Economic Order Quantity (EOQ)

Economic Order Quantity (EOQ)

Overview

EOQ determines the order quantity that minimizes total inventory cost = ordering cost + holding cost. Formula: EOQ = √(2DS/H) where D=annual demand, S=ordering cost per order, H=holding cost per unit per year. Assumes constant demand and instantaneous replenishment.

When to Use

Trigger conditions:

• Setting standard order quantities for inventory replenishment
• Balancing ordering frequency against warehousing costs
• Baseline calculation before applying safety stock adjustments

When NOT to use:

• When demand is highly uncertain (use newsvendor model)
• When products are perishable with short shelf life
• When quantity discounts change the cost structure significantly

Algorithm

IRON LAW: EOQ Assumes CONSTANT, KNOWN Demand
If demand is variable or uncertain, EOQ gives the wrong answer.
Real-world application: use EOQ as a starting point, then add
safety stock for demand variability and lead time uncertainty.
Total cost curve is flat near EOQ — ±20% from optimal Q changes
total cost by only ~2%.

Phase 1: Input Validation

Determine: D (annual demand in units), S (fixed cost per order), H (holding cost per unit per year = unit cost × holding rate, typically 20-30% of unit value). Gate: All costs positive, demand estimate reasonable.

Phase 2: Core Algorithm

1. EOQ = √(2 × D × S / H)
2. Number of orders per year = D / EOQ
3. Reorder point = d × L (daily demand × lead time in days)
4. Total annual cost = (D/Q × S) + (Q/2 × H) at Q = EOQ

Phase 3: Verification