Economic Order Quantity / Ordering quantity

One important question before the materials department, when placing an order before the supplier,  is to select an optimum order size  which is also called economic order quantity. Economic order quantity(EOQ) is the optimum ordering quantity i.e. the quantity for which cost of holding plus the cost of purchasing is the minimum. The factors that affect EOQ are material carrying charges and the ordering cost associated with placing the order. The basic aim behind setting of EOQ is to minimise both the costs. The material carrying costs include interest on the capital invested in stock of materials, rent of the storage space occupied, salary and wages of the store keeping department,insurance charges, any loss due to pilferage and deterioration of materials, taxes on materials etc. Ordering cost includes rent for the space occupied by purchase department, postage, stationery and other consumables, telephone charges of the purchase department, depreciation on the assets of the department, travelling expenses and cost of  inspection of the materials if any.

Economic order quantity is calculated using the following formula:

E.O.Q=√(2U×P/ S)

Here  U=annual consumption of materials in units

P= cost of placing an order

S=annual storage cost of one unit



Setting of Various Stock Levels

Determination of various levels of  inventory is one of the prime responsibility of Materials Department. The purpose behind setting of different stock levels is to ensure smooth operation of the enterprise and allocation of appropriate amount of monetary resources to different items in the inventory. A number of factors affect the determination of  stock levels for different items. Some of these are:

  • Rate of consumption
  • Lead time
  • Storage /warehousing /carrying costs
  • Insurance cost
  • Seasonal considerations
  • Price fluctuations
  • Economic Order Quantity (EOQ)
  • Quality of raw material
  • Availability of space
  • Availability of funds
  • Government and other legal and statutory requirements.

A  systematic material control results in economy and efficiency in the maintenance of each item of inventory and at the same time ensures that it is available as and when required.  It helps in avoiding blocking up of funds in unnecessary stock items.  Now, coming back to the topic under discussion, to ensure smooth running of production process, the materials department of an enterprise sets different levels for each item of inventory. These levels are:

  1. Maximum level
  2. Minimum level
  3. Reorder level
  4. Danger or safety stock level

Now lets have a detailed discussion on each one of these.

1. Maximum level: This is the maximum quantity above which stock should never be held at any time. It is fixed after considering the following factors:

  • Investment required in stores, raw materials and other items of inventory
  • Availability of storage space
  • Lead time for delivery of materials
  • Obsolescence rate
  • Consumption rate of materials
  • Economic Order Quantity
  • Storage and Insurance costs
  • Price advantage due to bulk purchases.

Maximum Level can be calculated as:

Maximum Level=Re-order Level ×  Re-order Quantity –( Minimum consumption × Minimum Re-order period)

2. Minimum Level: This is the minimum level below which an item of stoeck should never be allowed to fall. Minimum level depends on the following factors:

  • Consumption rate of materials.
  • Lead time for delivery of materials.
  • Production requirements.
  • Minimum order size fixed by suppliers.

Minimum level is computed using the following formula:

Minimum level=Re-order level – (Normal consumption × Normal reorder-period)

3. Danger or safety level: Safety or reserve stock is fixed to avoid stock out conditions. Carefully fixed safety stock level helps in minimising stock-out and carrying costs. This level is fixed usually between minimum level and zero level. On reaching this level, the storekeeper stops issuing materials. However sometimes for preventive measures, this stock is fixed above minimum level.

Formula for calculating Danger level is:

Danger/Safety level= Ordering Level–(Average rate of consumption×Re-order period)


(Maximum rate of consumption–Average rate of consumption)×Lead Time

4. Ordering Level: Ordering Level is that level on reaching which, a fresh order is placed with the suppliers. This level depends on:

  • Annual consumption of an item.
  • Lead time.
  • Expected usage during lead period.
  • Minimum Level.

Ordering level is calculated using the formula:

Ordering Level= Minimum Level + consumption during lead period


Maximum consumption × Lead time + Safety stock


Maximum consumption×Maximum re-order period