Just in time, total quality management and total cost of ownership are just a few of the myriad ways manufacturing companies have come to measure and quantify the costs associated with holding inventory. Economic order quantity (EOQ) is the point when order costs and the costs associated with carrying inventory are at a minimum. The number provides insight into the optimal quantity of items to order based on a certain cost.
Understand and review the formula. The basic formula for EOQ is: [2 (Annual Usage in Units Order Cost) / Annual Carrying Cost per Unit]^(1/2).
Define the variables. The most difficult part about calculating the EOQ is defining the variables. Annual usage is the forecasted number of units of inventory the company will require for the year. Let's use 100 units of inventory for this example, based upon the company's previous year's data. Order cost is the purchase cost or the sum of the "fixed costs" associated with ordering a specific quantity of goods, for example, $500. Carrying cost or holding cost is the cost associated with keeping inventory on hand (storage, interest, insurance, taxes, and so on). Let's use $100.
Calculate the numerator: 2 Annual Usage in units (100 units) Order Cost ($500) = $100,000.
Divide the numerator ($100,000) by the Annual Carrying Cost per Unit ($100). This equals 1,000 units.
Take the square root of 1,000 units. A simple way to find the square root is to raise a number to the 1/2 power. That is, 1,000^1/2. The answer is 32 units (rounded up). On this particular item, the optimal number of units to purchase is 32 units.