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Calculating EOQ - Economic Order Quantity (Inventory Costs & Purchasing Costs)

hi guys the end Ronson from dried

success calm today we're gonna talk

about calculating economic or quantity

and we're going to use a very simple and

straightforward formula we're going to

use what's called the Wilson yo cue

formula this is a formula it's been

around for a hundred years that actually

started in 1913 and there's some pros

and cons to this to this formula but

it's important to note that a lot of

things have changed in terms of business

over the last hundred years so what

we're going to do today is we're going

to go over exactly how the formula is

used I'm going to go through this

example up here on the board I'm going

to show you how to determine your

economic order quantity and then we'll

just talk about some of the drawbacks

and the benefits of using the formula in

terms of identifying the ideal quantity

in terms of you know purchasing raw

materials or consumables what happened

okay so what we're going to do today is

we're going to go over these variables

and I'm going to show you how the

calculation is done and again the

calculation is very simple it's not

terribly difficult to understand

however it's there are certain variables

that go into the calculation that are

that are quite involved and they do take

some analysis on your part in order to

make sure that your calculation is

accurate because one of the biggest

mistakes companies make when it comes to

calculating genomic order quantity is

they they basically gloss over their

costs to purchase those raw materials

and their holding cost of inventory okay

so let's just basically go over these

variables and I'll show you exactly how

the calculation is done and when we get

to the cost of purposing the cost of

holding inventory I'll kind of delve

into that a little bit further

okay so annual usage is the simple

portion simplest portion of the

calculation you should know exactly how

much you use of a given raw material a

consumable or finish good that's that's

fairly simple okay in our example it's

three thousand units so this is going to

we're going to call this a alright again

the price it's fairly simple to

understand you know how much are you

paying for this part that you're buying

in this case it's twenty dollars the

cost to actually make the purchase now

this is not a per unit cost rather this

is the cost that is included in terms of

actually going ahead and getting an

approval doing a purchase requisition

placing the order

sending the order up to your van

emailing or faxing and you know

receiving the incoming shipment

inspecting the parts and putting them on

the shelf in your warehouse and then

paying your vendor now this may not seem

like that much what you've got to take

into consideration when you do this

portion of the equation is that your

cost of purchasing has to be taken

across all of the orders that you

process okay so it may not seem like a

lot but the fact is is that it's really

broken down in terms of how many orders

you process and what those after mention

costs are in terms of receiving

inspection putting them on the shelf and

doing all those other things okay

holding costs of inventory this is

critical now a link just popped up above

my head this link is going to give you a

sample Excel spreadsheets going to allow

you to determine your specific inventory

carrying cost okay or your specific

holding cost of inventory now these are

these are the costs to hold inventory

without sales now the thing is is that

the reason why you have to click on this

link and go to my website in order to

figure this out is because you know

you're holding costs as a company you

know are always different from one

company to the next okay

it's different for companies that

operate in business-to-business markets

it's different for companies that

operate in business the consumer markets

and it's not just your cost to finance

inventory a lot of companies think that

they're holding cost of inventory is

nothing more than the cost of financing

the inventory there's so much more

that's included in that first of all

there's the cost of obsolescence parts

finished goods and obsolescence in terms

of raw materials there's the cost of

pilferage okay Steph it's a big issue in

business to consumer markets the cost of

inventory damage cost of insurance the

per unit freight cost get parts into

your warehouse so that after mention the

length that I mentioned earlier it's

going to allow you to determine your

specific inventory holding costs by

giving you a percentage of the inventory

value on hand in our example we're just

going to take 3% because once you do the

calculation you're going to probably

come close to that 3% most companies

apply 3% as

holding cost for the inventory value on

hand okay and that's made up of all

those other things I mentioned cost of

financing obsolescence damage pilferage

insurance per unit freight cost cost of

counting handling all those things okay

so in this case the holding cost of

inventory we're going to take the price

of the unit which is $20 multiplied by

our holding cost of inventory which is

3% and it gives us 60 cents so let's put

this all into the equation okay so let's

call cost of purchasing I just don't

want it I don't want to forget about

this CP and holding costs we're going to

call this HC holding costs okay so the

calculation goes like this you're going

to take two okay and you're going to

multiply it by a and then you're going

to times this number times your cost to

purchase times CP and you're going to

divide everything by your holding costs

HC okay so we're going to plug

everything into the equation e oq equals

it's going to be two times three

thousand is going to be six thousand

multiplied by the cost of purchase which

is going to be two divided by zero point

six zero which is our holding cost okay

so this is going to be e oq is going to

equal to twelve thousand six thousand

times 2 divided by zero point six zero

and REO q is going to be square root of

20,000 okay so once you take twelve

thousand divided by 0.6 maybe 20,000

that means your EO q sorry

make sure that's e o q is going to equal

141

units okay 141 units that is the ideal

quantity where your costs to purchase

and your costs of holding inventory are

minimized now if you wanted to take this

ego cube quantity and say how many

orders are we going to place throughout

the year

you just take 3,000 units 3000 divided

by 141 and you're going to get 21 orders

so throughout the year you're going to

place 21 orders then you're going to buy

141 units at a time and in this case

what you've done is you have minimized

your cost of purchase and your holding

cost of inventory now this formula is

very straightforward it's not terribly

difficult however as I mentioned earlier

the problems arise when you have to

determine your specific costs to make

the purchase and what your specific

inventory holding costs are you've got

to calculate what this numbers okay

because as I said earlier you know your

holding cost of inventory depend upon

the type of market you operate in the

type of customers you sell to your

business model and you know again you

know business the business markets you

know issues of obsolescence and damage

or maybe more prevalent than business

the consumer markets where we're theft

and pilferage is a bigger concern so

make sure you calculate your holding

cost of inventory okay again this is a

very simple and straightforward formula

we've used it all we determine our

economic order quantity 141 units and

we're going to place 21 orders

throughout the year based on 3,000 units

purchased in the given year now let's

just talk about some of the drawbacks

okay first of all the eoq you formula

again it's a hundred years old and it

makes a lot of assumptions the first

thing is it assumes that the lead time

from your vendors is constant and

doesn't change we know that doesn't

happen it also assumes that the price

stays the same and again it doesn't

account for any discounts or anything

else like that that also assumes if

you're ordering costs are constant and

that they don't change and of course

that's not the case and it also assumes

that your demand and

the units that you're purchasing of the

year is going to be constant as well so

there's a lot of drawbacks to the

formula it's a good formula and it's

something you want to look at when you

look in terms of you know when you're

calculating safety stock and then the

link just popped up above my head this

will show you how to do a proper

calculation of safety stock and yo Q

plays a role in that in terms of when

you hit your reorder point so that's it

economic order quantity simple

calculation more difficult parts or cost

of purchasing holding constant inventory

so that's it economic order quantity Ian

Johnson driver success calm bye bye