In 1913, the world was first introduced to the Economic Order Quantity (EOQ) formula. This revolutionary approach would soon go on to redefine the discipline of supply chain management.
But in today’s volatile world, is this 100-year-old formula still relevant?
The answer, of course, is yes!
For many businesses, inventory is typically one of the biggest assets on the balance sheet. If you’re in the manufacturing industry, it’s likely your inventory costs could take up 40% of your total.
For retailers or wholesalers, the number’s even higher. And in some cases, it can be as large as 50%.
That’s a whopping outlay. And something that needs careful management. Owning, maintaining, and managing inventory takes a lot of time, effort and money. And if you get it wrong, it causes a huge amount of stress throughout the entire business.
You obviously need enough in the warehouse to make sure customers are satiated. But you never want too much. After all, in these times of high inflation, soaring costs and general economic woe, it’s never been more important to keep your inventory levels in check.
And for this reason, the Economic Order Quantity is just as useful today as it was back in 1913.
In this article, we’ll dive the into topic of Economic Order Quantity. We will explore how you can use this formula to make better supply chain decisions.
We’ll highlight how you can apply the EOQ principles within your business. And for good measure, we will highlight some potential pitfalls you should watch out for.
The order quantity conundrum
Ordering quantities touch many areas of your business. None more so than inventory height.
Naturally they influence the frequency and volume with which you order. But they’re a big influencer on the day-to-day efficiency of your supply chain operations. As such, the process of determining order quantities should be thought out, planned and strategic.
In practice, this often is not the case.
Order quantities are often not underpinned by strategy or well-intentioned plans but dictated by suppliers. Sometimes, the situation’s even worse and nobody knows how the EOQ number was reached at all.
This leaves a scenario where disproportionate order quantities arise. And in turn, you’ll see expensive mistakes. Mistakes like high inventory levels, unnecessary risks in obsolescence, excessive waste, and the need for additional storage capacity.
On the other hand, order quantities that are too small cause inefficiencies throughout the supply chain and wider business processes. All of which lead to avoidable cost.
But how can you avoid all of this? Simply ordering the right amount of stock is a great place to start.
Ordering correct quantities will lower your operational expenses while boosting your return on inventory investment.
It will help you ensure you can offer your customers the best possible availability with the lowest possible level of stock. And this, in turn, results in a huge improvement on your bottom line.
What is the EOQ formula
Before, we go any further, let’s start with basics.
The EOQ formula was developed by Ford W. Harris in 1913 and updated later on by Wilson (1915) and Camp (1922). Since then, the Economic Order Quantity has become a supply chain staple that has been studied and discussed at length in lecture halls and boardrooms alike.
Economic Order quantity is a big part of supply chain literature and is in applied within a huge proportion of businesses chasing supply chain excellence.
However, let’s not get carried away. The early interactions of the Economic order quantity were not without their limitations.
For example, the traditional Ford model was somewhat restrictive. This is because it required a fixed price and didn’t take things like quantity discounts into account.
Furthermore, the results were based on known and stable demand, which, considering the recent disruption we have become accustomed to, is simply not realistic. Finally, the original formula only considered ordering and holding costs of replenishment.
But despite these limitations, the EOQ formula has been proven time and time again to yield fantastic results. In the next sections, we will explore some of main benefits of Economic Order Quantity.
How can the economic order quantity help you to reduce supply chain costs?
Satisfying the needs of your customers does not come cheap. But that does not mean you cannot take steps to cut your supply chain costs down to size.
The first step in minimising your supply chain costs is to identify the most important cost factors. For companies that operate in an inventory-rich environment, supply chain costs can be roughly categorised by:
- Ordering costs
- Holding costs
- Shortage costs
- Set up costs
- Unit costs
Focus on the major costs
The two most important types of supply chain costs are ordering costs and holding costs. And the former of the two is often underestimated because a large part of it is considered a sunk cost.
Business managers often think they’ve financed their inventory with their own capital. But that doesn’t mean you can ignore costs like these when you make optimisation decisions.
Imagine your company without any inventory. What investments, risks, and expenses would be missing? How much manpower, time, trouble, and effort would you save daily?
The point here is that even if you cannot see the costs directly, there is likely an opportunity for optimisation.
Holding costs are another major type of supply chain cost. They comprise all the costs a business incurs when they handle certain lot sizes. However, many businesses don’t realise handling just one unit involves many different processes.
Let’s take a production facility as an example.
What does it cost to produce just one unit? You have to select and collect the right raw materials, set up a production line, clean up after production, cope with starting-up failures and much more.
Don’t forget the other costs
Although you should focus on the two major cost factors above, all supply chain costs directly influence one another. They also directly influence your business, so keeping on top of them is a wise choice.
To avoid a suboptimal solution, you should incorporate all cost types into your inventory management strategy.
Think of the bigger picture.
When you, for example, optimise for inventory carrying costs, you would lower the ordering quantities. In practice, this often negatively affects your transportation and warehousing costs, because this results in many order lines and probably inefficient use of transportation modes.
Likewise, when aiming for lower production costs by increasing batch order sizes, your inventory and warehousing costs would rapidly increase. The one thing that influences all your supply chain costs when replenishing your inventory position, is the order quantity.
Order quantities drive transportation modes, warehouse operations, and production capacity. When ordering the right logistic quantities, you can excel in operational efficiency. Ordering the correct number of pallet-layers, full pallets, or even truck loads pay off.
And if you optimise order quantities, you significantly improve the use of invested capital in operations and production. Due to the balance between ‘number of order lines to be processed’ and ‘order size to be handled’, improving.
However, be warned, underestimate the capital requirements for inventory management at your peril. Without careful planning, it’s easy to make bad decisions when it comes to transportation mode selection, network design, and sourcing. And they’re three big parts of the process.
In the real world, inventory costs are often underestimated. That’s due in part to purchase managers only looking at ordering costs and forgetting about warehousing, transportation, and other inventory-related costs.
An unrealistic guess of capital requirements can inevitably lead to an unexpected financial setback. Consequently, your inventory investment requirements should be balanced against operating expenses taking heed of the cost of capital associated.
Transportation management’s just one example. Inventory can be lowered by utilising faster transportation modes such as air freight that allow for shorter lead times and smaller order quantities.
Given that your transportation costs will increase, this may sound like an expensive option. However, if you consider that the total inventory and supply chain costs can be lowered, it is possible that the overall financial performance may be improved compared to cheaper transport alternatives.
Finally, consider the impact of knowing the total cost of inventory on procurement decisions. On the face of it, moving production to the Far East might reduce purchase-price costs. But overall, may lead to increased investment due to higher in-transit and safety stock inventories.
In this scenario, it may be the case that the supplier with the lowest purchase-price cost does not always have the lowest total landed costs.