Vendors are always offering better prices or discounts when you buy inventory in larger quantities. However, does pocketing 5% savings to pick up 20% additional inventory make business sense? Manufacturers offer discounts on larger purchases as an incentive to encourage you to sell more and also because they are able to pass on savings with increase in production. However, as a trader you need to weigh the cost of additional inventory. After all, the inventory also has a carrying cost.
This is the cost associated with holding the stock instead of keeping the money in the bank earning interest. Use the Economic Order Quantity [EOQ] formula to help you know the units of inventory you can stock that minimises your cost of storage and ordering.
Economic order quantity (EOQ) is the ideal order quantity a company should purchase to minimize inventory costs such as holding costs, shortage costs, and order costs. This production-scheduling model was developed in 1913 by Ford W. Harris and has been refined over time. The formula assumes that demand, ordering, and holding costs all remain constant.
The goal of the EOQ formula is to identify the optimal number of product units to order. If achieved, a company can minimize its costs for buying, delivery, and storing units. The EOQ formula can be modified to determine different production levels or order intervals, and corporations with large supply chains and high variable costs use an algorithm in their computer software to determine EOQ. EOQ is an important cash flow tool. The formula can help a company control the amount of cash tied up in the inventory balance. For many companies, inventory is its largest asset other than its human resources, and these businesses must carry sufficient inventory to meet the needs of customers. If EOQ can help minimize the level of inventory, the cash savings can be used for some other business purpose or investment.
Limitation to EOQ is that the formula assumes consumer demand constant. The calculation also assumes that both ordering and holding costs remain constant. This fact makes it difficult or impossible for the formula to account for business events such as changing consumer demand, seasonal changes in inventory costs, lost sales revenue due to inventory shortages, or purchase discounts a company might realize for buying inventory in larger quantities.
Source: Investopedia and bajaj Finserv