Economic Order Quantity (EOQ)

Too much or too little inventory can lead to significant external costs, from loss of sales to excess warehousing fees. By managing economic order quantity (EOQ), ecommerce companies can stay on top of their logistics and fulfillment needs while minimizing expenses.

Economic order quantity (EOQ) is the number of units a business orders at one time to meet customer demand without overspending on excess inventory or warehouse space. Ecommerce businesses use EOQ to minimize their holding costs and reduce excess inventory. Proper use of EOQ also helps prevent backorders, which could drive customers to competitors.

While EOQ is a useful metric for all businesses and industries, it's particularly important for direct-to-consumer brands that rely on inventory management and demand forecasts to maximize profits.

The EOQ model looks at purchasing costs and delivery costs as well as product demand, discounts, and holding costs like warehouse management expenses. EOQ can help you determine the optimal order size to place with vendors, and whether product discounts are worth taking advantage of.

Before you can calculate your EOQ, you’ll need to determine the value of three key variables in the EOQ formula: demand, order cost, and holding cost.

Demand

The EOQ formula uses annual demand, or the number of units sold in a year. Though order volume may vary due to seasonality, you can use historical data and growth projections to estimate the number of units you anticipate selling in a year. 

Order cost

The order cost used in the EOQ formula is calculated on a per-order basis. This is the total cost for each purchase order, including shipping and handling fees. 

Holding cost

Holding costs account for all the expenses associated with storing your product, from warehouse fees to depreciation. To determine your holding costs, you can use this formula: 

Let’s further explore the variables included in holding cost. 

• Storage costs are the expenses incurred from keeping the products in a warehouse until they’re sold. For companies that own their warehouses, this may include all the fixed costs of running the fulfillment center. 
• Employee salaries are an important consideration for ecommerce companies that keep logistics in-house; but if you outsource to a 3PL, this expense will likely be baked into your daily or monthly storage fees. 
• Opportunity costs refer to intangible limitations your company accepts as a result of storing inventory. Typically, this is the cost of holding dead stock as opposed to other, more profitable products. 
• Depreciation costs are also intangible, and represent the loss in value over time as products sit in storage. The products could become obsolete, go out of style, or expire.

Here’s an example, using a hypothetical company that sells jigsaw puzzles for $10 apiece. Last year, they held 10,000 units of inventory.

First, the company calculated the following:

• Annual inventory value = $100,000 ($10 x 10,000)
• Storage costs = $6,000 (These are the storage fees charged by their 3PL.)
• Employee salaries = $0 (The company outsources fulfillment, so they do not directly pay the warehouse employees.)

Now the company needs to calculate its opportunity cost. Let’s say they sell 10 puzzle designs, and held 1,000 units of each design last year. While the company sold all 10,000 puzzles for a $100,000 profit, the most popular design was on backorder within 9 months, while the least popular design barely sold out by year’s end. 

If the company had optimized its stock to hold 1,500 units of the popular design and 500 units of the unpopular design, it could have brought in $105,000.

The opportunity cost = (Return from unchosen scenario) – (Return from chosen scenario).

So, the puzzle company’s calculated opportunity cost would be as follows:

Opportunity cost = $105,000 – $100,000.

The opportunity cost is $5,000. 

Lastly, the company has to determine its depreciation cost. 

Let’s say the company’s designs are updated every year. Once new designs are released, the old ones are sold at a 50% discount. If it costs the company $50,000 to produce the puzzles, and the salvageable cost at the end of the puzzles’ lifespan is $25,000, they can calculate their depreciation. 

The inventory’s depreciation = (Cost to make goods) – (Salvageable value) / (Inventory lifespan)

So for the puzzle company, the calculation would look like this: 

$50,000 – $25,000 / 2 = $12,500

Now the company has all the data it needs to calculate its holding cost. Remember: 

Holding cost = [(Storage Costs + Employee Salaries + Opportunity Costs + Depreciation Costs) / Total Value of Annual Inventory]

The holding cost is [($6,000 + $0 + $5,000 + $12,500) / $100,000] = .235, or 23.5%.

For the purpose of calculating EOQ, you’ll need the holding cost per unit. 

The puzzle company’s puzzles are $10 apiece, so 23.5% would set the per-unit holding cost at $2.35.

In general, EOQ applies when the demand for a product remains consistent over the year, each order has a fixed cost, and each item in storage has a holding cost. 

The mathematical formula used to calculate EOQ is EOQ = √[2DS/H], where:

• D = Annual demand in units
• S = Cost per purchase order
• H = Annual holding costs per unit

EOQ is used to determine the ideal number of product units to order that will minimize delivery, storage, and purchase costs. Using the EOQ also helps businesses control their cash flow by understanding the amount of capital that is tied up in inventory at any given time. 

In most cases, ecommerce businesses no longer directly calculate the EOQ. Instead, they use modern inventory management software to quickly calculate the EOQ. Still, it’s helpful to understand the basic calculation. 

Here’s an example of the EOQ calculation, using the same puzzle company as our earlier example, assuming the puzzle company orders inventory several times per year:

• Annual demand: On average, the company sells 10,000 puzzles each year.
• Cost per purchase order: $5,000
• Holding cost per unit: $2.35

The puzzle company’s EOQ would be the square root of [(2 x 10,000 x 5,000) / 2.35] = 6,523.

This would mean that the puzzle company would need to order inventory twice per year to meet demand of 10,000 puzzles. 

Businesses can use their inventory management software to set automatic reorder points so that when inventory reaches a certain level, an order is automatically made to keep EOQ and inventory levels correct and maintain a safety stock.

Using EOQ helps you set the optimal order level from your supplier. However, ecommerce businesses also have to engage in constant inventory management to ensure they can meet shifting demand throughout the year.

A logistics provider like Airhouse can help businesses maximize their inventory efficiency. Instead of checking inventory levels to reorder products, businesses can set automatic reorder points using their EOQ metrics as a guideline.

Safety stock is also key to optimizing inventory levels. Businesses want to have enough on hand to deal with a sudden supplier crisis or a surge in demand. It is also important for handling seasonal fluctuations like holiday demand or response to a large promotion. Using modern inventory management software can help ecommerce businesses build a cushion, since they track inventory in real time.

The economic order quantity formula can tell businesses the optimal order size for each product. In general, EOQ assumes that demand remains flat, which may complicate factors for fast-growing ecommerce businesses, but this model can help companies roughly plan the number of orders per year as well as the size of each order.

Ecommerce businesses can adapt the EOQ model to accommodate defective items, backorders, discounts, and other changes. There are several major benefits of using EOQ for an ecommerce business:

• Reduced inventory carrying costs: When an ecommerce business orders the right amount of goods, it has fewer products to store. This means spending less on warehouse space, utilities, security, insurance, and other costs associated with carrying excess inventory.
• Reduced over-ordering and related costs: Ecommerce businesses do not want to tie up too much of their cash in inventory, especially when it’s unnecessary. By accurately forecasting inventory needs, the company can keep more of its assets liquidated.
• Reduced waste: This is a particular concern for ecommerce businesses with perishable goods with expiration dates. Unused inventory may need to be sold at a discount, or even discarded. Using EOQ can help reduce or eliminate waste.
• Improved discount timing for savings: EOQ can help ecommerce businesses decide when to take advantage of discounts and bulk order rates offered by vendors.
• Improved customer satisfaction: Customers expect to find products in stock and available for order. EOQ helps businesses have an adequate supply for customers while avoiding excess and costly inventory taking up space.