14 minute read

What Is Economic Order Quantity (and How Do You Calculate It)?

Calculating your business’s economic order quantity can help cut inventory costs and boost your bottom line. Learn the EOQ formula here.

what-is-economic-order-quantity

Knowing your business’s EOQ can help you meet customer needs. When it comes to getting inventory to customers, trust Circuit for Teams.

Economic order quantity (EOQ) refers to a company’s ideal order quantity. 

It’s the number of orders your business can successfully fulfill while minimizing costs like inventory holding (storing products before they go to customers).

An inventory holding cost example would be what you pay for warehousing.

If you sell goods — whether through an eCommerce shop or a brick-and-mortar store — EOQ matters to you.

Why? 

If you can identify your business’s EOQ, you can spend less on costs related to the purchase, storage, and delivery of inventory (don’t worry, I’ll explain how in more detail below).

For example, you can use EOQ to determine when it makes sense to order more inventory (also known as your reorder point).

If done right, you’ll have just enough inventory to meet customer demand without having stuff you can’t sell (and must store — no thanks).

But just how can you figure out EOQ? Good news: There’s a straightforward formula.

Below, I’ll explain how to calculate EOQ for your business and give some examples to show the EOQ formula in action.

I’ll also discuss what goes into the EOQ formula and how to make calculations (just a warning: there’s a lot of math ahead).

Finally, I’ll explain how figuring out your EOQ can help you save on costs and boost your bottom line. 

Hey, if you’re going to do all that math, it’d better be worth it, right?

Once you finish this guide, you should understand what EOQ is, why it matters, and how to calculate it.

Let’s get to it. 

Circuit for Teams is a simple software for optimizing routes with multiple drivers. Click here to start your free 14-day trial.

How to calculate economic order quantity (EOQ)

EOQ has a formula that business owners like yourself can use.

Before we jump in, though, I should give you a heads-up: You’ll be using this formula more than once, so it’s good to know it well!

EOQ isn’t a constant since some of the factors it’s based on — like customer demand — aren’t constant.

For example, if your online store specializes in swimming pool supplies, the odds are you’ll see higher customer demand in warmer months, like May to August.

Similarly, demand may change as your business changes.

You might start as a small online store with just a few hundred customers one day and grow into an eCommerce retail giant with millions of customers (even Amazon got their start with a single book sale).

Calculate EOQ for your business now, but keep in mind that you’ll want to do it again later. 

You might calculate EOQ on a monthly, quarterly, and annual basis or based on seasonal milestones. 

For example, if you sell barbecue supplies, you’ll probably need to adapt your EOQ for the summer months when demand goes up.

Now, let’s get into the formula.

EOQ formula 

First, I’ll show you the full formula for calculating EOQ. Then, I’ll break down what each part of that formula means.

Here’s the entire formula:

eoq formula

Here’s an overview of what each part of that formula actually means:

  • S: S refers to setup costs (sometimes called order costs). This is the amount of money it takes to order inventory — including packaging, handling, and shipping it to your business — so you can distribute it to customers.
  • D: D represents demand in units. This just means the number of units customers are ordering. Usually, demand in units is specified within a given time frame, such as a month or year. In most cases, demand in units is calculated annually (how many product units your customers request in an entire year).
  • H: H refers to inventory holding costs. This refers to how much money it costs to store inventory. H is usually calculated on an annual per-unit basis. So, how much will it cost to store one piece of inventory for a whole year? There’s a separate formula for calculating holding costs, which I’ll get into below.

To get your EOQ, multiply 2 times setup cost (S) times demand in units (D).

2 x S x D

Then, divide that number by your holding cost (H).

(2 x S x D) divided by H

The final step: Take the square root of the result.

√ of ((2 x S x D) / H )

I’ll go into more detail about each of those components and how to calculate them in the next section. 

After the two EOQ formula examples, I’ll explain how to calculate holding cost, annual demand, and setup cost.

EOQ calculation: example 1 

Let’s say you have a small business selling knit hats. 

It’s just opened, so you don’t have a huge customer base. You estimate that your demand in units for the year (D) will be 100.

You order the hats in bulk from an online wholesaler. Packaging, delivering, and handling inventory costs you $500 for 100 hats. So, that’s a total cost of $5 per hat. 

Your setup cost (S) is 5.

Since you’re just starting, you haven’t stocked up on a lot of inventory — you want to feel out customer demand first. 

You’ve rented one small storage unit for $10 per month, totaling $120 per year. That’s plenty to hold your hats.

