One major mistake that many dropshippers, even the experienced ones, usually make is that they think short-term for many aspects of their business, such as stock replenishment. In particular, when restocking their inventory, they place their orders based on ‘gut feeling’ rather than economic rationale. In this blog post, we will introduce a concept called Economic Order Quantity (EOQ), which is used to determine the amount of inventory to be purchased.
What exactly is EOQ?
Economic order quantity, also known as optimum lot size, is a formula that helps store managers and owners determine the optimal order quantity and frequency to minimise inventory related and other overhead costs.
What are the benefits of calculating EOQ?
1. Enhanced cost-effectiveness
As briefly mentioned above, determining your order quantity based on EOQ saves you costs that are related to ordering, receiving, and holding inventory. For instance, storage fees usually make up a decent portion of operation costs of many dropshipping businesses. Another challenge that dropshippers run into is overstocking, which could lead to many other issues, such as damaged and obsolete products (if not sold in time). Essentially, EOQ prevents you from over-ordering, thus preventing you from wasting your money on unnecessary things .
2. Fewer inventory bottlenecks
Moreover, because EOQ is computed based on the expected sales volume, it encourages businesses to perform thorough market research and forecasting. As a result, you are less likely to encounter back orders and make your customers wait for a long time, which would lower their satisfaction and discourage them from revisiting your store.
3. Improved overall efficiency and performance
Lastly, it helps you to decide the order quantity based on logical reasoning with back-up data instead of intuition. With just enough inventory on hand to keep your operations running, your team members are more focused and motivated with their tasks and less likely to get distracted and confused by excess materials.
Nonetheless, the largest disadvantage of EOQ is that it assumes demand is constant, which is usually not the case in reality. Regardless, it is still useful to help you manage your store. Moreover, you can always adjust the variable for demand in the formula to determine the optimal order volume for your dropshipping business.
How do you calculate EOQ?
The formula for EOQ is as follows.
In order to compute the EOQ, you need to know three variables:
1. Demand (D)
This could be calculated on a monthly, quarterly, or annual basis depending on how fast you sell your products. This variable is the quantity of products you sell and determined by using historical data of your store. If past data is not available or not enough, you could conduct secondary research to find out some industry, sector, or niche figures.
2. Order cost (S)
As the term suggests, this refers to the cost of a single order, including all related costs such as shipping and handling fees.
3. Holding costs (H)
This variable equals the cost of inventory holding. This is computed with the formula below:
Note: If you are using a third-party warehousing service, it is most likely that you don’t need to pay separately for the staff members as it is already included in the storage fees that you pay to your service provider. Hence, you can ignore that part.
One important thing that you should take note is that the time frame used for holding costs should be compatible with that of demand. More specifically, if quarterly demand is used in the formula, the holding costs should also be computed within a quarter.
Finally, you should be aware that EOQ is specific to one particular product. This means if you are selling a wide range of goods, you have to compute individual EOQ for each product when you plan to order them.
Besides using EOQ to optimise inventory, you can also incorporate ‘reorder points’ (ROP). This refers to the practice that orders are automatically made for you once your stock levels fall below a certain threshold. If you are working with a dropshipping agent, they will assist you in this matter. In most cases, you won’t even need to be actively involved in the ordering process. However, you would first need to provide them your desired inventory level. The instructions to compute ROP can be found below.
ROP = Lead time demand + Safety stock
The two variables in the formula above can be easily calculated with some basic data from your store:
Lead time demand = Lead time x Average daily orders
Safety stock = (Maximum daily orders - Maximum lead time) - (Average daily orders x Average lead time)
With over 30 years of logistics experience, Xianchao Logistics began to branch out to serve the dropshipping industry in 2015. With our experience in logistics fulfilment and close relationships with suppliers, our company has risen to help different dropshippers grow their businesses over these years. We believe that our company’s success and growth will only come with helping our clients grow. Do you have a dropshipping business to grow? Discuss with us and let’s get started ASAP!
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