We use 2,000 electric drills per year in our production process. The ordering cost for these is $100 per order and the Holding( carrying) cost is assumed to be 40% of the per unit cost. Each drill costs $78. What is the optimal quantity that would minimize the sum of Holding and Ordering costs.

The Optimal Quantity to minimize Holding and Ordering Costs:

This is also known as the Economic Order Quantity (EOQ).

We can work it out using the EOQ formula.

The formula for EOQ is:

Q = √(2DS)/H  

where:

Q=EOQ units

D=Demand in units (typically on an annual basis)  = 2,000

S=Order cost (per purchase order)  = $100

H=Holding costs (per unit, per year) = $31.20 ($78 x 40%)

Formula and Calculation of Economic Order Quantity (EOQ)

Q =  √(2x2,000x $100)/$31.2

Q = √12,820.5 = 113.228 or 113 approximately.

Explanation:

EOQ is an important cash flow management tool. The formula assists a company to control the amount of cash tied up in inventory.  For many companies, inventory is their largest asset.  Companies hold enough inventory to meet customers' demand.  Since EOQ minimizes the level of inventory, the cash savings can be used for some other business purposes or investments.

The goal of the EOQ formula is to identify the optimal number of product units to order. If achieved, a company can minimize its costs for buying, delivery, and storing units, including the costs from running out of inventory.