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The basic formula in dollars is:
EOQ = √2cu/h
Where:
c = Cost of placing an order
u = Total annual units that you expect to order.
h = Annual cost of holding the product in inventory
Looks like a voodoo economics for sure and for many years I held this formula in strong doubt. Eventually, I discovered that the square root technique is used by mathematicians as a method of determining an average.
Ordering costs are all those costs that you incur every time you place an order, receive the product from the order, and account for that order. They include the time of the purchasing people to make and transmit the PO and follow-up on its status. Receiving costs would include the cost of people to check and move the inventory into the warehouse. Accounting costs would include both the accounting departments cost to record the invoice and pay the bill as well as all of the other recording costs involved with the transaction. Recognizing what it costs to place an order can easily exceed $100 per order may lead you to the conclusion that you should place one order each year and then let the purchasing department go. Well maybe not.
Nothing is free and holding costs are the penalty you pay for storing product on your site. They include the cost of capital invested in the inventory, the insurance premium to cover it while in stock, wastage, handling costs, and building costs. Recognizing that annual holding costs may be as high as 20% above the original product cost could lead you to decide that you will only order product when a customer has already bought it. Nice idea, but customers generally don't feel too good about stores with empty shelves and what about that $100 plus ordering cost?
Now you can see the advantages of using EOQ to balance the cost of placing the order with the cost of holding the product. However, be warned that this answer will not work will in situations where:
Look for EOQ options in the inventory control module before you buy any accounting software. Otherwise, get your slide rule out.
11/15/00
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