Economic Order Quantity
The economic order quantity (EOQ) is the amount of inventory ordered at one time that minimizes annual inventory cost. If a company buys materials infrequently and in large quantities (the opposite of the just-in-time approach), the cost of carrying the inventory is high because of the sizable average investment in inventory. If purchases are made in small quantities, with frequent orders, correspondingly high ordering costs can result. Therefore, the optimum quantity to order at a given time is determined by balancing two factors: 1)the cost of possessing (carrying) materials and 2) the cost of acquiring(ordering) materials.
The costs of carrying inventory are often expressed as percentages of the average inventory investment, because the most common variable cost is interest or the cost of capital . other costs can be estimated and should be limited to only those costs that vary with
the level of inventory. In the case of warehousing or storage, for example, only those costs that vary with changes in the number of units ordered should be included. In contrast, the cost of labor and equipment used in the storeroom is generally a fixed cost, which is not relevant to the decision.