How Much Should You Buy? Part 1
By Jon Schreibfeder
Over the past several months we have been reviewing the basics of setting replenishment parameters to ensure that you achieve the goal of effective inventory management: meeting or exceeding your customers’ expectations of product availability while maximizing your net profits. Last month, we finished up our discussion of when you should issue a replenishment order. This month, we will explore how much of a product you should actually order.
When placing a replenishment order, how do your buyers decide how much of each item to order? Often reorder quantities are based on “habit” (i.e., “this is the way we’ve always done it”) rather than logic. There is a better way. The economic order quantity (EOQ), derived by a formula available in most software packages, calculates a “best buy” quantity of each item. This is the quantity that will minimize your total cost of each piece of each product that you buy. The EOQ balances four factors:
- The current forecast demand for the product
- The cost of carrying inventory (also known as the “K” cost)
- The cost of issuing a replenishment order (also known as the “R” cost)
- The replacement or landed cost per piece of the item
It is important that these four factors of the EOQ are accurate:
- In previous newsletters we’ve discussed forecast accuracy.
- You can also find articles on the subject on our web site, EffectiveInventory.com.
- We also provide free help in calculating your “K” and “R” costs in the articles “The Mysterious Cost of Carrying Inventory” and “What Does it Cost You to Buy”.
By utilizing an accurate EOQ you will ensure that you are buying the quantity that will maximize your corporate profitability.
The EOQ is calculated with the formula:
The square root of:
(24 * R Cost * Forecast Demand) ÷ (K Cost * Cost per Piece)
Don’t be intimidated by this formula (the idea of a “square root” is kind of scary). Just be able to interpret the results. Let’s look at a couple of examples:
Forecast = 25 pcs per month
K Cost = 21% per year
R Cost = $5 per line item
Cost per Piece = $10
The EOQ = Square Root of: (24*$5*25) ÷ (.21 * $10) = 37.7 ≈ 38 pieces
38 pieces represents about a 45-day supply of the product.
If the cost per piece is raised to $50, we get a different result:
Forecast = 25 pcs per month
K Cost = 21% per year
R Cost = $5 per line item
Cost per Piece = $50
The EOQ = Square Root of: (24*$5*25) ÷ (.21 * $50) = 16.9 ≈ 17 pieces
17 pieces represents about a 20-day supply. Why the difference? It’s the dollars moving through inventory (i.e., the Forecast * Cost per Piece). The EOQ will suggest that if you have a lot of money moving through inventory, you buy smaller quantities, more often. Fewer dollars moving through inventory? The EOQ will encourage you to buy larger quantities, less often. Remember that the EOQ will guide you to buy quantities that will maximize your net profitability.
Next month we will continue our discussion of this powerful replenishment tool! In the meantime, let us know if you have any questions.