When you replenish the stock of an item, you must decide how much you should order. Many computer systems utilize the economic order quantity (EOQ) formula in helping to make this decision. The formula was originally developed by Ford W. Harris in 1913. Since that time, there have been many refinements and derivations of the formula.
The version of the EOQ equation used in most computer systems today is the square root of:
(24 * Cost of Reordering * Monthly Demand) ÷ (Cost of Carrying Inventory * Unit Cost)
- “24” is a constant, it will never change.
- The cost of reordering (also known as the “R” Cost) is the cost of buying and receiving a single line item on a replenishment order; regardless of the actual quantity made or purchased.
- The monthly demand is the quantity of the product you predict will be sold or used in an upcoming month.
- The cost of carrying inventory (also known as the “K” Cost”) is the cost of maintaining a dollar’s worth of inventory in your warehouse for an entire year. It is expressed as a percentage. So, a K Cost of 21% means that it costs you 21 cents to maintain a dollar’s worth of inventory in your warehouse for an entire year.
- Finally, the unit cost is the landed cost (i.e., including freight, inspection and other charges) of buying one piece of the product.
The EOQ is not perfect. Even Harris said it should only be used as a guide in making replenishment decisions. It is essential that buyers understand how to interpret and refine the results. In this process buyers often ask where did the constant of “24” come from? What does it mean?
- Harris’ original formula was the square root of: (Cost of Reordering * Annual Demand) ÷ [(Cost of Carrying Inventory * Unit Cost) ÷ 2]
- The numerator and denominator of the equation are multiplied by two to remove the division by “2” within the denominator.
- There is now a constant of “2” in the numerator: (2* Cost of Reordering * Annual Demand) ÷ (Cost of Carrying Inventory * Unit Cost).
- But demand for products fluctuates throughout the year, so R.H. Wilson in a revision of the EOQ equation, replaced the Annual Demand in the numerator with Monthly Demand. And because there are 12 months in a year, the constant of “2” became “24” (2 * 12 Months equals 24).
The result is the version of the EOQ equation that most computer systems use today:
(24 * Cost of Reordering * Monthly Demand) ÷ (Cost of Carrying Inventory * Unit Cost)
But remember that the EOQ is only meant to be a guide in deciding how much of a product should be made or purchased. Next month we will explore how to interpret the results of the EOQ equation and adapt them to real world circumstances.