Ordering costs are the money your company spends to buy inventory with each purchase order. These are some of the inventory management decisions that warehouse orderers must keep in mind. Other factors important to effective warehouse management include customer demand, storage costs, available storage space, and inventory level. Calculating your ordering costs will help you choose the right order size while meeting consumer demand.
In this article, you will learn how to calculate ordering costs. You will also learn to use the ordering cost formula to calculate the economic order quantity (EOQ). You will learn about how calculating ordering costs will help you reduce expenses so that you can use your resources efficiently and offer your product at an affordable price.
What are Order Costs?
Order costs are the amounts you pay every time your company orders merchandise from a supplier. They include transportation costs, shipping fees, inspection fees, and setup rates. It is the nature of order costs that they tend to stay the same from one order to another. Therefore, the orderer does not need to shop around for the best prices every time the company makes an order. Together with delivery costs, setup costs, and storage costs, ordering costs are among the biggest expenses that affect a warehouse’s efficiency.
How Do I Calculate Ordering Cost?
You can calculate ordering costs using mathematical formulas such as the EOQ formula. Calculation of ordering costs is just the beginning; you should also include an analysis of other factors to balance out your decisions about ordering products and materials for your warehouse. Companies need to be aware of their ordering cost in order to make long-term projections about the goods that they keep in stock. Calculating ordering cost is most useful with items that are consistently orderable and do not fluctuate in value.
What is Economic Order Quantity (EOQ)?
Economic order quantity (EOQ) is a popular way of calculating order cost. It is also known as the Wilson formula. Calculating EOQ has some limitations, though. Specifically, it is based on several assumptions that do not always hold true in the field of logistics. For instance, it assumes that the price of goods remains consistent. In practice, this is not always true, because when production costs rise for suppliers, you will need to give a bigger cash payment to the supplier. The EOQ formula also does not account for the discounts you can get when you buy items in large quantities or when you buy a high volume of goods over a period of time. Another example of the limitations of the EOQ formula is that it does not account for seasonal fluctuations in demand. Many companies need to order a different number of units of a given product at different times of the year.
When to Use the Ordering Cost Formula for EOQ
There is no firm rule about when the EOQ ordering cost formula is appropriate and when it is not. Instead, you should ask questions about how the circumstances of the current order are likely to be similar or different in future orders. In other words, you should decide on a case-by-case basis when to use the ordering cost formula for EOQ. Consider that economists make their entire careers out of predicting how commerce would work under ideal circumstances, but their economic models only sometimes make sense in the real world.
4 Steps to Calculate EOQ with the Ordering Cost Formula
To calculate EOQ, you must determine the values of the following variables: the cost of each order (represented by the letter K), the annual demand for the product or raw material (represented by the letter D), and the storage cost per unit (represented by the letter G). Multiply K and D together, double the product, and then divide it by G. The quotient is the optimum quantity of each order, represented by the letter Q.
1. Identify your annual demand
The EOQ is only applicable to articles for which demand does not fluctuate from one season to the next or one year to the next. Figure out how much of the product in question your customers order each year. This is D.
2. Determine the cost per order or CPO
When there is a product you order consistently, calculate how much you pay every time you order it. This includes not only the purchase price of the item but also the services you must pay for in order to get it to your warehouse. If you pay for transportation, shipping costs, and inspection fees, include this in the cost per order. Let K represent this number.
3. Calculate the carrying cost per unit
Next, determine how much you must pay to store the products in the order. How much warehouse space do they take up? Do you usually sell completely out of them before getting a new shipment?
4. Complete the ordering cost formula
Plug the values into the formula to find out the most economical quantity in which you can order a product for which demand remains consistent. Multiply two times the demand times the cost per order, and divide it by the storage cost per unit. This is the ideal quantity in which to order the product.
Ordering Cost: Tips for Business Owners
There is not a one-size-fits-all way to calculate ordering costs. The EOQ formula is only applicable to products and materials for which the demand and price are highly stable and resistant to market fluctuations. To find out how much of each product you should order, you should analyze large volumes of data specific to your warehouse. The best way to do this is with inventory management software.
Conclusion
Keeping track of your ordering costs helps you decide how much of each product you should order and how often you should reorder it. It is only one aspect of an effective warehouse management strategy, though. You must also take measures to reduce waste due to inventory spoilage. You should also take care to design the layout of your warehouse to be space efficient and to allow for a streamlined workflow.
Ordering Cost FAQs
Saving money on ordering costs requires you to ask the right questions. In fact, you should always be asking questions about many aspects of your warehouse management strategy, so that you can constantly improve on it. These are some common questions that business owners ask about ordering costs and the EOQ formula.
What is the optimal order quantity?
The optimal order quantity is the number of units of a certain product that you order per shipment in order to get the best possible return on your investment. To calculate the order quantity, multiply the annual demand for the product by the cost per order. Multiply this amount by two, and then divide it by the cost of storing each unit of the product in your warehouse. The result of this calculation is the optimal order quantity, the best possible number of units of the item to order per shipment.
Why should you calculate order cost?
You should calculate order costs because doing so will help you save money. It will also help you run your warehouse more efficiently, keep up with customer demand, and reduce waste.
What are the 3 components of ordering cost?
The three components of ordering cost are the cost per order, the annual demand, and the storage cost per unit. These values make up the EOQ formula.
