Economic Order Quantity (EOQ) : A decision about how much to order has great
significance in inventory management. The quantity to be purchased should neither be small
nor big because of buying and carrying cost of materials are very high. EOQ is the size of the
lot to be purchased which is economically viable. This is the quantity of material which can
be purchased at minimum cost. Generally EOQ is the point at which inventory carrying costs
are equal to order costs. In determining EOQ, it is assumed that cost of managing inventory is
made up solely of two parts i.e., ordering cost and carrying costs.
1. Ordering Costs : These are the cost which are associated with the psurchasing or ordering
of materials. These costs include
(a) Costs of staff posted for ordering of goods. A purchase order is processed and then placed
with suppliers. The labour spent on this process is included in ordering costs.
(b) Expenses incurred on transportation of goods purchased.
(c) Inspection costs of incoming materials.
(d) Cost of stationery; typing, postage, telephone charges, etc.
These costs are also known as buying costs and will arise only when some purchases are
made.When materials are manufactured in the same concern than these costs will be known
as set-up costs. These costs will include costs of setting up machinery for manufacturing
material, time taken up in setting cost of tools, etc.The ordering costs are totalled up for the
year and then divided by the number of orders placed each year.
2. Carrying Costs : These are the costs for holding the inventories. These costs will not be
incurred if inventories are not carried. These costs include
(a) The cost of capital invested in inventories. An interest will be paid on the amount of
capital locked up in inventories.
(b) Costs of storage which could have been used for other purposes.
(c) The loss of materials due to deterioration and obsolescence. The materials may deteriorate
with passage of time. The loss of obsolescence arises when the materials in stock are not
usable because of change in process or product.
(d) Insurance cost.
(e) Cost of spoilage in handling of materials.
Ordering cost increases as a number of orders increases. Carrying cost decreases as the
number of orders increases. EOQ is that quantity where the total cost is minimum.