Your
economic order quantity is the ideal amount where your company’s inventory
holding costs and your company’s purchasing costs are minimized. Ultimately,
it’s about avoiding those situations where you’re either buying too much or not
buying enough. Ideally, you want to have just enough to cover sales, but not so
much that your costs of carrying inventory are too high. Companies that need to calculate this ideal quantity typically turn to a well-established EOQ formula.
The Wilson EOQ Formula, or simply the “Wilson Formula”, is a well-established calculation that supply chain management professionals have used for over 100 years. Its beginning dates back to 1903 and it uses three essential principles.
First, it uses the company’s annual usage or annual consumption. This is the amount of consumables, raw materials or finished goods purchased by the company in a given year.
Second, it uses the company’s costs of purchasing as part of the overall equation. These costs include time spent on approvals and purchase requisitions. Next, it accounts for the time spent placing the order, sending the order, receiving the order, inspecting the order, placing the goods on the shelves, and finally, paying the vendor for the order.
Third, it relies upon the company’s specific costs of holding inventory. These costs include costs of inventory damage, pilferage (theft), obsolescence, counting, storage and handling, financing (cost of capital), insurance and incoming freight. These aforementioned costs vary in their impact depending upon the company’s market, its customers purchasing patterns and the company’s market.
Calculating Economic Order Quantity
Yearly or Annual Consumption: The first part of the equation is easy. Every company knows exactly how much they’ve purchased over a given year.
The second and third portion involves much more time and analysis. Unfortunately, this is where most companies encounter problems. Instead of using actual numbers, they populate the calculation with assumptions on their costs of purchasing and their costs of holding inventory. Cutting corners will not help you use the calculation or provide a better result. To help, here are some simple steps to determining these two critical portions of the equation.
Cost of Purchasing:
Your company’s purchasing costs are not per-unit costs: Instead, they are the costs to place and process each order. Don’t use assumptions. Instead, determine the number of operations for each process step divided by the hourly rate for each operation. For instance, what are the hourly rates for those who approve the orders, place the orders, fax or email the orders, receive the orders, inspect the orders, place the orders on the shelves and pay for the orders? Next, how many transactions for each of these steps are done monthly?
The above table provides a working example of how a company might go about determining its costs of purchasing raw materials and finished goods. This is merely an example. The analysis takes time and the willingness to calculate the costs accordingly. However, most ERP and MRP systems do this calculation themselves. As such, the costs and outcomes are likely more accurate when compared to manual processes.
Costs of Holding Inventory:
Most companies skip this entire process and simply assume that their holding costs are 3% per month. However, it’s critical that you identify your company’s specific holding costs in order to better understand what your cost drivers are.
So, why is this so important? Simply put, not every company manages its inventory the same way. Some companies work in cyclical and seasonal markets, ones where customer demand constantly fluctuates from month-to-month and quarter-to-quarter. Other companies operate in linear markets where customer demand is constant and expected. These companies must maintain ship dates on an hourly, daily and weekly basis.
Some companies operate in business-to-business (B2B) environments where large volume contracts and blanket orders help to offset their costs of inventory. Some operate in business-to-consumer (B2C) markets where the rule is simply: First Come, First Serve. Yet, some companies operate in business-to-government (B2G) markets where they must retain semi-finished and work-in-process inventory for months.
Ultimately, a company’s costs to have inventory can’t be the same from one company to the next. While all companies must cover these inventory costs, not all companies have the same percentage of costs. This is why you must determine your specific costs to hold inventory. Don't make the assumption of just using 3% as a monthly cost to retain inventory. You may be higher or lower, depending upon all of these aforementioned cost drivers. Take the time to figure out your own specific costs. It will make the calculation more relevant.
A Working Example
The video above explains the following example in detail. However, to simplify the calculation, we'll review each step in detail.
- Annual or Yearly Consumption: 3000 units
- Price Paid Each Unit: $20.00
- Cost to Purchase: $2.00
- Inventory Holding Cost Percentage: 3%
From the above example, the company's EOQ would be 141 units. Given that the company purchases 3000 units a year, it will then make 21 separate purchases of 141 units at a time. This is simply the 3000 units divided by the EOQ of 141.
Drawbacks of the Economic Order Quantity Formula
Unfortunately, there are some inherent drawbacks to the Wilson EOQ formula. First, it assumes that the consumption is constant and doesn't change. Second, it assumes the price remains the same. This doesn't allow companies to account for any discounts or price reductions.
Third, it assumes that the lead time for deliver is the same. Ultimately, none of these aforementioned variables can be considered static. They change constantly. So, while the formula has a long history, it's also worth noting that a lot of things have changed in business over the last 100 years.
Your economic order quantity will likely change depending upon the seasonality of your business. Granted, if you operate in a market where linear demand is guaranteed, then using the Wilson formula does have its advantages. Unfortunately, far too many of today's enterprises operate in cyclical markets where customer demand is rarely guaranteed from one quarter to the next.
To read about how to calculate a safe amount of inventory so you never encounter a material shortage or inventory stock out, please go to: Determining Safety Stock & its Impact on Inventory Holding Costs
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