The Economic Order Quantity is used to minimize the
ordering cost and total inventory costs. Organizations use this method to
determine an order quantity to minimize ordering costs and inventory holding
costs.

The EOQ determines the amount of units to be added
to the inventory so that the inventory costs such as holding, shortage and
order costs can be minimized. Usually companies use the EOQ on a regular basis
as part of their inventory system. This way each time a fixed quantity is
ordered when the inventory reaches the reorder point. This way the inventory is
replenished with the right amount at the right amount, without any shortage to
the inventory. This is most ideal for small businesses to determine the
inventory to be kept, how much to order every time and the frequency of
reordering in order to minimize the costs.

**Definition**

The Economic Order Quantity more commonly known as
EOQ is used to determine the most favorable quantity to produce or purchase in
order to minimize inventory holding costs and production/purchase costs.

**Some Assumptions for EOQ**

These assumptions are necessary in order for the Economic
Order Quantity to work to its full potential.

·
The Ordering Cost needs
to be constant

·
The annual demand rate
should be known and spread throughout the 12 months evenly

·
Fixed Lead time

·
Constant Purchase Price,
that means no discounts

·
The EOQ should be
applied to one product

·
Restocking is done
without delay and the order delivery is
of the complete batch

These assumptions are necessary for companies to
keep in mind when applying the EOQ model so that the shortcomings of applying
this model are highlighted.

**Variables of the Equation**

C= per unit cost

Q= order quantity

Q*= Economic Order Quantity

D= Annual Quantity Demanded

K= Fixed Per Order Cost

h= Annual per unit carrying cost

**Example**

Let’s look into an example to understand how the EOQ
actually works.

·
Annual Quantity
Requirement (D) = 10000 units

·
Per Order Cost (K)= $2

·
Per Unit Cost (c)= $8

·
Percentage of Carrying
Cost= 0.02

·
Annual Per Unit carrying
cost= $0.16

EOQ= = 500 units

Annual number of orders

Total cost =

**c * D + K(D/EOQ) + h(EOQ/2)**
Total cost = 8

*** 10000 + 2(10000/500) = 0.16(500/2) = $80080**
If the total cost is checked on the basis of another quantity than
500, then the cost would result as higher. Let us have a look at the cost of
the quantity order is increased to 600 instead of 500.

Total cost =

**8 * 10000 + 2(10000/600) + 0.16/2) = $80081**
Likewise, if the order quantity is reduced from 500 to 300, then
the total cost is as follows

Total cost=

**8 * 10000 +2(10000/300) + 0.16(300/2) = $80091**
With
the help of this example we can see that EOQ is in the best interest of the
business to be applied in order to minimize the costs.