When a new item of inventory is ordered for purchase, it involves three types of costs which are acquisition cost, carrying cost and ordering cost. The acquisition cost remains the same whether you order the same quantity of inventory in one order or more than one order unless and until, you are given a discount in purchasing bulk quantities of the stock.
Carrying Cost, on the other hand, is the cost of holding the materials/ stock in the store department. It is a broad term and can include items such as:
Cost of spoilages,
Cost of bins and racks where these stocks are stored,
Insurance cost,
Cost of storage space,
Rent expense
Ordering Cost
Ordering cost involves all the cost incurred in placing the order for fresh supply of materials or inventories. Normally, it includes costs such as:
Staff costs – such as purchase department, QC department and finance department’s staff,
Telephone costs – costs incurred to communicate with the supplier of the materials,
Stationary costs – costs incurred in making purchase orders, writing other correspondence letters, floating tender costs etc.
| EOQ requires that the quantity ordered should be such that it minimizes both the carrying cost and the ordering cost at the same time. |
Formula
EOQ (Economic Order Quantity) = Square root of ( 2OA / C )
Where:
O = Ordering cost
C= Carrying cost
A = Annual Demand of the material
Example
Aero is engaged in manufacturing shoes for ladies and gents in different designs. Its management is interested in knowing what is the most economical order quantity level because it thinks that the company is incurring a heavy expenses on placing and holding the materials in the store. As a management accountant, you are required to calculate EOQ using the data given below:
Cost of spoilages = $ 1 per unit
Insurance cost = $ 2 per unit
Other holding costs = $ 3 per unit
Ordering cost = $ 100 per order
Annual demand of materials = 8,000 units
Solution
Carrying cost = cost of spoilages + insurance cost + other holding cost
Carrying cost per unit = 1 + 2 + 3 =$ 6
EOQ (Economic Order Quantity) = Square root of ( 2OA / C ) = Square root ( 2 x 100 x 8,000 / 6 ) = 516 Units