What it means
Every business that holds stock faces a trade-off. Ordering in large batches means fewer orders and lower administration cost, but it leaves cash tied up in goods sitting on shelves.
Ordering in small batches keeps stock lean, but it multiplies the cost of purchasing, delivery and handling. EOQ finds the point where those two costs are equal, which is where the total is lowest.
Ordering costs include the time to raise a purchase order, delivery charges and receiving checks. Holding costs include storage space, insurance, spoilage or obsolescence, and the cost of the money tied up in the stock.
The model rests on simplifying assumptions. It assumes demand is steady and known, that the cost per order and the holding cost per unit are constant, and that goods arrive all at once.
Real businesses rarely match these assumptions perfectly, so EOQ is best treated as a starting point rather than a rule. For a non-finance manager, the practical message is that there is a sensible order size and that guessing is costly.
Companies usually combine EOQ with a reorder point, which says when to place an order based on lead time and safety stock. Together they answer the two key questions: how much to order and when.
Variants exist for situations where the basic model breaks down, such as quantity discounts from suppliers or stock that is produced gradually in-house rather than delivered at once. The logic is the same, but the formulas are adjusted to reflect the extra costs and savings.
In practice, EOQ is often built into inventory software, which recalculates the order size as demand and costs change. Managers should still review the inputs from time to time, because a supplier increasing its delivery charge or a rise in storage rent changes the answer.
The formula is only as good as the numbers that go into it.
In practice
Real-world examples
Example 1
A hardware shop sells 10,000 boxes of screws a year. The owner ordered 2,000 boxes at a time, which left cash tied up in slow stock. After calculating an EOQ of 500, she orders four times as often and reduces her average stock by 75%.
Example 2
A hospital supply department uses EOQ to decide how many boxes of disposable gloves to order. The ordering cost is high because each delivery needs special handling, and the holding cost is low because the gloves are compact. The model recommends larger and less frequent orders.
Example 3
An online fashion retailer applies EOQ to its best-selling basics. For seasonal items that might go out of date, it sets a higher holding cost to reflect the risk of markdowns, which pushes the recommended order size down.
Think of it
EOQ is the sweet spot order size-big enough to avoid constant orders, small enough to avoid excess stock.
Formula
Calculation
EOQ = square root of (2 x Annual demand x Cost per order / Annual holding cost per unit)
Suppose a business sells 10,000 units a year, each order costs $50 to place and holding one unit for a year costs $4.
EOQ = square root of (2 x 10,000 x 50 / 4) = square root of (1,000,000 / 4) = square root of 250,000 = 500 units.
Number of orders per year = 10,000 / 500 = 20.
Annual ordering cost = 20 x 50 = $1,000.
Average stock held = 500 / 2 = 250 units, so annual holding cost = 250 x 4 = $1,000.
The two costs are equal at $1,000 each, for a total of $2,000, which is the lowest combined cost.Case study
Seen in the real world
Pinecrest Bicycle Parts is an illustrative, fictional distributor that ordered inner tubes once a quarter because that was how it had always done it. The warehouse was crowded and the finance director was worried about the cash locked up in stock.
She estimated that annual demand was 40,000 tubes, that each order cost $200 to place and that holding a tube for a year cost $2.50. The EOQ came out at 2,530 tubes, which meant about 16 orders a year instead of 4.
Average inventory fell from 5,000 tubes to about 1,265, releasing roughly $7,500 of cash at a purchase price of $2 per tube, and combined ordering and holding costs dropped. The illustrative lesson is that a regular rhythm is not the same as an efficient one.
Watch out
Common mistakes
- Leaving out the cost of money tied up in stock when estimating the holding cost per unit.
- Treating EOQ as an exact answer, when demand and costs are estimates and the formula assumes they are constant.
- Using the formula without adjusting for supplier minimum orders or quantity discounts.
Questions
People also ask
What does EOQ tell me?
It gives the order size that minimises the total of ordering and holding costs for a product, given your demand and cost assumptions.
Does EOQ tell me when to reorder?
No, that is the job of the reorder point, which depends on lead time and demand during that lead time.
Is EOQ still useful with just-in-time systems?
Yes, because the same logic of balancing order costs and holding costs applies, although just-in-time aims to push ordering costs so low that very small orders become economic.