Your warehouse is probably filled with excess inventory because of large-volume purchases, leading to increased storage pressure and management challenges. Or maybe you’re frustrated by high storage costs and frequent stock-outs.
If you’re facing these issues, there’s a core concept you might be missing: a lack of EOQ thinking in your procurement process. Applying the Economic Order Quantity (EOQ) model is an excellent solution for these problems.
If you don’t know what EOQ is yet, keep reading! The answers you’re looking for are in the following sections.
What is EOQ?
If this is your first time hearing about EOQ, you’re probably wondering what it is and how it can help you. Let me explain everything for you.
EOQ: A Procurement Concept
First, let’s break down what EOQ stands for: Economic Order Quantity. In simple terms, EOQ is a formula that helps us calculate the most cost-effective quantity of goods to order each time. The term “cost-effective” here refers to the lowest total cost.
This total cost mainly consists of two parts:
- Ordering Cost: The costs incurred each time an order is placed, such as labor for placing orders, transportation fees, etc.
- Holding Cost: The costs of storing goods in a warehouse, such as warehouse rent, insurance, and product spoilage.
The core idea of EOQ is that when we order too little, holding costs are low, but we have to place frequent orders, which drives up ordering costs. Conversely, if we order too much, ordering costs are low, but goods pile up in the warehouse, and holding costs become very high. EOQ aims to find the perfect balance point where the sum of these two costs is minimized.
How Can EOQ Help Us?
Reduce Total Inventory Costs
This is the most crucial function of EOQ. By calculating the optimal order quantity, EOQ helps you balance ordering costs and holding costs, ensuring their total is at its lowest. This means your company can save more on inventory management and increase profits.
Optimize Cash Flow
Without EOQ, two situations might occur:
- Ordering too much: Large amounts of inventory tie up your valuable working capital. This money could have been used for other investments or operations but is now “frozen” in the warehouse.
- Ordering too little: While inventory is low, frequent orders generate high ordering costs and could lead to stock-outs, affecting sales.
With EOQ, you can allocate your capital more reasonably, avoid unnecessary waste, and maintain healthier cash flow.
Reduce Stock-out Risks and Waste
The order quantity calculated by EOQ is based on certain demand forecasts. While it can’t completely eliminate stock-outs or overstocking, it serves as a scientific basis for decision-making. It helps you find a better balance between meeting customer demand and avoiding inventory buildup. This, in turn, reduces lost sales due to stock-outs and the risk of goods expiring or losing value due to overstocking.
Improve Operational Efficiency
With a clear EOQ value, your procurement department can create purchasing plans more efficiently. Instead of guessing how much to order based on experience or intuition, they have a quantified, scientific basis. This reduces decision-making time and boosts work efficiency.
Lay the Foundation for More Complex Inventory Models
EOQ is a fundamental yet very important inventory management model. By mastering EOQ, you build a solid foundation for learning and applying more advanced inventory management methods, such as EOQ with safety stock, batch discount models, and more.
Holding Costs in the EOQ Model
Holding costs are crucial for the EOQ model.
Why? The essence of EOQ is finding a perfect balance between holding costs and ordering costs.
- If holding costs are high, EOQ will suggest you order less frequently because you don’t want too many goods piling up in your warehouse, which would increase costs.
- If holding costs are low, EOQ will suggest you order more frequently to reduce the number of orders, thereby lowering ordering costs.
Therefore, if you can’t accurately calculate holding costs, the EOQ result will be skewed, leading you to make the wrong purchasing decisions. This is why most articles on EOQ emphasize this point.
What Makes Up Holding Costs?
Holding costs are more than just warehouse rent; they are a comprehensive set of expenses, mainly including the following:
- Storage Space Cost: This is the most straightforward part, including warehouse rent, utilities, shelf depreciation, and maintenance fees.
- Capital Cost: This is the most easily overlooked but very important item. The money used to purchase inventory can’t be used for other investments. The opportunity cost of this capital is the capital cost.
- Insurance and Tax: You need to buy insurance to protect your inventory. As a company asset, inventory may also be subject to relevant taxes.
- Spoilage and Obsolescence Cost: Goods in the warehouse may be damaged, expire, or become obsolete due to technological updates, all of which result in a loss of value.
How to Calculate Holding Costs
You need to know how to quantify these costs. In the EOQ model, holding costs are usually expressed as the cost to hold one unit for one year.
