Economic order quantity (EOQ): Definition, formula, and examples

Inventory management is a balancing act. Order too much, and you tie up cash in excess stock. Order too little, and you risk stockouts that disrupt operations.

Economic order quantity (EOQ) is the optimal order quantity to minimize total inventory costs. It helps businesses find the sweet spot for optimizing their order size, controlling costs, and keeping their operations running smoothly.

What is economic order quantity (EOQ)?

Economic order quantity is the ideal order quantity that minimizes total inventory costs, including ordering and storage expenses. It’s a mathematical model that helps businesses determine the most cost-effective number of units to order at a time, preventing the risks of overstocking and understocking.

First introduced by Ford W. Harris in 1913, EOQ is still widely used in industries such as retail, manufacturing, and e-commerce. It helps businesses reduce total inventory costs by balancing ordering and holding costs. Ordering costs are those related to placing and receiving orders, and holding costs are related to storing unused inventory.

The EOQ model is a formula for calculating your optimal order quantity. It’s a simple and powerful tool for inventory managers, procurement professionals, and business owners to make inventory ordering and storage more efficient.

Why EOQ matters for businesses

EOQ helps businesses maintain the optimal stock levels, sufficient to meet customer demand without overspending on storage or frequent reorders. The main benefits of EOQ include:

• Reduces excess inventory and associated costs: It prevents overordering, minimizing storage fees and waste
• Minimizes risk of stockouts and emergency orders: When you order and reorder at the right times, you’ll maintain steady stock without the need for last-minute purchases
• Improves cash flow and operational efficiency: EOQ ensures you won’t tie up your funds in inventory management, saving your business money and allowing you to use excess cash flow in other ways

EOQ also helps solve for common inventory pain points like:

• Tying up capital in inventory costs
• Warehousing and storage costs
• Uncertainty about order quantities and timing
• Disruptions from low stock

How to calculate EOQ

The economic order quantity formula calculates the ideal order size that minimizes total inventory costs. It balances two key expenses:

1. The cost of ordering (expenses for placing and receiving orders)
2. The cost of holding (costs of storing unsold inventory levels)

EOQ variables and definitions

First, let’s take a look at the key variables in the economic order quantity formula:

• D = Annual demand rate: The total number of units sold per year
• S = Ordering cost per order: Fixed costs per order, which include setup costs, admin fees, and shipping
• H = Holding cost per unit per year: The cost to store your inventory, which includes warehousing, insurance, and depreciation

Step-by-step EOQ formula calculation

The EOQ formula is:

EOQ = √(2DS / H)​​

Here’s how to calculate the EOQ formula:

Step 1: Gather the required data

To calculate EOQ, businesses need three key figures:

• Annual demand: The total number of units a company expects to sell in a year
• Ordering cost: All expenses tied to placing an order, such as administrative fees, supplier charges, and shipping costs
• Holding cost: The cost of storing unsold inventory, including warehousing fees, depreciation, and insurance

Step 2: Plug the values into the formula

Substitute your business's actual numbers for the variables in the equation.

Step 3: Calculate the results

Solve based on your numbers to determine the optimal number of inventory units. To illustrate, let’s assume a company sells 10,000 units per year, pays $50 per order, and has a holding cost of $5 per unit. Their EOQ would be:

EOQ = √((2 * 10,000 * 50) / 5)​​ = 447 units

This means ordering 447 units at a time keeps costs at a minimum. Ordering in smaller or larger batches would increase expenses due to excessive ordering or high storage costs.

Applying EOQ to real-world scenarios

The economic order quantity formula is a valuable baseline for calculating your ideal inventory units. However, when applied in practice, it sometimes requires adjustments based on real-world situations.

These are some common variables that can impact your EOQ calculations:

• Quantity discounts: If your supplier offers discounts for larger orders, it might be more cost-effective to purchase more inventory than your EOQ formula recommends, even with higher holding costs
• Fluctuating demand: If seasonal trends or promotional campaigns drive demand for your product, that demand may rise and fall. Take that into account before you rely on the optimal unit calculation.
• Variable lead times: There are times logistics can disrupt your inventory flow, so consider potential supplier delays when deciding how much inventory you need

EOQ requires regular review as your business conditions shift. Supply chain management, customer behaviors, or renegotiated contracts can impact your formula. According to The Business Continuity Institute, over 80% of businesses experience supply chain delays each year, which can lead to stock shortages.

