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Managing inventory is one of the most important aspects of a thriving eCommerce business, but most entrepreneurs have little experience in it when they launch. Effective inventory management can help you optimize how and when you order inventory to reduce overhead, risk, and thus total costs.
The calculation most inventory managers rely on for this is economic order quantity (EOQ), which is the order size you need to minimize risks and costs such as holding/storage, shortage, order processing, and waste. You need a considerable amount of data for this calculation, including actual costs associated with holding inventory, the likelihood of risk, and more.
Although there are dozens of inventory management equations, EOQ is a crucial one. It calculates figures such as the rate of sale, the cost of placing an order with your wholesaler or manufacturer, and delivery, processing and stocking, holding, overstock, and overselling expenses to set ideal timelines between orders.
Once you tweak the formula to fit your business, you’ll be able to minimize the amount of inventory in your warehouse at any given time. This frees up floor space and lowers the possibility of damage or being stuck with dead stock. It also cuts down the number of people needed to manage, track, and audit inventory, while making room for other types of stock.
At the same time, EOQ should balance the costs it computes with those of delivery so you reach an equilibrium. For example, if you place an order and it’s more expensive than placing a larger one and simply storing stock for longer, you need to increase the order size.
The most common EOQ formula is:
The square root of [(2 x Demand) (Sales) x Cost per order / Holding costs]
In this equation, the terms are defined as:
In practice, your EOQ equation might look like this:
(2 x 1,000) x $27 / $1.12 = $219
You can then round up to $220 or down to $200 based on how your supplier sends shipments. Order frequency is simply your EOQ divided by your demand.
While EOQ can help you optimize total costs, it’s not perfect. In fact, it introduces complications at multiple points, including:
While many organizations traditionally calculate EOQ manually, you can let technology handle the math instead. An intelligent inventory or warehouse management system will track EOQ and other calculations in near real-time. For example, JIT (Just-in-Time) inventory is an extreme form of EOQ where you minimize in-stock inventory at any given point, scheduling reorder points to arrive exactly when you sell out.
Keeping up with those numbers is all but impossible without real-time data. The algorithms make up-to-the-minute calculations based on both the current (exact) rate of sale and long-term forecasts. That’s possible when you have all of your sales points and marketplaces linked to a central inventory management system, because you see the actual rate of sale per location or warehouse, per channel, and per product. You can then track the actual rate of sale and update your EOQ on a per-order basis with the supplier.
Often, this allows you to automate reorder points either by flagging an administrator when the stock reaches a critical level or by automatically submitting the order.
A credible EOQ calculation takes data from every part of your business to align metrics like rate of sale, sales forecasts, and historic data with demand. Then, you can determine how many times per year you have to order and update that frequency as data changes. Granted, you’ll still have to calculate reorder points, which rely on supplier data and shipping timelines, as well as the time required to process incoming orders.
However, EOQ isn’t infallible, so you should regularly update your calculation or your order based on current, real-world data. While EOQ can be complex to figure out at first, in the long run, it can greatly reduce the inventory you have in your warehouse at any given time while preventing you from selling out.