There are two common calculation methods:
- Absolute Amount Method: Directly estimate the annual cost of holding one item. For example, if you estimate it costs $5 to hold one item for a year, the holding cost is $5.
- Percentage Method: Express the holding cost as a percentage of the item’s purchase cost. For example, if you estimate the holding cost is 20% of the purchase cost, and one item costs $50, the holding cost is $50 * 20% = $10.
The percentage method is generally more common because it better reflects the relationship between holding costs and product value.
Factors Affecting Holding Costs
Understanding what factors influence holding costs can help you estimate and manage them more accurately:
- Product Characteristics: Perishable, fragile, or short-shelf-life goods, or those requiring special storage (like refrigeration), will have higher holding costs.
- Warehouse Operational Efficiency: If warehouse management is chaotic and shelf utilization is low, storage costs will increase.
- Market and Technology Changes: Goods with fast-changing market demand or rapid technological updates will have higher obsolescence costs.
From “Theoretical Formula” to “Practical Application”
Next, I will combine theory with practical application. I’ll use a hypothetical medium-sized manufacturing company as an example to explain in detail how to use the EOQ model in conjunction with a warehouse racking system to optimize inventory management.
Case Study: ABC Manufacturing Company – Raw Material Inventory Optimization Project
Case Background:
ABC Manufacturing Company is a medium-sized enterprise that produces various electronic devices. They recently rented a new warehouse in the suburbs and plan to transform it into an efficient raw material storage center. Currently, they face two main challenges:
- High Inventory Costs: The procurement department habitually orders raw materials in large quantities to get price discounts, which leads to a large amount of inventory piling up in the warehouse and tying up the company’s working capital.
- Inefficient Warehouse Operations: The current warehouse layout is disorganized, and employees waste a lot of time searching for and retrieving goods, often leading to expired or misplaced raw materials.
To solve these problems, ABC Company decided to use the EOQ model to calculate the optimal order quantity and, based on that, design a brand-new warehouse racking system.
Step 1: Applying the EOQ Model – Calculating the Optimal Order Quantity
ABC Company chose three key raw materials for analysis. We’ll use one of them, called “Type A Circuit Board,” as an example.
- Annual Demand (D): 12,000 units per year
- Ordering Cost (S): $100 for labor, transportation, etc., per order
- Holding Cost (H): The purchase cost for each circuit board is $50, and the holding cost is 20% of the purchase cost, so H = $50 * 20% = $10
Using the EOQ formula:
Substituting the data:
Conclusion: Through the EOQ model, ABC Company found that ordering 490 units of “Type A Circuit Board” each time is the most economical. This was a stark contrast to their previous habit of ordering 2,000 units at a time. By calculating a similar EOQ for each raw material, they got a more accurate total inventory requirement, which provided a data foundation for the next step of racking planning.
Step 2: Combining a Racking System – Designing the Warehouse Layout
Based on the EOQ calculations, ABC Company realized their raw material inventory would be smaller than before, but the replenishment frequency would be higher. This meant they needed a racking system that could both store and allow for quick access.
They planned the following for different types of raw materials:
- High EOQ, Large-Sized Raw Materials: For raw materials with a high EOQ value and large size, like “steel casings,” they chose Selective Pallet Racking.
- Reason: Pallet racks can store standard-sized pallets, and each pallet can be accessed directly, which is convenient for forklift operations. This perfectly meets the needs of large-volume storage and retrieval while maintaining a moderate storage density.
- Layout: In the new warehouse, they placed the pallet racks near the receiving and shipping areas to reduce handling distances.
- Medium EOQ, Multiple-Category Raw Materials: For raw materials with a medium EOQ value and many different categories, like “Type A Circuit Board,” they chose Very Narrow Aisle Racking (VNA).
- Reason: VNA racks significantly reduce the width of aisles between shelves, thereby increasing storage density. While it requires the use of specialized narrow-aisle forklifts, it’s an ideal choice for storing many different types of items that require efficient space utilization.
- Layout: The VNA racking area was planned for the center of the warehouse, making it easy for employees to quickly retrieve different models of circuit boards using forklifts.
- Low EOQ, Small-Sized Raw Materials: For small parts like “screws and connectors” with a low EOQ value, they chose Mezzanine Racking.
- Reason: Mezzanine racks use the vertical space of the warehouse to create multiple floors. Lightweight or low-frequency items can be stored on the upper floors, while commonly used items are kept on the ground floor. This greatly improves space utilization without increasing the footprint.