It's not a one-size-fits-all solution for solving inventory challenges, so make decisions that consider all relevant variable costs to your business operations.

EOQ in action: Quick examples

To illustrate how EOQ works in the real world, let’s take a look at two quick examples:

Scenario 1: Textiles manufacturer

Let’s say a textiles manufacturer uses a certain type of thread to create its fabrics. The company wants to keep inventory costs down.

The demand (D) is 50,000 spools of thread, the unit cost (S) is $100 per order, and the holding costs (H) are $2 per spool per year.

Using the EOQ formula, the manufacturer can reasonably store about 2,236 spools to minimize inventory costs.

Scenario 2: Consumer goods

Let’s say a local grocery store chain sells 7,500 boxes of cereal each year, but has limited storage space. They want to optimize their inventory to minimize costs.

The demand (D) is $7,500, the cereal (S) costs $50 per order, and the holding costs (H) are $1 per box per year.

When they plug this into the EOQ formula, the store determines that the ideal number of cereal boxes to maintain is approximately 866.

Limitations and assumptions of EOQ

The EOQ model provides a straightforward method for calculating your ideal inventory levels. But the model relies on some key assumptions:

• Constant demand: EOQ assumes that businesses sell the same number of units each month, making it easy to determine when to reorder. This assumption simplifies planning by removing the need to adjust for seasonal or unexpected changes in demand. To keep EOQ accurate, regularly update your calculations and forecast demand to adjust for market trends.
• Constant ordering and holding costs: EOQ assumes that the costs of placing an order and storing inventory don’t change over time. This assumption makes comparing the trade-offs between ordering frequently and holding more stock easier. Review your costs regularly and adjust EOQ as expenses change.
• No quantity discounts (unless specifically adapted): EOQ assumes that ordering larger quantities doesn’t reduce the price per unit. This makes the formula simple because it only balances ordering costs and holding costs without factoring in bulk pricing. However, ignoring supplier volume discounts can lead to higher expenses. Compare your EOQ-based costs with supplier discount structures to determine whether a larger order quantity would save money on procurement.
• Instantaneous replenishment: EOQ assumes that inventory arrives immediately after you place an order, preventing stockouts. This assumption removes the complexity of supplier lead times, making EOQ calculations more straightforward. To mitigate this risk, consider supplier lead times when establishing reorder points and maintain a buffer stock to account for unexpected delays.

EOQ may not always be the best tool for calculating your ideal inventory in less-static environments. These are some situations where it may not be the best fit:

• Seasonality: If demand lasts only a short period, you may need to calculate your inventory differently
• Perishable items: When your inventory has a literal shelf life, your holding costs may outweigh the amount of inventory you want on hand
• High-variability demand products: Demand for products can spike and then wane, such as when a high-profile author publishes a new book. Geopolitical factors could impact them, as they do with oil or gold. In those instances, the EOQ model may not work.

You may want to turn to a different model if you experience any of these factors:

• Demand is variable
• Your product has a short lifecycle
• Supply chain lead times are unpredictable
• Your supplier offers significant volume discounts

It’s also possible to adapt EOQ to integrate dynamic forecasting or lead-time variability models and adjust your cost inputs accordingly.

Make smarter inventory decisions with Ramp's real-time expense tracking

EOQ isn’t a set-it-and-forget-it number. Businesses that review and refine their EOQ based on demand fluctuations, supplier changes, and storage capacity make the most intelligent inventory decisions.

Companies using Ramp’s real-time expense tracking and automated categorization no longer have to manually reconcile supplier payments or warehouse costs before calculating EOQ. Instead, financial data syncs automatically, ensuring every EOQ adjustment relies on the latest purchasing trends and cost changes.

This helps you reduce waste, negotiate better supplier terms, and avoid cash flow issues caused by inefficient ordering.

Interested in learning more about how Ramp can help? Try an interactive demo.