To understand the Economic Order Quantity, it is helpful to review the Order Cycle. The vendor Order Cycle represents a number of days between ordering. Order Cycle Analysis is one of the most significant components when it comes to the suggested order. If you don’t know what the best cycle is, it will be difficult to know the right amount of inventory to order. The Order Cycle Analysis tool works to help you find the optimal order cycle for your vendor regarding lowest annual net cost. The two main costs that are considered are acquisition cost (ordering cost) and the carrying cost.
Economic Order Quantity: The order quantity that minimizes total inventory carrying costs and ordering costs.
Ordering Costs: These costs include the expenses that are involved in placing an order. So if a buyer is ordering too often, these costs will be higher than they should be.
Carrying (Holding) Costs: These costs represent the cost of storing or maintaining inventory. The more that is held, the higher the costs. When companies order too much inventory, this will lead to higher carrying costs. Here are the most common costs associated with carrying costs:
Obsolescence and Shrinkage
Cost of Money Invested
After determining the values of each variable above, you can take the sum of those values annually and divide it by your Average Inventory Value to determine your carrying rate.
Product purchase price: The cost of the item being bought. For example, ordering too much of an expensive product will bring on higher costs for the time period.
Shortage Cost: The cost of not having enough inventory to satisfy demand. This is also known as the stockout cost. It is considered an opportunity cost since not having enough to satisfy demand leads to missing out on a chance for profit.