The storage unit holds 100 hats, so the annual cost of storing a single hat is $12 (remember, H is given on an annual per-unit basis).

Start by multiplying 2 x S x D:

2 x 5 x 100 = 1,000

Now, let’s divide the result (1,000) by H, the holding cost (12):

1,000 / 12 = 83.33

Finally, we take the square root of 83.33:

√83.33 = 9.13

The EOQ is 9.13 units of product (in this case, 9.13 hats). This means that the ideal order size is 9.13 hats to meet customer demand while still minimizing operating costs.

It also means that if you have fewer than 9.13 hats in your inventory, it’s time to get some more! 

(Or since you can’t have 9.13 hats, let’s say it’s time to stock up once you have fewer than ten hats.)

EOQ calculation: example 2 

Now, let’s say you’re a well-established online retailer. You’ve been selling coffee mugs for five years. 

Based on the last five years of sales, you know that your annual demand is 10,000 units.

It costs you $10 to have a single coffee mug shipped and delivered to you (they’re fragile, so you have to pay for extra packaging). 

Your setup cost (S) is 10.

Since you already have a lot of demand, you keep a good amount of inventory on hand. You rent space in a shared warehouse for holding inventory for $250 per month. 

That totals $3,000 per year in annual holding costs.

The warehouse unit holds 1,000 coffee mugs, so the annual cost of storing a single mug is $3 (H is an annual per-unit cost).

(Learn how to efficiently organize warehouses.)

Start by multiplying 2 x S x D:

2 x 10 x 10,000 = 200,000

Now, let’s divide the result (200,000) by the holding cost (3):

200,000 / 3 = 66,666.67

We then take the square root of 66,666.67:

√66,666.67 = 258.20

The EOQ is 258.20.

This means the ideal order size is 258.20 units of product (258.20 mugs) to meet customer demand while minimizing operating costs. 

You should always have an inventory level of at least 258.20 mugs (or 259, since you can’t have 0.20 of a mug) ready to go in your inventory storage space.

components of eoq formula

Components of the EOQ formula explained

I mentioned a few key components in the economic order quantity calculation examples above: 

  • Demand in units (D)
  • Setup cost or order cost (S)
  • Holding cost (H)

If you’ve read my post on minimum order quantity (MOQ), some of these might look familiar.

That’s practical because you can use your calculations of units like demand and holding costs for both MOQ and EOQ.

Below, I’ll explain how to determine those numbers (you’ll need them for your EOQ).

How to calculate holding cost (H) 

Holding costs — also called carrying costs — refer to the money you spend on storing inventory. They’re given on a per-unit, per-year basis.

Use this formula to calculate holding costs:

(Storage Costs + Employee Salaries + Opportunity Costs + Depreciation Costs)

÷

Total Value of Annual Inventory

=

Holding Cost

Let’s break it down:

  • Storage costs refer to costs like warehousing or storage unit fees.
  • Employee salaries refer to the money you pay workers who might work in your warehouse or storage unit.
  • Opportunity costs refer to a potential benefit your business misses out on (like a missed opportunity) when choosing A over B. For example, if you increase your inventory balance by $500 (option A), you have $500 less to put toward operating costs (like production equipment, rent for manufacturing facilities, and raw materials to produce goods). Alternatively, if you don’t increase your inventory balance (option B), you have that $500 to put toward operational costs.
  • Depreciation costs refer to how much value a piece of inventory loses over time. This might apply to technical products, like machinery, which can become worn and broken with repeat use.
  • Total inventory value refers to how much your inventory is worth (monetarily).

How to calculate annual demand (D) 

Annual demand refers to the number of orders you get from customers in a given year. The easiest way to figure this out is using demand forecasting, a process that looks at historical data to predict future trends. 

Check how many orders you got last year — that’s a good estimate of your annual demand. 

Learn more about demand forecasting.

What if your business just started and doesn’t have historical data?

Some software products predict demand based on a product’s attributes instead of the product itself. Examples include Streamline, Blue Yonder, and Oracle Demantra.

So if you’re selling black sweatshirts, the software will look at how black sweatshirts have sold. This article explains how it works in greater detail.

How to calculate setup cost (S) 

Setup costs (or order costs) relate to ordering inventory. This can include packaging, shipping, and delivery.

For example, you’ll likely pay for shipping if you order inventory from a supplier like Alibaba or AliExpress.

