As customers demand ever shortening delivery times, coupled with increasing SKU inventory demands, businesses face increasing challenges over how to maintain optimum stock levels.
As any e-commerce business manager will tell you effective inventory management is not only one of the most important business strategies but also one of the hardest to get right.
Business owners and inventory managers often utilise a range of inventory controls and here we take a look at just one of those – EOQ (economic order quantity). We aim to demystify EOQ and analyse the best methods for applying this to inventory management particularly within multi-channel e-commerce and ecommerce fulfilment.
What Is Economic Order Quantity (EOQ)?
According to the Chartered Institute of Procurement & Supply the economic order quantity (EOQ) is “a method used to determine the optimum order quantity for an item of stock that minimises ordering and carrying costs” But this is a simplistic definition and EOQ has many facets across different sectors and industries and applications vary.
The ultimate goal of the EOQ formula is to calculate the optimal number of product units to order at any given time. It is used to determine a company's inventory reorder point such that when inventory falls to a calculated level, the system triggers the need to place an order for more units.
Challenges from more recent conflicting concepts such as ‘Just-in-Time’ and ‘Lean’ have led many to question the continued relevance of EOQ. So, is the concept still relevant?
What are the Limitations of EOQ?
The EOQ has some obvious limitations. It assumes that:
- Demand is relatively constant and is known or predictable
- The item is purchased in lots or batches and not continuously
- The order and delivery costs of the inventory are constant and known
- Replacement of inventory occurs all at once
As such, particularly in the context of today’s fast paced multi-channel e-commerce and e-commerce fulfilment sectors, the formula can be flawed. Care should be taken in ensuring that the business conditions are favourable for the formula to be used effectively.
Clearly, inventory control is an important factor in operating a successful e-commerce business and without such management companies can lean toward holding too much inventory during periods of slow periods and too little inventory during peak periods.
Either problem creates missed opportunities for companies: too much inventory generally means cash flow issues, while not holding enough inventory will lead to extended delivery times and lost customers. For investors, it can be a useful tool for assessing how efficiently that company is managing its inventory.
As already mentioned, the EOQ formula determines a company's inventory reorder point. The EOC is just one of many formulae that can be used for inventory management and can be used alongside other systems for optimum inventory control.
Whilst EOQ is often overlooked as too simplistic, it can still be used effectively across a range of industries and sectors.
Is EOQ for my Business?
Before jumping into implementing EOQ the first step is to assess the suitability of this measurement in relation to your specific business model. There are a number of key criteria which make EOQ an effective inventory management calculation:
- The EOQ formula is best applied in situations where demand, ordering, and holding costs remain constant over time.
- That is not to say it cannot be used where such changes as seasonality occur, but the peaks and troughs need to be relatively constant.
- Inventory strategy is often dependent on a size of a company: small businesses often face financial and logistical limitations when erecting their inventory systems and a simple inventory management system such EOQ can be effective.
- Inventory needs often differ across sectors, for example, consumer goods producers require well-balanced inventories at the point of sale whereas suppliers of industrial and commercial product usually do not face as much delivery lead time pressure.
The limitations of the formula makes it almost impossible to account for businesses that are particularly sensitive to events such as changing consumer demand, unpredictable seasonal changes in inventory, or discounts a company can leverage by buying inventory in larger quantities.
But the formula can be modified to determine different production levels or order intervals, and corporations with large supply chains and high variable costs will often use an algorithm in their computer software to determine EOQ.
EOQ is particularly useful where companies hold large numbers of stock items that require careful inventory control.
Demand for shortened lead times make stock management vital and companies operating with high SKU alongside highly competitive lead times will find considerable benefit in structured inventory management. Providing sales levels remain relatively constant, or at least highly predictable, EOQ can be a highly effective and simple tool for inventory control.
And while it is undeniable that EOQ has its limitations it is a relatively simple formula to calculate so as circumstances change the order formula can be recalculated to reassess inventory management requirements. A useful tool – yes, but one that should be used cautiously alongside careful consideration of changing demands on inventory, costs and business conditions.
What do you need to know before calculating the economic order formula?
In order to use the EOQ formula, you need:
- Your annual demand
- Fixed costs
- Annual carrying cost per unit
Your fixed costs are the amount you have to spend on procuring stock, covering approval processes, inspections, and so on, while carrying costs are what you spend on storage and utilities.
What is the Economic Order Formula?
The formula is: *EOQ = square root of: 2 x (setup costs x demand rate) / holding costs*
- Q=EOQ units
- D=Demand in units (typically on an annual basis)
- S=Order cost (per purchase order)
- H=Holding costs (per unit, per year)
Demand: the EOQ assumes constant demand.
Costs: An increase or decrease in your transport costs, discounts for bulk shipping, a change in the employee costs, or a change in the cost of rent for storage can all impact costs and affect the calculations that go into the EOQ. While some companies use a fixed cost approach, others use a variable cost model in their formula to account for these sensitivities such as changing transport costs, seasonality and lead times.
No discounts: The EOQ fails to factor in vendor discounts which can be important to consider. Often it can make sense for a retailer to buy a product in bulk from the supplier in order to get bulk discount. Buying items in larger quantities in this case can actually optimise the retailer's costs despite the EOQ predictions.
Why do E-commerce Retailers use Economic Order Formula?
Recent studies of the particular issues faced by e-commerce businesses in inventory control cite a range of problems facing the e-commerce inventory manager. Online retailers are faced with a myriad of inventory management problems including demand fluctuations, reverse logistics, stock outs, managing SKU’s. Even stock control of large inventory, multi-channel buyers, bottleneck and weak points and bullwhip effect. This is alot to process!
Clearly monitoring all of these factors is challenging and e-commerce operators increasingly turn to inventory control measure to help them effectively manage stock. EOQ can be used effectively to help in this monitoring.
Advantages of Economic Order Formula for Ecommerce Businesses
- EOQ is particularly appropriate for repetitive purchasing models.
- It may be suitable for determining which items fit into a just-in-time (JIT) model and what level is economically beneficial for the company.
- EOQ can minimise warehouse costings for e-commerce and e-commerce fulfilment centres.
- The method demonstrates a commitment to ordering in a stable manner from suppliers which minimises risk of stock-outs or over stocking.
Managing inventory to create higher inventory turnover and just in time delivery practices are two of the most important processes for online retailers. Flexible systems that respond to customer demand and inventory uncertainties are critically important in e-commerce. The EOQ model does not account for every factor, and a business needs to understand the limitations of the formula. But the EOQ formula can be helpful with many purchasing plans and with careful consideration to external influences can be a useful addition to the inventory management arsenal.