The economic order quantity model is used in inventory management by calculating the number of units a company should add to its inventory with each batch order to reduce the total costs of its inventory. The costs of its inventory include holding and order costs; therefore, the total inventory cost can be represented by the following equation:
Total inventory costs = ordering costs + holding costs
The economic order quantity model states there is a trade-off between inventory holding costs and inventory ordering costs, and total inventory costs are minimized when both ordering costs and holding costs are minimized.
Holding costs refer to all the costs associated with holding additional inventory on hand. Inventory holding costs include warehousing and logistical costs, insurance costs, material handling costs, inventory write-offs and depreciation. Economic order quantity seeks to reduce these costs by ensuring the right amount of inventory is ordered with each batch so there is not an excess of inventory sitting on hand and incurring these types of costs.
Ordering costs refer to all of the costs associated with actually ordering the inventory, such as the cost of packaging and delivery. Economic order quantity seeks to ensure that the right amount of inventory is ordered per batch so a company does not have to make orders too frequently and incur these avoidable costs.
Ordering a large amount of inventory increases a company's holding cost, while ordering smaller amounts of inventory more frequently increases a company's ordering costs. The economic order quantity model finds the quantity that minimizes both types of costs.