Often, when purchasing goods, suppliers offer a discount if the quantity of items ordered exceeds a certain amount specified by their quantity/price break points. This discount is provided because suppliers can produce and deliver the product at a lower cost when orders are larger.
To minimize total costs, the buying organization must decide whether the purchase quantity discount is the best option. This can be determined by using the EOQ formula.
Economic Order Quantity – A type of fixed order quantity model that determines the amount of an item to be purchased or manufactured at one time. The intent is to minimize the combined costs of acquiring and carrying inventory.
Formula for EOQ
To calculate the ideal quantity to order, you can use this formula: Quantity = square root of (2 x A x S) divided by (i x C). A represents your annual usage in units, while S stands for the ordering costs in dollars. i is the annual inventory carrying cost rate expressed as a decimal, and C is the unit cost. The EOQ indicates the optimal order quantity that minimizes both ordering and carrying costs based on the current price.
Formula for Annual Ordering Cost
Annual ordering cost is calculated as: number of orders per year x cost per order
Ordering Cost – The costs that increase as the number of orders placed increases. Used in calculating order quantities. Include costs related to the clerical work of preparing, releasing, monitoring, and receiving orders; physical handling of goods; inspections; and set up cost.
Formula for Carrying Cost
The annual carrying cost is calculated as: (order quantity x cost x carrying cost percentage) /2
Carrying Cost – The cost of holding inventory, usually defined as a percentage of the dollar value of inventory per unit of time (generally one year). Carrying cost depends mainly on the cost of capital invested as well as costs of maintaining the inventory such as taxes and insurance, obsolescence, spoilage, and space occupied. Such costs vary from 10% – 35% annually, depending on type of industry. Carrying cost is ultimately a policy variable reflecting the opportunity cost of alternative uses for funds.