Do you want to know the advantages and disadvantages of economic order quantity? If YES, here are the pros and cons to note.
When reordering products, many businesses prefer to place orders based on what they require at the exact moment rather than using a reorder quantity formula. But many businesses have optimized the way they order by using the Economic Order Quantity formula (EOQ).
The EOQ formula helps calculate the optimal order quantity to save money on logistics and ecommerce warehousing costs. By calculating EOQ, you’re able to make better decisions on how much product to order in a given period of time.
Economic order quantity is also popularly known as EOQ. It is more or less a production scheduling concept as it is leveraged to analyze the frequency and volume of orders that are required to satisfy a specific demand while reducing the cost per order to minimum levels.
Economic order quantity is very crucial to minimize the order-related and holding costs of merchandise. The economic order quantity is also known as the optimal order quantity and optimal order size.
This measurement tool is applicable in the fields of supply management, logistics, and operations and is computed by merchandising as well as manufacturing companies.
The merchandising organizations use it for computing the optimal order size of inventory related to ready-to-use merchandise, whereas manufacturing companies use it to measure the optimal order size of inventory related to raw materials.
Indeed, the EOQ is the level at which the combined holding and ordering cost is at its minimum level. It is imperative to collect information about the two most important factors of EOQ as there is an inverse relationship between both the ordering cost and holding cost.
Whenever a company places an inventory order with the supplier, the cost which incurs is known as ordering costs. The total will vary as it is dependent upon the frequency of placing orders.
If the number of orders that have been placed rises in a given year, then the annual ordering cost will also grow, and the same applies if the company places small number of orders because then the ordering cost will be lower. Some ordering costs are delivery charges, telephone expenses, payment processing charges, and invoice verification charges.
Holding costs are also known as carrying costs as they are incurred while holding the inventory in a warehouse or a store. The total cost is dependent upon the size of the order, and larger the order the higher the annual holding cost and vice versa.
Have it in mind that the sole aim of the EOQ formula is to identify the maximum number of units so that an organization can minimize its costs in terms of storing, taking delivery, and buying the units.
The formula is easily modified to gather information about varying production levels. It has become a cash flow tool that can minimize the amount of cash and the cost of inventory that is integrated into the inventory balance. The formula also calculates inventory reorder point of an organization. This helps the company as it avoids running out of inventory so that it can fulfill all the orders promptly.
Advantages and Disadvantages of Economic Order Quantity
When leveraging the Economic Order Quantity (EOQ), there are a number of advantages and disadvantages that can help you with deciding whether or not you should utilize the metric for your inventory.
Economic Order Quantity (EOQ) may be able to offer extensive insight into your inventory situation and ultimately locate ways to maximize profits and reduce costs within your organization or manufacturing operation. Therefore, here are the advantages and disadvantages pertaining to economic order quantity (EOQ).
Advantages of Economic Order Quantity (EOQ)
There are a few advantages of Economic Order Quantity (EOQ) and they include;
Reduce Holding Costs
One of the biggest advantages of EOQ is that it helps the company in reducing the holding cost of inventory because when the company has an EOQ system in place, it does not need to have a big warehouse to store goods as the company orders goods in limited quantity so that current production of goods does not stop abruptly.
If a company fails to follow this method then it needs a warehouse. Besides it will need staff for that warehouse which again involves expenses, but due to this system, the company is able to save all the holding costs related to inventory.
Reduce Ordering Costs
In terms of EOQ while ordering good, companies order goods on fixed date which may be fortnightly or monthly which results in reduction in ordering costs, because if a company orders 10 times in one month, then company is expected to pay transportation costs, packing costs and other costs 10 times but if the company orders goods only once in a month, then all costs will incur one time only.
Better Inventory Management
Another benefit of EOQ is that it is necessary for better inventory management and when the company can manage its inventory in an effective way than it can reduce substantial operational costs which in turn will lead to more profits for the company.
Simply put, EOQ indirectly helps the company in earning profits through a reduction in operational costs associated with inventory management.
Note that maintaining sufficient inventory levels to match customer demand is a balancing act for many small businesses.
Another advantage pertaining to the EOQ model is that it is able to provide specific numbers particular to the business regarding how much inventory needs to be held, when to re-order it, and how many items are needed to be ordered. This can smooth out the re-stocking process and ultimately result in enhanced customer service.
The Disadvantages of Economic Order Quantity (EOQ)
The disadvantages of economic order quantity (EOQ) consist of the following:
Complicated Math Calculations
The EOQ model requires a good understanding of algebra, a disadvantage for small business owners lacking math skills. In addition, effective EOQ models require detailed data to calculate several figures. The benefit to resolving the math is the ability to determine how much inventory should be attached to each order at the lowest possible costs.
Keeping costs low will inflate margins and ultimately drive more revenue. EOQ software is one solution that may be worth the investment for small business owners lacking the time and capital to hire a consultant or employee for regular calculations.
Forecast of Accurate Demand not Possible
One of the biggest disadvantages of economic order quantity is that it is based on the assumption that demand for company’s products can be forecasted accurately which in real life is not possible because demand for a company’s product never remain static rather it keeps changing and if demand for goods produced by the company rises or decreases substantially, then having EOQ system in company is of no use.
Immediate Availability of Products with Suppliers
Another issue with EOQ is that it may be possible that the supplier does not have raw materials and if the company requires immediate raw material for meeting unexpected demand, then it can lead to problems.
But if the company has good relationship with multiple suppliers, then it is not much of a problem. However, if the company is dependent on only 1 or 2 suppliers for its raw material then the company may face trouble following the EOQ method.
Requires Continuous Monitoring
Companies in case of economic order quantity, are expected to constantly monitor reorder levels. As the level of raw materials reaches reorder level, the company has to order goods from suppliers. This is where the company needs to employ staff so as to monitor stock levels, which again is a time consuming as well as an expensive process.
Having an adequately managed inventory and an efficient inventory system is absolutely essential when attempting to maximize profits – especially within small businesses. By using EOQ for your business, you can improve your overall inventory management process.
By ordering the right amount of inventory instead of guessing what to order, you can reduce costs, prevent stock outs, and keep your supply chain operating smoothly.