For operative buyers, optimizing order quantity is a critical aspect of their role. Order quantity impacts inventory management, operating capital, and the costs associated with procurement. One effective method for optimizing order quantity is by using the Economic Order Quantity (EOQ) model. This model calculates the optimal order quantity for a given product, balancing various costs to achieve efficiency.

The EOQ model considers several key factors: the cost of placing an order (ordering cost), the cost of holding inventory (holding cost), and the demand for the product. By inputting these parameters into the EOQ formula, buyers can determine the optimal order quantity that minimizes total costs while maintaining sufficient inventory levels.

The formula for calculating Economic Order Quantity is also called Wilson formula. 

The Economic Order Quantity model was originally developed by Ford Whitman Harris in 1913 while he was working at Westinghouse Electric and Manufacturing Company. Harris’s work was later popularized by R. H. Wilson, a consultant who extensively applied and developed the formula, leading to it sometimes being referred to as the Wilson model. Harris’s seminal paper, titled “How Many Parts to Make at Once,” laid the groundwork for modern inventory management practices by proposing a systematic way to calculate the most cost-effective order size.

Benefits of the Economic Order Quantity Model

One significant benefit of the EOQ model is its ability to prevent overstocking and understocking. Overstocking ties up capital in excess inventory and increases storage costs. It can also lead to obsolescence, especially for products with limited shelf life. Conversely, understocking can result in stockouts, missed sales opportunities, and customer dissatisfaction. By optimizing order quantity, buyers ensure they have the right amount of inventory to meet demand without incurring unnecessary costs.

Another advantage of the EOQ model is its support for the automatic placement of purchase orders through Enterprise Resource Planning (ERP) systems. Once the optimal order quantity is determined, it can be programmed into the ERP system to automatically generate purchase orders when inventory levels fall to a predetermined threshold. This automation saves time, reduces the risk of human error, and ensures timely replenishment of stock.

Reflecting on the Applicability of EOQ

While the EOQ model offers numerous benefits, its applicability can be challenging in real-world scenarios due to the variability and unpredictability of key input parameters. The model assumes steady and predictable demand, constant ordering and holding costs, and immediate replenishment. However, these conditions are often not present in dynamic market environments.

Demand Variability: In many industries, demand can fluctuate significantly due to seasonality, market trends, or economic conditions. This variability makes it difficult to accurately predict demand, which is a critical input for the EOQ calculation. For instance, a sudden spike in demand could render the calculated EOQ insufficient, leading to stockouts, while an unexpected drop in demand could result in overstocking.

Variable Costs: Ordering and holding costs are not always constant. Factors such as supplier price changes, transportation costs, and storage fees can vary over time. The EOQ model’s assumption of fixed costs can lead to suboptimal order quantities if these costs fluctuate. For example, a rise in holding costs due to increased warehouse fees would necessitate smaller order quantities, whereas a drop in ordering costs might justify more frequent orders.

Lead Time Uncertainty: The EOQ model assumes that replenishment happens instantly, which is rarely the case. Lead times can vary due to supplier reliability, shipping delays, or customs clearance issues. These uncertainties can complicate the application of the EOQ model. A delay in delivery could result in stockouts despite using the EOQ, or early deliveries could cause temporary overstocking.

Prerequisite Data Accuracy: Accurate data is essential for the EOQ model to be effective. Inaccurate or incomplete data on demand, ordering costs, and holding costs can lead to incorrect EOQ calculations. For example, if demand is underestimated, the EOQ will be too low, resulting in frequent reordering and higher ordering costs. Conversely, overestimating demand can lead to excessive inventory and increased holding costs.

Overcoming EOQ Limitations

To address these challenges, procurement professionals can adopt several strategies to enhance the applicability of the EOQ model.

Flexible EOQ Adjustments: Implement dynamic EOQ calculations that can be adjusted based on real-time data and changing conditions. Regularly review and update the input parameters to reflect current market conditions, costs, and demand patterns. This flexibility ensures that the EOQ remains relevant and accurate over time.

Safety Stock Incorporation: Incorporate safety stock into the EOQ model to account for demand variability and lead time uncertainty. Safety stock acts as a buffer against unforeseen demand spikes or supply delays, ensuring that inventory levels remain sufficient to meet customer needs.

Scenario Planning: Use scenario planning and sensitivity analysis to understand how changes in demand, costs, and lead times impact the EOQ. By simulating different scenarios, procurement professionals can develop contingency plans and make more informed decisions.

Supplier Collaboration: Strengthen relationships with suppliers to improve lead time reliability and cost stability. Collaborative forecasting and shared inventory management can help align supplier capabilities with the company’s inventory needs, reducing variability and enhancing the effectiveness of the EOQ model.

Technology Integration: Leverage advanced technologies such as AI and machine learning to improve demand forecasting and cost estimation. These technologies can analyze vast amounts of data to identify patterns and trends, providing more accurate inputs for the EOQ model.

Description of the EOQ Formula

The Economic Order Quantity (EOQ) formula is a mathematical model used in inventory management to determine the optimal order quantity that minimizes total inventory costs. These costs include ordering costs (the expenses incurred each time an order is placed) and holding costs (the expenses associated with storing inventory).

EOQ is equal to the square root of [(2 times the annual demand for the product times the ordering cost per order) divided by the holding cost per unit per year].

By calculating the EOQ, businesses can identify the most cost-effective quantity to order, balancing the trade-off between ordering too frequently (which increases ordering costs) and holding too much inventory (which increases holding costs). This helps ensure that inventory levels are optimized, reducing overall costs while meeting demand efficiently

Learn more about Calculating EoQ at Investopedia. (2022). Economic order quantity (EOQ).

Conclusion Economic Order Quantity

Using the EOQ model can significantly aid operative buyers in optimizing order quantity, avoiding overstocking or understocking and supporting automatic purchase order placement. However, the practical application of the EOQ model requires careful consideration of its limitations and the dynamic nature of procurement environments.

By adopting flexible strategies, incorporating safety stock, engaging in scenario planning, fostering supplier collaboration, and leveraging advanced technologies, procurement professionals can enhance the applicability of the EOQ model. This approach ensures that buyers can make informed decisions, maintaining the right amount of inventory to meet demand while minimizing costs, even in the face of changing conditions and uncertainties.

Learn more about the Operative buyers processes in Basics for an Operative Buyer. EFFSO introduces the Purchasing function and recent years’ changes in purchasing. The course is based on Arjan van Weele’s definition of operational and tactical purchasing and a 1 on 1 meeting with course instructor.

Note: Illustration to the blogpost “Economic Order Quantity – for operative buyers” was created on May 31, 2024.

Information about LHTS courses in Swedish.