Note on Eoconomic Order Quantity

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INTRODUCTION TO ECONOMIC ORDER QUANTITY

One of the major problem in management is the determination of order size quantity to be purchased which should be neither small nor big because cost of ordering and carrying materials are very high. Economic Order Quantity (EOQ) is the size of the lot to be purchased which is economically viable or which can be purchased at minimum costs.

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Fig: Economic Order Quantity graph
Source:www.eazystock.com

So, the economic order quantity is that quantity, when the total cost of an inventory is minimum and is determined to keep in view the ordering cost and to carrying cost minimized.

An economic order quantity (EOQ) is an inventory related equation that determines the optimum order quantity that a company should hold in its inventory given a set cost of production, demand rate and other variables this is done to minimize variable inventory costs. Here’s the equation that uses to calculate EOQ as follows:

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While the interaction of them about the cost, the economic ordering costs during a particular period are equal to carrying costs and ordering costs. During that period, total cost to order and carry is the lowest. It is also known as re-ordering quantity. Economic order quantity involves two types of cost:

Carrying Cost

All those costs which are incurred when we carry (or keep) the inventory in the store for a certain period of time are known as total carrying cost. It is the cost of holding the materials in the store. In next word, carrying cost is related with the storing of materials. The cost incurred for maintaining a given level of inventory is called carrying a cost.

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Total carrying cost will increase when we purchase more and more quantities of inventory at a time. The carrying cost includes the following costs:

  • Clerical cost / store administrative overhead cost.
  • Insurance and rent charges of inventory.
  • Transportation cost in relation to stock.
  • The cost of spoilage in the store of handling.
  • The cost of storage space.
  • Interest on capital or loan blocked on the material.
  • Opportunity cost.
  • The cost of maintaining the material.
  • The cost of bin & rack for the storage of stock
  • Losses and thefts.
  • Inventory taxes.

Ordering Cost

All those costs which are related to the purchase activities of inventory are ordering costs. It is the cost of placing an order for the purchase of material. Ordering cost varies with the number of order. The ordering cost normally includes clerical costs of preparing a purchase order or production order and special processing and receiving costs related to cost and a number of order processed.

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Ordering cost tends to increase or decrease in proportion to the number of orders placed. When we purchase more and more quantity at a time, the number of the order will decrease.

The examples of ordering cost are:

  1. The cost of staff in the purchasing department, inspection section and payment department.
  2. The cost of stationery, postage and telephone charges.
  3. The cost of floating tender.
  4. The cost of paperwork.

Calculation of Economic Order Quantity (EOQ)

The order quantity where the total ordering cost and carrying costs are equal is known as the economic order quantity. The economic order quantity can be calculated under the following methods;

  1. Formula method
  2. Graphical method
  3. Trial and error method

However, according to the syllabus, we will discuss the calculation of economic order quantity using formula method only.

With the help of using following formula, the economic order quantity can be calculated.


eoq formula

References:

Koirala, Madhav et.al., Principles of Accounting -XII, Buddha Prakashan, Kathmandu

Shrestha, Dasharatha et.al., Accountancy -XII, M.K. Prakashan, Kathmandu

Bajracharya, Puskar, Principle of Accounting-XII, Asia Publication Pvt. Ltd., Kathmandu

  1. It is the size of the lot to be purchased which is economically viable or which can be purchased at minimum costs. So, the EOQ is that quantity when the total cost of an inventory is minimum.
  2. EOQ determined to keep in view the ordering cost and carrying cost are minimized.
  3. Economic order quantity involves two types of cost: Carrying cost and Ordering cost.
  4. Total carrying cost will increase when we purchase more and more quantities of inventory at a time. 
  5. Ordering cost tends to increase or decrease in proportion to the number of orders placed.
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