I recently wrote about the importance of managing inventory due to its direct impact on working capital. In the article I mentioned Quidsi, the parent company of Diapers.com, Soap.com (Soap is no longer around – updated June 2019 – see what happened to it here)and BeautyBar.com, which used effective inventory management to generate respectable profit margins in the otherwise cutthroat business of online retailing. Quidsi is on track to surpass $300 million in sales this year. The company was doing so well that it caught the eye of Amazon.com. The online retailer is expected to purchase Quidsi for $500 million in cash plus the assumption of $45 million in debt.
Quidsi was able to use the inventory management method of Economic Order Quantity to help achieve the performance, which ultimately led to this acquisition and a successful exit for its founders and investors.
What is Economic Order Quantity?
Economic Order Quantity (EOQ) is the level of inventory held by a business that minimizes the sum of the holding and ordering costs. It was originally developed in 1913 by F. W. Harris, and was further refined and enhanced by R. H. Wilson. Despite its existence for nearly 100 years, companies like Quidsi are using it as the basis for effective inventory management. Even in very expensive supply chain software implemented by large companies, the core inventory management algorithm is based in many instances on EOQ. In low margin businesses like electronic retailing, running short on inventory for a single month or overestimating demand (and therefore holding too much inventory) can mean the difference between success and failure.
EOQ Variables
In order to determine the EOQ for your company, the following data points are required:
- Demand or usage – This represents the total number of units your company is forecasted to sell during the year.
- Order costs – This is the sum of the fixed costs associated with the placing of each order. This is primarily based on the cost of employee time required to place orders, obtain approvals and process the necessary paperwork.
- Carrying costs – These include the costs associated with keeping the inventory on hand such as interest on borrowings to maintain the inventory, insurance and storage costs.
EOQ Constraints
In order to use the formula effectively, there are certain assumptions that have to be taken into consideration:
1. The ordering cost is constant.
2. Demand is constant.
3. Lead time doesn’t change.
4. Purchase price is constant.
The Economic Order Quantity Formula
The goal of using EOQ is to determine the inventory level that will minimize total cost for the year:
Go to the article: Economic Order Quantity: The $545 Million Formula