You also have to think about handling costs. For example, if you have warehouse workers dedicated to receiving and processing incoming inventory, you’ll need to pay them salaries or wages.

Factors that impact EOQ

Above, I gave two examples of the economic order quantity formula in action. As you can see from the hugely different results in each case, EOQ can vary.

Obviously, holding costs, setup costs, and demand directly impact EOQ.

Other factors to consider include:

Reorder point

This is the period when you need to reorder inventory to replenish stock. 

Knowing your reorder point can help reduce the risk of stockouts when you don’t have enough stock on hand to fulfill a customer’s order.

Stockouts can lead to backorders, when a customer orders an item that’s out of stock. Learn why backorders happen and how to avoid them.

The hat and the coffee mug examples show how EOQ and reorder points relate. 

But you may want to shift your reorder point if you’re anticipating more customer demand (for example, due to seasonal demand).

Purchase order lead time

This is the time that passes from when you place the order for inventory (for example, to a wholesaler) to when the inventory is delivered to our business.

It’s important to think about lead time whenever it comes to inventory management and supply chain metrics — including EOQ. 

You can’t assume that new inventory will arrive immediately after ordering it. You must leave time for shipping.

For example, check out the delivery times for these tank tops from AliExpress. If you place an order on Dec. 9, you can expect it by Feb. 11 (see the bottom of the screen grab).

aliexpress

There ARE faster shipping options available, but they cost a lot more (and still aren’t THAT fast. You could pay $28.64 to get the tank tops by Dec. 24, for example):

aliexpress shipping

Purchase cost per unit

The EOQ formula assumes you pay the same amount per inventory unit every time. 

The cost per unit shouldn’t change with time, theoretically. However, external factors like rising materials costs, increases in production costs (like labor costs), and inflation can influence the purchasing cost per unit.

For example, in 2022, manufacturers faced rising production costs because of inflation, which drove up the cost of raw goods they used to make their products.

Shipping prices are also rising, thanks largely to increased demand without enough capacity to meet it.

There were also lingering pandemic-related issues, like Americans spending stimulus checks and doing more shopping (driving demand). 

Meanwhile, ongoing COVID-related restrictions in China, a major manufacturing and shipping hub, slowed the ability to meet demand for certain products (like iPhones).

Challenges of calculating accurate EOQ

EOQ can be helpful to know, but it’s not a foolproof formula. There are some challenges to calculating EOQ, including:

Lack of data or poor-quality data

Estimating factors that impact EOQ (like demand) can be tricky if your business is just starting out. 

While I’ve talked about how predictive forecasting software can help, this isn’t a 100 percent accurate solution. 

Data issues can also happen because of outdated inventory management systems or incorrect data (like inventory shrinkage, when the amount of inventory recorded doesn’t match up with how much inventory there actually is).

Changing demand

EOQ is a formula that assumes constant demand. But customer demand isn’t constant. Seasonality can play a role, for example, as can trends. 

For example, an online viral video of someone using a product can make it take off. 

In 2022, the SKIMS long dress went viral, getting over 110 million views on TikTok (for context: SKIMS as a brand had 379.9 million views, so 110 million for one dress was quite a lot).

Viral TikTok products are such a big deal that some holiday guides are devoted to them (like this one).

A set mathematical formula can’t account for these real-world scenarios. Market research can help you track trends.

For example, you can use Google Trends to see what people are searching for online. As you can see, interest in the SKIMS dress has increased over the past year, with more people Googling it:

google trends results example

Other market research methods include running focus groups or doing interviews, reading industry publications (like fashion magazines if you're in fashion), and watching what your competitors do.

This primer to market research offers more in-depth detail on the different methods.

Inventory shortages

Some business owners are conservative when estimating demand, which can result in a low EOQ. 

They might worry they’ll end up with more stock than they can sell, especially if they’re a newer business without a big customer base.

This can lead to stockouts (not having enough inventory to fulfill customer orders). 

Alternatively, some business owners overestimate demand and end up with more inventory than they need, which can result in paying for extra storage.

Business growth

A growing business is good news. However, it means you’ll have to recalculate your EOQ regularly — perhaps more regularly than you’d like. 

As I mentioned, EOQ can change because the factors that determine it, like demand, change.

If your business is growing and customer demand is increasing, you’ll likely need more stock to keep up. 

And if you have a viral product, you might need to calculate EOQ even more regularly (every week instead of every month, for instance).

If you’re struggling to maintain operations and keep up with demand, you might consider using a fulfillment center to help your business scale up. 

