Every textbook on inventory management features the Economic Order Quantity formula. It's elegant, mathematical, and promises to minimize your total inventory costs. It's also from 1913 and makes assumptions that don't hold for most modern businesses.
That doesn't mean EOQ is useless—it's a valuable mental model and works well in specific situations. But treating it as gospel leads to problems. Here's how to use EOQ intelligently: understanding when it helps, when it misleads, and how to adapt it for the real world.
What Is Economic Order Quantity?
Economic Order Quantity (EOQ) is the order quantity that minimizes total inventory costs by balancing two opposing forces:
- Ordering costs: Fixed costs incurred each time you place an order—processing, shipping, receiving, paperwork. More orders mean more of these costs.
- Holding costs: Costs of keeping inventory—storage, insurance, opportunity cost of tied-up capital, obsolescence risk. More inventory means more of these costs.
Order too frequently in small quantities, and ordering costs pile up. Order too rarely in large quantities, and holding costs balloon. EOQ finds the sweet spot where total costs are minimized.
The EOQ Formula
The classic formula is:
EOQ = √(2DS / H)
Where:
- D = Annual demand (units sold per year)
- S = Ordering cost per order (fixed cost each time you place an order)
- H = Holding cost per unit per year (cost to store one unit for one year)
EOQ Calculation Example
Let's say you sell 10,000 units per year of a product. Each order costs you $50 to place (admin time, receiving labor, paperwork). Each unit costs $10, and your annual holding cost rate is 25% of product value, so holding cost is $2.50 per unit per year.
EOQ = √(2 × 10,000 × 50 / 2.50)
EOQ = √(1,000,000 / 2.50)
EOQ = √400,000
EOQ = 632 units
According to this calculation, you should order 632 units at a time. That means approximately 16 orders per year (10,000 / 632).
Total Cost Comparison
How much does order quantity actually affect costs? Let's compare three scenarios for our example:
Order 300 units (33 orders/year):
- Ordering costs: 33 × $50 = $1,650
- Average inventory: 150 units → Holding costs: 150 × $2.50 = $375
- Total: $2,025
Order 632 units (EOQ, 16 orders/year):
- Ordering costs: 16 × $50 = $800
- Average inventory: 316 units → Holding costs: 316 × $2.50 = $790
- Total: $1,590
Order 1,000 units (10 orders/year):
- Ordering costs: 10 × $50 = $500
- Average inventory: 500 units → Holding costs: 500 × $2.50 = $1,250
- Total: $1,750
EOQ does minimize total costs in this example. But notice the differences aren't enormous—the range is $1,590 to $2,025. This is typical. EOQ helps, but it's not life-changing for most businesses.
When EOQ Works Well
EOQ is most useful when its underlying assumptions actually hold:
- Demand is stable and predictable. The formula assumes constant demand. If you sell roughly the same quantity week after week, EOQ math works.
- Costs are well-understood. You know your actual ordering costs and holding costs with reasonable accuracy.
- Lead times are reliable. EOQ tells you how much to order, not when. Reliable lead times make the timing piece manageable.
- No quantity discounts. The basic formula doesn't account for volume pricing. If you get 10% off at certain quantities, EOQ needs adjustment.
- Single-item decisions. EOQ considers one product at a time. It doesn't account for shared shipping or consolidated orders.
Commodities, stable staples, and B2B consumables often fit these criteria well.
When EOQ Breaks Down
Seasonal or Volatile Demand
If demand varies 300% between peak and slow seasons, annual average demand is meaningless. You'd need different EOQs for different periods—and by then, you're not really using EOQ anymore. You're doing seasonal planning.
Significant Quantity Discounts
Suppliers often offer 5%, 10%, or more off at certain order quantities. The discount savings can easily exceed the added holding costs. Modified EOQ formulas exist for this, but in practice, just run the total cost comparison at different quantity breaks.
Shipping Container Constraints
If you're importing and shipping costs jump dramatically between partial and full containers, EOQ is less relevant than container economics. A full 40-foot container might be far cheaper per unit than a half-full one, regardless of what EOQ says.
Short Product Lifecycles
For fashion, seasonal products, or items with expiration dates, holding cost isn't just capital and storage—it includes obsolescence risk. EOQ tends to recommend larger quantities than you should actually order when products might not sell.
Low-Cost, High-Volume Items
For cheap items where holding costs are tiny, EOQ often suggests ordering a year's worth at once. That technically minimizes ordering costs, but it creates cash flow problems and warehouse space issues the formula doesn't consider.
Practical Adaptations
Use EOQ as a Starting Point
Calculate EOQ, then adjust for real-world constraints. If EOQ says 632 units but your supplier has a 500-unit minimum, order 500. If EOQ says 632 but you can fit 800 in a full pallet that ships at a better rate, consider 800.
Round to Practical Quantities
Orders of 632 units are awkward. Round to case quantities, pallet quantities, or other logical units. The cost difference between 632 and 600 or 650 is usually trivial.
Factor in Shelf Life
For perishable products, cap order quantities at what you can sell before expiration—regardless of what EOQ suggests. A 90-day shelf life means you shouldn't order more than 90 days of supply.
Consider Order Consolidation
If you order multiple products from the same supplier, individual EOQs miss the efficiency of consolidated orders. It often makes sense to order everything from a supplier at once on a regular cadence, even if quantities aren't precisely optimal for each SKU.
Common Mistakes to Avoid
- Treating EOQ as sacred. It's a model, not a mandate. Use it as input to your decision, not the final answer.
- Using guessed costs. Garbage in, garbage out. If you're not sure about ordering costs or holding costs, EOQ won't give you useful answers.
- Ignoring quantity discounts. Many companies follow EOQ while leaving volume discounts on the table. Always run the comparison.
- Applying EOQ to everything. Some products need EOQ thinking; others need different approaches. Match the tool to the situation.
- Never revisiting the calculation. Costs change. Demand patterns change. Recalculate EOQ periodically, not once.
Key Takeaways
- EOQ balances ordering costs against holding costs to minimize total inventory cost
- The formula works best with stable demand and predictable costs
- Seasonal products, quantity discounts, and shipping constraints all break EOQ assumptions
- Use EOQ as a starting point, then adjust for real-world factors
- Round to practical quantities—case packs, pallets, container loads
Frequently Asked Questions
What is economic order quantity and how do I calculate it?
Economic Order Quantity (EOQ) is the order quantity that minimizes total inventory costs by balancing ordering and holding costs. Calculate it with: EOQ = √(2DS / H), where D is annual demand in units, S is ordering cost per order, and H is holding cost per unit per year.
What counts as ordering cost?
Ordering costs include purchase order processing time, communication with suppliers, receiving labor, quality inspection, paperwork and documentation, and any fixed shipping charges that apply per order rather than per unit. They don't include the actual product cost.
How do I estimate holding cost?
Holding cost typically includes storage costs (rent, utilities), insurance, capital cost (interest on money tied up in inventory), and obsolescence/shrinkage risk. A common estimate is 20-30% of product value per year, but calculate your actual costs if possible.
Does EOQ work for products with quantity discounts?
The basic EOQ formula doesn't account for quantity discounts. When discounts are available, calculate total cost at EOQ and at each discount break quantity. The lowest total cost option wins—even if it's not the calculated EOQ.
How often should I recalculate EOQ?
Recalculate EOQ annually at minimum, or whenever costs change significantly (new warehouse rates, shipping price changes), demand patterns shift substantially, or you're reviewing supplier agreements. For fast-changing businesses, quarterly reviews make sense.