Financial Glossary
Economic Order Quantity (EOQ)
Economic Order Quantity (EOQ) is the optimal reorder quantity that minimizes total inventory-related costs, specifically the sum of ordering costs and holding costs. The formula is: EOQ equals the square root of (2 times annual demand times ordering cost per order, divided by annual holding cost per unit). Ordering costs include procurement, administrative processing, and receiving labor per purchase order. Holding costs include warehousing, insurance, obsolescence risk, and the opportunity cost of capital tied up in inventory. EOQ produces the order size at which these two cost curves intersect at their lowest combined point.
Problem & Application
A campground gift shop sells 1,200 units of a branded merchandise item annually (D = 1,200). Each purchase order costs $40 to process and receive (S = $40). Holding one unit for a year costs $8 in storage and capital (H = $8). EOQ equals the square root of (2 times 1,200 times $40 divided by $8), which equals the square root of 12,000, approximately 110 units per order. Ordering 110 units roughly 11 times per year minimizes combined inventory costs. Ordering 200 units at a time would reduce order frequency but increase holding costs beyond the savings; ordering 50 units increases order frequency and processing costs. While EOQ assumes stable, predictable demand -- a limitation in seasonal businesses -- it provides a useful baseline that can be adjusted with safety stock buffers for peak weeks.
In Short
EOQ is a valuable tool for minimizing inventory costs but must be adjusted for fluctuations in demand and other factors.