The Economic Order Quantity: How Supply Chain Batch Decisions Determine Inventory and Working Capital

A supply chain director at a global industrial manufacturer faces a familiar dilemma. A key component used across multiple product lines is sourced from a specialised supplier in Germany. Each order incurs a fixed transport and handling cost of £8,000, regardless of whether the shipment contains 2,000 units or 20,000. Ordering in large quantities reduces transport cost per unit and protects against stockouts. But it also means holding months of inventory in warehouses across Europe and North America, tying up millions in working capital and increasing the risk of excess stock if demand slows. Ordering smaller quantities more frequently would release cash and reduce risk, but increase logistics costs and operational complexity. How much should be ordered each time?

This trade-off exists in every supply chain, whether ordering raw materials, scheduling production, or replenishing distribution centres. Larger, less frequent orders reduce the fixed cost of replenishment, but increase the amount of capital tied up in inventory. Smaller, more frequent orders reduce inventory and free up cash, but increase operational and logistics costs. Most organisations settle into patterns shaped by historical constraints, minimum order quantities, transport conventions, or production habits, rarely questioning whether those batch sizes are economically optimal. Yet this decision is not arbitrary. There is a precise relationship that governs it. The Economic Order Quantity, or EOQ, identifies the replenishment quantity that minimises the combined cost of ordering and holding inventory.

This relationship can be expressed precisely. The Economic Order Quantity is calculated as:

EOQ = √(2 × Annual Demand × Order Cost ÷ Annual Holding Cost per Unit)

Each term reflects something every supply chain leader recognises. Annual demand is how much the business consumes over a year. Order cost is the fixed cost incurred each time replenishment occurs, such as transport, supplier administration, production setup, or quality inspection. Holding cost is the annual cost of carrying one unit in inventory, including storage, obsolescence risk, and the cost of capital tied up in stock.

The equation identifies the replenishment quantity that minimises total cost. Ordering too frequently increases transport and setup costs. Ordering too infrequently increases inventory and ties up cash. EOQ defines the balance point between operational efficiency and capital efficiency.

Consider a manufacturer consuming 100,000 units per year, with a replenishment cost of £4,000 per order and a holding cost of £5 per unit annually. Applying the EOQ equation: √(2 × 100,000 × 4,000 ÷ 5) = √160,000,000 ≈ 12,650 units. At this level, average inventory is around 6,300 units. Ordering twice that amount would double average inventory and working capital, and would increase total cost. Ordering half would increase replenishment cost unnecessarily.

The equation makes visible something that is otherwise invisible: batch size is not simply an operational decision. It is a financial one.

This relationship becomes particularly powerful when viewed in real production environments. Consider a manufacturer of precision machined components supplying the aerospace industry. Each production run requires recalibrating equipment, preparing tooling, and performing quality validation, a process that takes several hours and costs thousands of pounds in labour and downtime. To avoid these setup costs, production managers are often tempted to run large batches. On the surface, this appears efficient. Machines run longer, and setup frequency is reduced. But large batches create inventory that may sit in storage for weeks or months before being used or shipped. The capital tied up in that inventory quietly accumulates. When demand shifts or engineering specifications change, excess inventory becomes difficult to use.

This exact dynamic was one of the drivers behind Toyota’s transformation of automotive manufacturing. In the 1970s and 1980s, Toyota engineers focused intensely on reducing changeover times on production equipment. By redesigning tooling and standardising setup procedures, they reduced setup times from hours to minutes. This dramatically reduced the cost of initiating production runs. As setup costs fell, the economically optimal batch size fell with them. Toyota was able to produce in smaller quantities without increasing total cost. Smaller batches meant less inventory, faster response to demand changes, and less capital tied up in unsold goods. Competitors running large batches carried far higher inventory levels, with corresponding financial burden.

The same principle applies in procurement and global sourcing. A consumer electronics company sourcing circuit boards from Asia may face high fixed shipping costs per container. To minimise shipping cost per unit, procurement teams may order large quantities infrequently. This reduces transport cost per unit but increases inventory exposure. Circuit boards may sit in warehouses for months before being used. If product demand slows or product designs change, this inventory can quickly become obsolete. The initial savings in transport cost are often outweighed by the financial cost of holding excess inventory. EOQ provides a framework to evaluate this trade-off objectively, balancing transport efficiency against capital efficiency.

Holding cost is often underestimated because it is less visible than procurement cost. Warehouse rent and handling are obvious, but the largest component is typically the cost of capital. If a company’s cost of capital is ten percent, holding £50 million in inventory carries an implicit financial cost of £5 million per year. This is equivalent to losing £5 million in profit. Unlike labour or material costs, this cost rarely appears explicitly in operational discussions. Yet it directly affects financial performance and return on capital employed.

EOQ also explains why investments in supply chain flexibility often deliver financial returns that exceed expectations. When companies invest in reducing setup times, improving supplier responsiveness, or streamlining replenishment processes, they reduce the fixed cost of ordering or producing. As these costs fall, the optimal batch size falls. This reduces inventory levels naturally, without requiring inventory reduction initiatives. The supply chain becomes structurally more capital efficient.

Apple’s supply chain illustrates the financial impact of reducing batch constraints and improving responsiveness. When Tim Cook joined Apple in 1998, he reduced inventory from months of supply to just days by eliminating warehouses and shifting toward just-in-time replenishment. Apple maintains close coordination with suppliers and keeps commitment late in the cycle where possible, allowing it to respond quickly to demand while minimising finished goods inventory. This reduces working capital requirements and protects against obsolescence in fast-moving product categories. Apple’s advantage does not come from carrying more inventory, but from designing a supply chain that allows it to carry less.

The implications for supply chain leaders are clear. Batch size decisions are not purely operational. They are financial decisions. Larger batches increase inventory, which increases working capital requirements and financial risk. Smaller batches increase operational cost, but release capital and increase flexibility. EOQ provides a practical way to evaluate these trade-offs, ensuring that replenishment decisions minimise total cost rather than optimising one cost at the expense of another.

Perhaps most importantly, EOQ reveals that companies which invest in reducing setup costs, improving supplier responsiveness, and accelerating replenishment cycles can operate with significantly lower inventory. This improves cash flow, reduces financial risk, and strengthens overall capital efficiency. Supply chain performance is often judged by service level and cost. But beneath those metrics lies a deeper financial reality. Every replenishment decision determines how much capital the business must commit to operate. The Economic Order Quantity is a lens through which supply chain leaders can understand and improve the financial performance of their operations.