EOQ Model

Economic Order Quantity (EOQ) model is a widely used inventory management formula that helps businesses determine the optimal order quantity to minimize total inventory costs. The EOQ model takes into account the costs associated with ordering and holding inventory and aims to find the quantity that balances these costs.

Despite its assumptions and limitations, the EOQ model remains a valuable tool for businesses to establish a baseline order quantity that can guide inventory management decisions and help minimize costs. It is often used in conjunction with other inventory management techniques to address more complex and dynamic business environments.

The formula for EOQ is as follows:

EOQ = (√2 *D*S /H)

Where:

• EOQ is the Economic Order Quantity (optimal order quantity),
• D is the annual demand or quantity of units sold,
• S is the ordering cost per order (cost to place an order),
• H is the holding cost per unit per year (cost to hold one unit in inventory for one year).

Concepts in EOQ:

1. Ordering Costs (S):

These are the costs associated with placing orders, which may include paperwork, processing, and transportation costs. The EOQ model assumes that the ordering cost per order remains constant.

2. Holding Costs (H):

Holding costs are the costs associated with holding inventory in stock. This includes storage costs, insurance, and the opportunity cost of tying up capital in inventory. The EOQ model assumes that holding costs are incurred on an average unit held per year.

3. Demand (D):

The annual demand for the product is a critical parameter in the EOQ model. It represents the quantity of units that the business expects to sell or use in a year.

Assumptions of the EOQ Model:

• Constant Demand:

The EOQ model assumes that demand is constant and does not vary over the course of the year.

• Constant Ordering Costs:

The ordering cost per order is assumed to remain constant, regardless of the order quantity.

• Constant Holding Costs:

Holding costs are assumed to be constant on an average unit held per year.

• Instantaneous Replenishment:

It is assumed that inventory is replenished instantly when it reaches zero, meaning there are no stockouts during the replenishment process.

Benefits of the EOQ Model:

• Cost Minimization:

The primary benefit is the minimization of total inventory costs by finding the optimal order quantity.

• Simplified Decision-Making:

The model provides a straightforward method for determining the most cost-effective order quantity.

• Reduction in Stockouts and Overstock:

By optimizing the order quantity, the EOQ model helps in minimizing both stockouts and excess inventory.

• Efficient Inventory Management:

It provides a foundation for efficient inventory management practices, balancing the costs associated with ordering and holding inventory.

Limitations of the EOQ Model:

• Assumption of Constant Demand:

The model’s assumption of constant demand may not hold true in situations where demand fluctuates significantly.

• Assumption of Constant Costs:

The model assumes constant ordering and holding costs, which may not be realistic in some business environments.

• No Consideration for Quantity Discounts:

EOQ does not consider quantity discounts that suppliers may offer for larger order quantities.

• No Consideration for Limited Storage Capacity:

The model does not take into account constraints related to limited storage capacity.

• Limited Applicability to JIT Systems:

EOQ is more suitable for businesses that do not follow Just-In-Time (JIT) inventory management practices.