Inventory Management with COVID-19 Part 7
The Economic Order Quantity (EOQ)
In the last two newsletters we have examined your costs of carrying inventory and replenishing inventory. You must know both of these costs to help determine the “best buy quantity” of an item. That is, the cost that will minimize your total cost of inventory, and as a result, maximize your profitability. Most computer systems include a formula to calculate this best buy quantity, also known as the economic order quantity or EOQ.
The most common version of the EOQ is the square root of:
24 * Cost of Replenishing Inventory * Monthly Forecast
÷
Carrying Cost % * Cost per Piece
Let’s look at several examples of how recommended purchase quantities are calculated using the economic order quantity formula:
Example #1: Product A120
Forecast Demand = 25 pieces per month
Unit Cost = $10.00
Cost of Ordering = $ 5.00
Carrying Cost = 20%
Square Root of:
[(24 * 5 * 25) ÷ (.20 * $10)] ≈ 39
The economic order quantity is suggesting that when stock of item #A120 is replenished, you order 39 pieces. As the demand forecast for the product is 25 pieces per month (or 0.83 pieces per day), this order quantity represents about a 47 day supply (39 ÷ 0.83 = 47 day supply).
The economic order quantity will vary depending on the total cost of the product passing through inventory each month. This value can be calculated by multiplying the demand forecast by the unit cost. In the example above, $250 (25 pieces * $10 cost) pass through inventory each month. The higher the value of product passing through inventory, the smaller the economic order quantity (in terms of day’s or week’s supply) of the product.
Let’s look at another example. Here the unit cost is $50.00, much higher than the $10.00 used in the first example:
Example 2: #B240
Forecast Demand = 25 pieces per month
Unit Cost = $50.00
Cost of Ordering = $ 5.00
Carrying Cost = 20%
Square Root of:
[(24 * 5 * 25) ÷ (.20 * $50)] ≈ 17
The economic order quantity suggests that when you replenish stock of product #B240, you order 17 pieces or about a 20 day supply (17 pieces ÷ 0.83 pieces/day = 20 day supply). This is less than one half of the 47 day supply the EOQ suggested for the first item. Why? Well, while $250 of the first item passes through inventory each month, $1,250 of the second item passes through inventory each month by being sold, transferred or used internally. Remember, THE GREATER THE NUMBER OF DOLLARS OF A PRODUCT PASSING THROUGH INVENTORY, THE SMALLER THE ECONOMIC ORDER QUANTITY. That is, in terms of day’s or week’s supply of the product.
You may be confused. Isn’t it common sense to buy a lot of what sells? Let’s look at it from another angle. The EOQ suggests that a distributor should order less of an expensive fast-moving product, more often. Remember that you invest in inventory and expect to earn a return on your investment. Every time you sell a product, you (hopefully) get back what you paid the vendor and earn a profit. If you buy a dollar of inventory from a vendor and then sell it, you have “turned” that dollar once. That is, the dollar’s back in your bank account (hopefully accompanied by a profit) and can be used again. If you buy more inventory with that dollar and then sell it, you’ve turned that dollar again. Every time you “turn” a dollar, you have an opportunity to earn a profit. Those profits are used to pay salaries, other expenses, and hopefully provide a return on investment to the owners.
In these challenging economic times it is important to maximize profitability. Utilizing the EOQ will help you achieve this goal. Be sure to refer to earlier newsletters in this series for help in accurately forecasting future demand of products and other replenishment-related activities.