The economic order quantity strategy seeks to balance handling and ordering costs for inventory while ensuring timely customer order fulfillment. The Wilson EOQ Model is commonly used and assumes constant costs, demand rate, delivery time, and purchase price. Minimizing inventory costs can save money and reduce the need for warehouse space.
Economic order quantity is an inventory strategy that seeks to identify and maintain the ideal balance between the handling 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 has recommended this approach to his clients, and in many cases worked with them to implement the strategy.
The goal of the economic order quantity strategy is to identify where the ordering costs and freight costs associated with an inventory are at their lowest possible. At the same time, the approach aims to ensure that the inventory owner fulfills customer orders in a timely manner. To identify this ideal balance, the formula makes use of some basic assumptions.
Foremost among the assumptions associated with the economic order quantity formula is that the cost of the order will remain constant. The demand rate is also assumed to remain constant, a factor that allows the seller to purchase items for inventory using recurring quantities. Furthermore, it is assumed that the delivery 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 fill and ship orders to the supplier in a consistent time frame. Finally, there is no change in the purchase price and the entire order is received at once, rather than in batches or segments.
The ideal situation for the supplier is to be able to build inventory that is used to fill pending customer orders without sitting on inventory for extended periods of time. Assuming that the materials required to manufacture inventory items arrive in a timely manner, are processed efficiently, and are placed on finished goods inventory within a reasonable amount of time, inventory costs can be reduced significantly. Finished goods are pulled from inventory, assigned to a specific sales order, and shipped before there is much time to assess taxes on the overall current inventory value. Keeping permanent inventory as close to zero as possible not only helps minimize your tax liability, but also allows the supplier to operate without the need to rent, lease, or otherwise manage warehouse space for a larger inventory. Therefore, achieving the ideal amount of inexpensive orders can save a significant amount of money over the course of a year.
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