and whether product discounts are worth taking advantage of.
Economic order quantity is closely related to the reorder point (ROP). Learn more about the reorder point formula.
Before you can calculate your EOQ, you’ll need to determine the value of three key variables in the EOQ formula: demand, order cost, and holding cost.
The EOQ formula uses annual demand, or the number of units sold in a year. Though order volume may vary due to seasonality, you can use historical data and growth projections to estimate the number of units you anticipate selling in a year.
The order cost used in the EOQ formula is calculated on a per-order basis. This is the total cost for each purchase order, including shipping and handling fees.
Holding costs account for all the expenses associated with storing your product, from warehouse fees to depreciation. To determine your holding costs, you can use this formula:
Let’s further explore the variables included in holding cost.
Here’s an example, using a hypothetical company that sells jigsaw puzzles for $10 apiece. Last year, they held 10,000 units of inventory.
First, the company calculated the following:
Now the company needs to calculate its opportunity cost. Let’s say they sell 10 puzzle designs, and held 1,000 units of each design last year. While the company sold all 10,000 puzzles for a $100,000 profit, the most popular design was on backorder within 9 months, while the least popular design barely sold out by year’s end.
If the company had optimized its stock to hold 1,500 units of the popular design and 500 units of the unpopular design, it could have brought in $105,000.
The opportunity cost = (Return from unchosen scenario) – (Return from chosen scenario).
So, the puzzle company’s calculated opportunity cost would be as follows:
Opportunity cost = $105,000 – $100,000.
The opportunity cost is $5,000.
Lastly, the company has to determine its depreciation cost.
Let’s say the company’s designs are updated every year. Once new designs are released, the old ones are sold at a 50% discount. If it costs the company $50,000 to produce the puzzles, and the salvageable cost at the end of the puzzles’ lifespan is $25,000, they can calculate their depreciation.
The inventory’s depreciation = (Cost to make goods) – (Salvageable value) / (Inventory lifespan)
So for the puzzle company, the calculation would look like this:
$50,000 – $25,000 / 2 = $12,500
Now the company has all the data it needs to calculate its holding cost. Remember:
Holding cost = [(Storage Costs + Employee Salaries + Opportunity Costs + Depreciation Costs) / Total Value of Annual Inventory]
The holding cost is [($6,000 + $0 + $5,000 + $12,500) / $100,000] = .235, or 23.5%.
For the purpose of calculating EOQ, you’ll need the holding cost per unit.
The puzzle company’s puzzles are $10 apiece, so 23.5% would set the per-unit holding cost at $2.35.
In general, EOQ applies when the demand for a product remains consistent over the year, each order has a fixed cost, and each item in storage has a holding cost.
The mathematical formula used to calculate EOQ is EOQ = √[2DS/H], where:
EOQ is used to determine the ideal number of product units to order that will minimize delivery, storage, and purchase costs. Using the EOQ also helps businesses control their cash flow by understanding the amount of capital that is tied up in inventory at any given time.
In most cases, ecommerce businesses no longer directly calculate the EOQ. Instead, they use modern inventory management software to quickly calculate the EOQ. Still, it’s helpful to understand the basic calculation.
Here’s an example of the EOQ calculation, using the same puzzle company as our earlier example, assuming the puzzle company orders inventory several times per year:
The puzzle company’s EOQ would be the square root of [(2 x 10,000 x 5,000) / 2.35] = 6,523.
This would mean that the puzzle company would need to order inventory twice per year to meet demand of 10,000 puzzles.
Businesses can use their inventory management software to set automatic reorder points so that when inventory reaches a certain level, an order is automatically made to keep EOQ and inventory levels correct and maintain a safety stock.
Using EOQ helps you set the optimal order level from your supplier. However, ecommerce businesses also have to engage in constant inventory management to ensure they can meet shifting demand throughout the year.
A logistics provider like Airhouse can help businesses maximize their inventory efficiency. Instead of checking inventory levels to reorder products, businesses can set automatic reorder points using their EOQ metrics as a guideline.
Safety stock is also key to optimizing inventory levels. Businesses want to have enough on hand to deal with a sudden supplier crisis or a surge in demand. It is also important for handling seasonal fluctuations like holiday demand or response to a large promotion. Using modern inventory management software can help ecommerce businesses build a cushion, since they track inventory in real time.
The economic order quantity formula can tell businesses the optimal order size for each product. In general, EOQ assumes that demand remains flat, which may complicate factors for fast-growing ecommerce businesses, but this model can help companies roughly plan the number of orders per year as well as the size of each order.
Ecommerce businesses can adapt the EOQ model to accommodate defective items, backorders, discounts, and other changes. There are several major benefits of using EOQ for an ecommerce business:
Airhouse makes it easy for ecommerce businesses to benefit from the EOQ formula. With real-time tracking, automatic reorder notifications, and instant calculations, your ecommerce business can maximize inventory efficiency quickly and easily. Schedule a demo with our fulfillment experts today to learn more.
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