Economic order quantity is an inventory strategy that seeks to identify and maintain the ideal balance between the holding costs associated with an inventory and the ordering costs that are incurred with that inventory. First developed in the early 20th century by F.W. Harris, the economic order quantity approach is commonly known as the Wilson EOQ Model, or simply the Wilson Formula. This is in recognition of the aggressive expansion of the use of this strategy by R.H. Wilson, a consultant who recommended this approach to his clients, and in many instances worked with them to implement the strategy.
The goal of the economic order quantity strategy is to identify the point at which the ordering costs and the carrying cost associated with an inventory are at the lowest point possible. At the same time, the approach strives to ensure that the owner of the inventory to fulfill customer orders in a timely manner. In order to identify this ideal balance, the formula makes use of a few basic assumptions.
First among the assumptions associated with the economic order quantity formula is that the ordering cost will remain constant. It is also assumed that the rate of demand will also remain constant, a factor that allows the vendor to purchase items for the inventory using recurring quantities. In addition, there is an assumption that the lead time will not change; the lead time applies to not only the customer’s demand for delivery within a given amount of time, but also the ability of the supplier to fill and ship the orders to the vendor in an amount of time that is consistent. Finally, there is no change in the purchase price, and the full order is received at one time, rather than in batches or segments.
The ideal situation for the vendor is to be able to create inventory that is used to fill pending customer orders without remaining in the inventory for extended periods of time. Assuming that the materials needed to manufacture the items for inventory arrive in a timely manner, are processed efficiently, and are placed in a finished goods inventory within a reasonable period of time, inventory cost can be reduced significantly. Finished goods are pulled from inventory, assigned to a specific customer order, and shipped before there is much time for taxes to be assessed on the overall value of the current inventory. Keeping the standing inventory as close to zero as possible not only helps to minimize tax debt, but also allows the vendor to operate without the need to rent, lease, or otherwise operate warehouse space for a larger inventory. Thus, achieving the ideal economic order quantity can save a significant amount of money over the course of a year.