Learn how fulfillment centers work and how they can help your business.

how eoq saves you money

How knowing EOQ helps you save money

Calculating your EOQ definitely takes some effort. That said, it has great benefits for your business — some can even boost your bottom line.

Here’s how EOQ helps you:

Cut cost of inventory

Carrying extra inventory you aren’t selling means paying more for inventory storage. If you know your EOQ, you can reduce the risk of excess storage. 

You can also avoid constant reorders, which add shipping and delivery costs. 

For example, if you order inventory every time you run low instead of using a concrete number like EOQ, you might underestimate how much you need. Making multiple orders close together instead of bigger orders spaced further apart wastes time and money. 

Plus, ordering inventory in bulk can be cheaper. For example, check out the per-unit price for these bags. 

One to 199 pieces costs $1.30 each, 200 to 9,999 costs $1.21 each, and more than 10,000 costs $0.98 each.

alibaba dropshipping

Reduce the risk of stockouts

You don’t want too much inventory because it could mean paying more for storage. 

If your current warehouse doesn’t have enough space, you’ll have to buy extra storage space to keep your stock.

Too much inventory can be bad. But you also want to have enough inventory to fulfill customer orders. 

When you know your EOQ, you reduce the risk of having insufficient inventory, which can lead to stockouts. Stockouts are problematic because they result in delayed customer orders (which can lead to unhappy customers). 

If you’re ordering items in bulk from a wholesaler, the delays can be drastic. 

Take a look at production times on Alibaba — since these wholesalers sell in bulk, they aren’t exactly offering overnight services.

For example, you’ll have to wait 40 days for these bags:

alibaba lead timealibaba faqs

Get a better handle on cash flow

Cash flow refers to the money that goes in and out of your business. You want to always have enough cash on hand to cover operating expenses, like fulfilling customer orders and paying salaries. 

EOQ can help you improve your control over how much company money is tied up in inventory. 

By optimizing inventory levels, for example, you avoid paying extra for storing unwanted inventory because of overstocking (ordering too much inventory).

Improve efficiency

Organizing, tracking, and storing inventory is complicated. 

You not only need to categorize inventory based on type, but you also need to make sure it’s readily available when and where you need it.

One technique that can improve inventory control is the FIFO method. This has you store inventory that sells quickly at the front of the warehouse, where it’s easy to reach, and inventory that sells slowly at the back.

You also need to track inventory, making sure you know where it is at all times to minimize the risk of loss.

Plus, you need to have the right amount of inventory on hand without having SO much that you have to pay for extra warehouse space.

That’s where EOQ comes into the picture.

With EOQ, you’ll use fact-based data to determine how much inventory you need to have on hand. 

As mentioned, this can reduce the risk of a stockout that leaves you scrambling for inventory (and maybe paying more for delivery).

Operations are more efficient when you have the inventory on hand and don’t have to order more at the last minute. It’s also faster to process orders.

EOQ conclusion

EOQ is just one of the many formulas you might use when working in logistics and supply chain management (I have a whole guide to must-know Excel formulas).

EOQ refers to your “perfect” order quantity — the number of orders you can fulfill while keeping costs, like inventory storage, low.

There’s a set formula for calculating EOQ, which I’ve detailed above. I’ve also given you some examples of the EOQ formula in action.

It’s well worth your while to master the EOQ formula and use it for your business. As I explained above, EOQ can help your business save money by reducing inventory costs.

It can also help improve operations by reducing the risk of stockouts.

In general, tools like EOQ can help you improve process efficiency for your business, offering clear data you can use for actionable decision-making — like deciding when to reorder inventory and how much inventory to order.

To make the most of EOQ, it’s important to calculate this number regularly. Various factors — from seasonality to changing customer demands — can impact EOQ.

Use the information in this guide to regularly calculate and update your company’s EOQ. Doing the math now will support your business success in the future!

Circuit for Teams is a simple software for optimizing routes with multiple drivers. Click here to start your free 14-day trial.
Published20 December 2022
Updated20 December 2022
AuthorHeather Reinblatt
You made it this far!

Chances are you'll love our other stuff too. Get our newsletter for the latest on all things delivery.

Simple software for optimizing routes with multiple drivers.Try Circuit free for 14 days

About the author

Heather Reinblatt
Heather ReinblattContributor

Heather Reinblatt is a managing editor currently living in St. Louis, Missouri. She spends her free time reading, trying new recipes, and cuddling her cat Paisley. You can find Heather on LinkedIn.

Share