How much do I make on an item to sell? Economic Order Quantity

As one is looking at a Side-hustle and trying to start out, once you do some of the preliminary work (determining what to build, material schedule, etc.) one of the first questions that hits you is one than manufacturing companies deal with every day. How much of this item do I produce? What is the most efficient amount to make, in my current conditions.

In manufacturing, this is known as EOQ, the “Economic Order Quantity.” The idea behind it is that you can calculate, based on sales & the cost of carrying inventory, what is the optimum number of pieces you should make of an item at any given time.

The assumptions on which EQO is based are:

  1. Demand is relatively constant and is known
  2. The item is produced or purchased in lots or batches, not continuously
  3. Order preparation costs and inventory carrying costs are constant and known
  4. Replacement occurs all at once

You can already see the problems with this once you are starting out. While you can assume #2 and #4, you have only a vague idea on #1. For #3, you can use your bill-of-materials to determine preparation costs, but how do you calculate inventory “carrying costs” or how much it costs to store the unsold merchandise? Most folks start out with a small number, and see what sells (and how much) and what doesn’t. From there, they build more and just sort of “wing it”

For basic manufacturing, the equation is actually somewhat simple (there are other derivatives, but this is the basic calculation). The idea is that the EOQ occurs at a point where the cost of ordering equals the cost of carrying the inventory. After many years of trial and error, the equation typically used in this situation is:

EOQ = Square root of (2 * Annual Sales * Cost-per-order)/(inventory carrying cost % * Cost-per-unit)

Annual Sales: Total number of pieces you expect to sell in a year

Cost-per-order: Cost for paperwork, scheduling, etc. For major companies, this could be 1 hour of clerical time, or $30 with cost/benefits. For a small craftsperson, this could be 15 minutes to assemble the required design documents and materials, or $5.   

Inventory carrying costs: Expressed as a percentage of the sales cost of your product inventory. Larger inventories mean you have to have more space, thus more cost here. Smaller inventories mean you may not have an item to sell.

Cost-per-unit: The cost for the materials & labor to make the item

So let’s take one of my items, a simple Face grain cutting board.

  • Let’s say I believe I will sell twelve (12) of these a year
  • I’m going to assume that it will take roughly 20 minutes to get the materials, get the documentation and prepare to work. At $15/hr (what I’m assuming for my labor) that comes to $5 for ordering costs
  • When I did my bill-of-materials and process, I came up with a total project cost (materials & labor) of $15.81
  • Let’s assume my inventory carrying costs are 20% to keep that inventory stored (space, heat, electrical, etc.)

So the calculation is square root of (2*12*$5)/(20%*$15.81) = square root (120/3.16) = 6.16

Round that to 6 pieces.

So based on those assumptions, when I make that particular item, I should make 6 of them. This means I’ll be making 6 months work of product each time I fire up the tablesaw for that item.

If my sales plan is that I’ll only sell six (6) a year, that ends up being the square root of (60/3.16) = 4.35 or 4 of them.

Hopefully this is useful for some folks.

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.