- Layout: The mezzanine racks were set up in a corner of the warehouse as a centralized storage area for small parts, equipped with picking aisles and small carts to improve picking efficiency.
Final Result: By applying EOQ and a carefully designed racking system, ABC Company not only successfully lowered total inventory costs but also increased the new warehouse’s storage density by 30% and improved access efficiency by 25%. This case fully demonstrates the perfect combination of EOQ as a decision-making tool and a racking system as the execution vehicle.
A Practical Perspective from a “Racking Manufacturer”
You’ve calculated the perfect EOQ number, but is your warehouse truly ready? Many businesses only focus on the financial meaning of EOQ and neglect its physical carrier—the racking. As a racking manufacturer, we believe EOQ data is the best starting point for evaluating and optimizing your warehouse racking system.
1. How to Evaluate Your Existing Racking System
Your EOQ calculation is the “gold standard” for checking if your existing racking system is outdated or doesn’t meet your needs. Compare your EOQ data with the following questions:
- Does your average inventory level match the EOQ calculation?
If your actual inventory level is consistently higher than the EOQ recommendation, it means you might be storing unnecessary “dead stock.” Your current racking system, if designed to be overly bulky or with wide aisles, may be implicitly encouraging this inefficient large-volume storage model. - Does your replenishment cycle match the order frequency calculated by EOQ?
A smaller EOQ value means a higher replenishment frequency. If you find your employees constantly running back and forth in the warehouse for frequent replenishments and picking, and your current racks (e.g., traditional pallet racks) have long aisles, your system is no longer efficient. - Does your number of SKUs (Stock Keeping Units) align with your racking design?
If you have a high number of product SKUs but a small EOQ order quantity for each, and you’re still using racks primarily designed for large pallets, a significant amount of rack space will be wasted, with each SKU occupying an incomplete pallet position.
Through this evaluation, you’ll realize that EOQ is more than just a number; it’s a “health report” that reflects the true operational efficiency of your warehouse.
2. Racking Selection Suggestions: Combining EOQ Data with Industry Characteristics
We’ve combined EOQ calculation results with the inventory characteristics of different industries to provide you with unique racking selection suggestions:
- For products with large EOQ orders and few SKUs (e.g., building materials, commodities, beverages):
- Recommended Racks: Drive-in Racking or Pallet Shuttle Racking.
- Our View: These racks sacrifice access flexibility (First-In, Last-Out principle) to greatly increase storage density. When your EOQ calculation shows a large order quantity and the goods are not perishable, this type of racking can maximize your storage per square meter, significantly reducing storage costs.
- For products with small EOQ orders and many SKUs (e.g., e-commerce, spare parts, medicine):
- Recommended Racks: Live Racking or Mezzanine Racking.
- Our View: A small EOQ order quantity means you need a more flexible picking system. Live racking uses gravity to achieve First-In, First-Out, which can significantly boost picking efficiency. Mezzanine racking, on the other hand, fully utilizes the vertical space of the warehouse, allowing you to manage different SKUs on separate levels and providing a dedicated picking area for low-EOQ small items, thereby improving overall space utilization.
- For cold chain logistics or high-value products:
- Recommended Racks: Mobile Racking.
- Our View: While the initial investment is high, it can increase storage density by over 80%, greatly reducing the need for refrigerated or security-controlled space. When the EOQ-calculated inventory is large and the storage environment is very expensive, mobile racking is the ultimate solution for lowering holding costs.
3. Emphasize Flexibility: Compensating for EOQ’s Limitations
The EOQ model is based on the assumption of stable demand, but in the real world, demand fluctuation is the norm. As a racking manufacturer, we know that a successful warehouse needs to be flexible to cope with market unpredictability.
Therefore, when choosing a racking system, you should focus on the following characteristics:
- Scalability: Choose modular racking systems that are easy to add to or subtract from. For example, some of our racking series can easily increase or decrease the number of layers or adjust beam spacing to accommodate different-sized goods.
- Adjustability: Consider racks with a flexible layout. When your product mix or market demand changes, a reconfigurable racking system can help you quickly adjust your warehouse layout instead of being forced to rebuild it.
Conclusion
EOQ is more than just a mathematical formula; it’s a strategic approach to inventory management. My goal in writing this article wasn’t just to help you understand what EOQ is, but to show you how combining EOQ with a racking system can truly help your business reduce costs and increase efficiency.
Finally, if you don’t want to spend too much time on this, we’re happy to listen to your needs and provide you with racking products and technical support! So, feel free to contact us!
