Economic order quantity (EOQ) is that size of the order which gives maximum economy in purchasing any material and ultimately contributes towards maintaining the materials at the optimum level and at the minimum cost.

In other words, the economic order quantity (EOQ) is the amount of inventory to be ordered at one time for purposes of minimizing annual inventory cost.

The quantity to order at a given time must be determined by balancing two factors: (1) the cost of possessing or carrying materials and (2) the cost of acquiring or ordering materials. Purchasing larger quantities may decrease the unit cost of acquisition, but this saving may not be more than offset by the cost of carrying materials in stock for a longer period of time.

The carrying cost of inventory may include:

Interest on investment of working capital

Property tax and insurance

Storage cost, handling cost

Deterioration and shrinkage of stocks

Obsolescence of stocks.

Formula of Economic Order Quantity (EOQ):

The different formulas have been developed for the calculation of economic order quantity (EOQ). The following formula is usually used for the calculation of EOQ.

A = Demand for the year

Cp = Cost to place a single order

Ch = Cost to hold one unit inventory for a year

* = ×

Example:

Pam runs a mail-order business for gym equipment. Annual demand for the TricoFlexers is 16,000. The annual holding cost per unit is $2.50 and the cost to place an order is $50.

Calculate economic order quantity (EOQ)

Calculation:

Underlying Assumptions of Economic Order Quantity:

The ordering cost is constant.

The rate of demand is constant

The lead time is fixed

The purchase price of the item is constant i.e no discount is available

The replenishment is made instantaneously, the whole batch is delivered at once.

**Re-order Level or Ordering Point or Ordering Level:**

Definition and explanation:

This is that level of materials at which a new order for supply of materials is to be placed. In other words, at this level a purchase requisition is made out. This level is fixed somewhere between maximum and minimum levels. Order points are based on usage during time necessary to requisition order, and receive materials, plus an allowance for protection against stock out.

The order point is reached when inventory on hand and quantities due in are equal to the lead time usage quantity plus the safety stock quantity.

Formula of Re-order Level or Ordering Point:

The following two formulas are used for the calculation of reorder level or point.

[ Ordering point or re-order level = Maximum daily or weekly or monthly usage × Lead time ]

The above formula is used when usage and lead time are known with certainty; therefore, no safety stock is provided. When safety stock is provided then the following formula will be applicable:

[ Ordering point or re-order level = Maximum daily or weekly or monthly usage × Lead time + Safety stock ]

**Minimum Limit or Minimum Level of Stock:**

The minimum level or minimum stock is that level of stock below which stock should not be allowed to fall. In case of any item falling below this level, there is danger of stopping of production and, therefore, the management should give top priority to the acquisition of new supplies.

Formula:

Minimum level or minimum limit can be calculated by the following formula:

[ Minimum limit or level = Re-order level or ordering point – Average or normal usage × Normal re-order period ]

Or the formula can be written as:

[ Minimum limit or level = Re-order level or ordering point – Average usage for Normal period ]

**Maximum Level or Maximum Limit of Stock:**

The maximum stock limit is upper level of the inventory and the quantity that must not be exceeded without specific authority from management. In other words, the maximum stock level is that quantity of material above which the stock of any item should not normally be allowed to go. This level is fixed after taking into account such factors as: capital, rate of consumption of materials, storage space available, insurance cost, risk of deterioration and obsolescence and economic order quantity.

Formula:

Maximum level or maximum limit can be calculated by the help of following formula:

[Maximum limit or level = Re-order level or ordering point – Minimum usage × Minimum re-order period + Economic order quantity]

**Danger Level of Materials or Inventory Stock:**

When danger level is reached, the try is made to purchase materials from the nearest possible source or place so that the workers and plant and machinery may not remain idle due to shortage of materials supplies.

Formula:

Danger level can be calculated by the help of the following formula:

[ Danger level = Average daily requirement × Time required to get emergency supply ]