How EOQ helps in Inventory Management?

Inventory Management also known as stock management is a crucial part of working capital
management. EOQ is one of the most prominent models used widely for effective inventory management.
EOQ calculates the ordering quantity of inventory using inputs of carrying cost, ordering cost, annual
usage of the said inventory.
Working Capital Management is an important specialized function of financial management. Every
component of working capital such as inventory, debtors or receivables, cash, creditors or payables, short
term debts, etc needs effort to manage. Inventory comprises a major part of working capital and its
funding. This makes its management critical, compared to other working capital components.
Two important questions of inventory management are how much inventory should be ordered? and
when should it be ordered? In manufacturing and merchandising companies, inventory management is
overemphasized. It is because the inventory covers major part of the asset pie. Inventory is a part of
current assets and it occupies a major share of working capital and hence it is necessary to ensure that it
does not block too much of finance .

While we are planning for inventory management, the

first thing that should be evaluated is the type of costs associated with it. However, there is a general
presumption that inventory cost means the cost price of product stored as inventory. Practically, there are
other costs as well, which are associated with inventory like ordering cost, carrying cost etc.
Various tools have been recommended for inventory management and new studies have added some
innovative methods like just in time (JIT) management, total quality management (TQM). However, one of
the proven, adopted and efficient models is economic order quantity (EOQ). This helps answering a major
question i.e. What quantity should be ordered? The quantity to be ordered should be optimum which
optimizes everything whether it is the space required or the money blocked in the inventory. At the same
time, quantity ordered should be sufficient to meet the needs. Insufficient inventory can lead to stoppage
of production.

How to calculate EOQ?

To determine the quantity to be ordered EOQ uses following inputs like annual usage or demand, cost per
order, carrying cost etc.
Annual Usage: It is the annual usage of that particular raw material.
Ordering Cost: Ordering cost is the cost associated with placing an order. It varies inversely with quantity
ordered. More the quantity ordered, less is the number of order to be placed and therefore ordering cost
incurred is less.
Carrying Cost: Carrying cost is the cost associated with storing and maintaining the inventory. The
carrying cost varies directly with the order size. More the quantity ordered, more is the cost incurred in
relation to storing and maintaining such inventory.
Since both the cost behaves in an opposite manner there is the need to find out an optimum quantity to be
ordered that can maintain a tradeoff between ordering & carrying cost.
The total of ordering and carrying cost is minimized when optimum quantity or economic quantity Q is
ordered.
Formula for EOQ:
Q or EOQ is calculated using following Formula:
EOQ = (2 * ACPO * AUU) / (UC * CCP)
ACPO
=
Acquisition
UC
=
Per
AUU
=
Annual
CCP = Percentage of Carrying Cost

Cost
Usage

Unit

Per
of

Order
Cost
Units

Drawbacks of the EOQ Model:

Though, EOQ gives an answer to how much inventory should be ordered, it does not give an answer to
when should it be ordered. EOQ model assumes in instantaneous procurement of material. However, in
practicality, procurement of material needs some time. This is known as lead time. So, ordering level for
material is generally defined as: Lead Time in days * Average Daily Usage.
Thus, EOQ can be an effective tool in inventory management to find optimum quantity to be ordered. But,
it cannot be adopted as one stop solution for total inventory management. Therefore, other techniques
and methods needs to be considered and adopted along with EOQ.