The formula
EOQ = √(2 × demand × ordering cost / holding cost)
What it means
Two costs pull in opposite directions. Ordering a lot at once makes ordering cheap, because you do it less often, but it fills the warehouse and pushes holding costs up. Ordering little and often does the reverse. The total cost curve is the sum of the two and it has a minimum, and that minimum is the economic order quantity. At it — and this is what serves as a check — the two annual costs come out exactly equal.
How to work it out by hand
- Note the annual demand, what one order costs to place, and what holding one unit for a year costs
- Multiply the demand by the ordering cost and by two
- Divide by the holding cost
- Take the square root: that is the optimal order size
What is worth knowing
The formula assumes constant demand, a fixed lead time and no volume discounts, and in practice none of the three quite holds. Its value lies elsewhere: the cost curve is very flat around the optimum, so being twenty per cent off on the order size raises the total by barely two per cent. That means there is no need to be precise, and any reasonably close order size will do. If the supplier offers quantity discounts, compare total cost at each price break.