Economic order quantity is an inventory strategy that aims to balance holding and ordering costs. The Wilson EOQ Model is used to identify the optimal balance and assumes constant order cost, demand rate, lead time, and purchase price. The strategy helps reduce inventory costs and tax debt.
Economic order quantity is an inventory strategy that seeks to identify and maintain the optimal balance between the holding costs associated with an inventory and the ordering costs incurred with that inventory. First developed in the early 20th century by FW Harris, the economic order quantity approach is commonly known as the Wilson EOQ Model, or simply the Wilson Formula. This is in recognition of the aggressive expansion of the use of this strategy by RH Wilson, a consultant who recommended this approach to his clients and, in many cases, worked with them to implement the strategy.
The objective of the economic order quantity strategy is to identify the point at which order costs and the book cost associated with an inventory are at their lowest possible point. At the same time, the approach seeks to ensure that the stockholder fulfills customer orders in a timely manner. To identify this ideal balance, the formula uses some basic assumptions.
The first of the assumptions associated with the economic order quantity formula is that the order cost will remain constant. It is also assumed that the demand rate also remains constant, a factor that allows the supplier to purchase items for inventory using recurring quantities. Also, there is an assumption that the lead time will not change; lead time applies not only to the customer’s demand for delivery within a given time period, but also to the supplier’s ability to fulfill and ship orders to the supplier in a consistent time period. Finally, there is no change in the purchase price and the entire order is received in one go rather than in batches or segments.
The ideal situation for the supplier is to be able to build up inventory that is used to fulfill backorders from customers without remaining in inventory for long periods of time. Assuming the materials needed to manufacture the items for inventory arrive in a timely manner, are processed efficiently, and are placed into a finished goods inventory within a reasonable period, the cost of inventory can be significantly reduced. Finished goods are pulled from inventory, assigned to a specific customer order, and shipped before there is too much time for taxes to be assessed on the overall current inventory value. Keeping perpetual inventory as close to zero as possible not only helps minimize tax debt, but also allows the supplier to operate without having to rent, lease, or operate warehouse space for larger inventory. Thus, achieving the optimal amount of cost-effective orders can save a significant amount of money over the course of a year.
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