How Much Should I Reorder? - Inventory Management & EOQ

Today is the third essay in a 4-part series on Inventory Management. In our first essay, we discussed Reorder Point which answered the question:

When should I reorder inventory?

The second essay dealt with the concept of Safety Stock. Safety Stock answers the question:

How much extra inventory should I hold to avoid stock outs?

Today we will discuss a new concept called Economic Order Quantity (EOQ) which answers the question:

How much should I reorder that is the most efficient use of cash?

Economic Order Quantity and Inventory Management

Understanding how much inventory to order can feel like a juggling act for any small business owner. Order too much, and you’re stuck with piles of unsold product and drained cash reserves. Order too little, and you miss out on sales and frustrate your customers. How do we solve this problem?

Enter the Economic Order Quantity (EOQ), your new best friend in inventory management. EOQ is a formula that determines the most efficient use of your cash to minimize your total inventory costs. This includes ordering costs (the cost of placing an order) and holding costs (the cost of storing inventory). Let’s break down how it works with a couple of examples.

Example 1: The Overzealous Baker

Meet Jane, the owner of “Jane’s Cupcakes,” a bustling bakery in town, if not a bit uninspired in the bakery's name.

Jane’s most popular item is her signature red velvet cupcake. Because she is so busy, she orders her flour in bulk. This means that managing the amount of flour she holds requires some savvy inventory management skills. Up until recently, she had been simply estimating how much she should order each time and not really following any system or process.

But when she does this, she faces two main issues:

If she orders too much flour, her storage room turns into a flour-filled fortress, which is both costly and a bit ridiculous. But
If she orders too little flour, she risks running out leaving customers and her bakery display sadly empty.

But here's the good news. Jane reached out and scheduled a one-week engagement with BreathEasy Consulting to help her with this issue. During the engagement, BreathEasy taught her about the EOQ formula and other techniques for efficient inventory management so that she would always know the perfect balance to strike. After we discussed Reorder Point calculations and determining how much Safety Stock to keep in reserve, we discussed how much to reorder each time using the EOQ formula, below:

Where:

D is the annual demand for flour (let’s say 5,000 pounds),
S is the ordering cost per order (about $10),
H is the holding cost per pound per year (around $730).

Plugging in the numbers, Jane calculates the following:

and discovers her EOQ to be around 12 pounds of flour per order. This means that, instead of buying flour haphazardly, Jane now orders 12 pounds each time. This represents the most efficient order to make when her inventory reaches its Reorder Point. This keeps her inventory costs low and her storage room from looking like the aftermath of a flour explosion. Plus, she has enough flour to keep up with her customers’ demand without any hiccups.

Example 2: The Confused Gadget Shop Owner

Now, let’s consider Bob, the owner of "Bob’s Gadgets." Bob sells a variety of electronics, but his best-selling item is a high-end phone charger. One day, when Bob called the vendor, the vendor informed him that they offer a discount the more Bob buys. Tempting...

Bob loves a good deal, and the discount forces him to consider making a larger order to get that discount. However, Bob realizes that buying these large quantities would fill his shop to the rafters.

Worse still, as Bob adds inventory, thinking that he is saving money from the discount, his holding costs increase as the chargers take up more and more space. And this larger inventory, of course, requires regular counting and organizing. We'll discuss holding costs in an upcoming essay but suffice it to say that there is no such thing as a free lunch.

Mo' Inventory, Mo' Problems...

Bob decides to get smart and uses the EOQ formula to determine if the bulk discount truly is a good deal. Looking back over his store's history, he discovers the following:

Annual demand (D) for chargers is 2,000 units,
Ordering cost (S) is $15 per order, and
Holding cost (H) is $0.50 per charger per year.

When he plugs these numbers into the EOQ formula, Bob determines that the most efficient order quantity is 18 chargers per order. But the vendor's bulk requirements require him to order a minimum of 150 chargers. This is significantly more than the most efficient order size of 18 chargers.

If demand remains the same (2,000/year), then this appears to not be as good a deal as the vendor might have led him to believe. Because of this, and considering that Bob would have to increase his marketing efforts ($$) to move so many chargers, Bob decides he is going to pass on this seemingly 'good deal.'

Why EOQ Makes Sense for Small Business

For small businesses, managing inventory, and doing it effectively, is among the most important topics for maintaining healthy cash flow and ensuring smooth operations. I tell retailers all the time:

You are not in the widget-selling business, you are in the Inventory Management business.

That’s how important good inventory control is.

When I teach my clients how to be efficient with their inventory, they are always amazed at how poorly they had been managing their inventory before we began our consultation. It is a real eye-opener.

But after they implement good practices, it always leads to reduced costs, improved cash flow, and most importantly, enhanced efficiency. Never underestimate the value of a good process to save you time and money.

This is particularly beneficial for small businesses with limited cash flow. When a business maintains too much inventory, it ties up capital that could otherwise be invested in growth, marketing, or other strategic initiatives.

But when small business owners use EOQ, Reorder Point and Safety Stock calculations to optimize inventory levels, small businesses free up cash while still ensuring that they have enough stock to meet customer demand. It's a Win-Win.

Process, Process, Process

Beyond 'mere' cost efficiency that good inventory management practices offer, I believe that the repeatable process of using these best practice formulas is among its greatest strengths. Once you build your formulas in excel, there really isn't much more to consider. When you order, and how much you reorder, is no longer a guessing game. It's given to you automatically.

EOQ and the other formulas we discussed in the two previous essays promote efficiency by creating a consistent, repeatable process for managing inventory. With the right order quantities and reorder points, small businesses can streamline their purchasing process and reduce the risks of stockouts or overstock situations. This improved inventory control leads to better customer service, fewer lost sales, and lower administrative burdens.

When you adopt these practices, you will achieve greater financial stability and efficiency within your business and allow you to focus on growth and customer satisfaction.

The Shameless Plug

If you’re thinking that you’d like some assistance in getting your inventories organized and optimized, or if you’re thinking that your business in general is not running as efficiently as you believe it could be, why not hop on a zoom call to chat? It's free and even in that 1-hour call, you'll most definitely get some ideas on how to optimize your business, regardless of if you decide to engage with BreathEasy.