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Cost accounting concepts: Economic order quantity
By definition, the Economic Order Quantity (EOQ) is the order quantity that minimizes inventory costs. This includes the costs of purchasing, shipping and holding inventory.
The EOQ is critical to maintaining adequate levels of inventory; it does this by ensuring that the right amount is ordered at the right time. This allows a business to balance the benefits of holding inventory against the cost.
The firm’s demand for inventory, its holding costs and ordering costs are used in determining the optimum order quantity. It is determined using a formula, table or graph. Using a graph, the optimum order quantity is where the holding costs line intersects the ordering cost curve. Using the formula, the EOQ is the square root of the quotient of [(2 x Ordering Cost of a consignment x Demand)/Holding Cost per unit).
Since ordering costs are fixed per order and holding costs are variable, smaller inventory levels yield higher total ordering costs and total holding costs rise as inventory levels rise. This is the reason for the ordering costs curve is a curve, while holding costs is a straight line.
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The EOQ optimizes the inherent trade-off between holding costs and ordering costs. With consistently low inventory, ordering costs would be substantial as the business would incur charges for carriage-in, would not benefit from discounts from large orders and would have to pay staff for additional work in receiving orders regularly.
On the other hand, too much inventory yields burdensome holding costs. This arises from the need to have more storage, staff and equipment to manage high inventory levels.
In the realm of inventory levels the reorder level is calculated as follows:
- Maximum usage x Maximum lead time
The maximum level is calculated as follows:
- Reorder level + Reorder quantity – (minimum usage x minimum lead time)
The Economic Order Quantity determines the optimum amount to order when inventory levels reach the reorder level. The EOQ would not take stock levels past the maximum level, however. This is because the maximum level is the level beyond which it is unsafe, uneconomic or impractical to hold inventory.