The EOQ formula can be modified to determine production levels or order interval lengths, and is used by large corporations around the world, especially those with large supply chains and high variable costs per unit of production. ("Economic order quantity," 2010) Inventory is held to avoid the nuisance, the time and the cost etc. of constant replenishment. However, to replenish inventory only infrequently would necessitate the holding of very large inventories. It is therefore apparent that some balance or trade-off or compromise is needed in deciding how much inventory to hold, and therefore how much inventory to order. There are costs of holding inventory and there are costs of re-ordering inventory and these two costs need to be balanced. The purpose of the EOQ model is to minimise the total costs of inventory. The important costs are the ordering cost, the cost of placing an order, and the cost of carrying or holding a unit of inventory in stock. All other costs such as, for example, the purchase cost of the inventory itself, are constant and therefore not relevant to the model. ("Economic order quantity," 2009)
What creates the cost components are annual usage/demand, order cost, and carrying costs. Annual usage and demand is expressed in units this is generally the easiest part of the equation. You simply input your forecasted annual usage. Order costs also known as purchase cost or set up cost, this is the sum of the fixed costs that are incurred each time an item is ordered. These costs are not associated with the quantity ordered but primarily with physical activities required to process the order. For purchased items these would include the cost to enter the Purchase Order and/or Requisition, any approval steps, the cost to process the receipt, incoming inspection, invoice processing and vendor payment, and in some cases a portion of the inbound freight may also be included in order cost.
It is important to understand that these are costs associated with the frequency of the orders and not the quantities ordered. For example in your receiving department the time spent checking in the receipt, entering the receipt and doing any other related paperwork would be included while the time spent repacking materials, unloading trucks, and delivery to other departments would likely not be included. If you have inbound quality inspection where you inspect a percentage of the quantity received you would include the time to get the specs and process the paperwork and not include time spent actually inspecting, however if you inspect a fixed quantity per receipt you would then include the entire time including inspecting, repacking, etc. In the purchasing department you would include all time associated with creating the purchase order, approval steps, contacting the vendor, expediting, and reviewing order reports, you would not include time spent reviewing forecasts, sourcing, getting quotes (unless you get quotes each time you order), and setting up new items. ("Economic order quantity," 2010)
In manufacturing the Order cost would include the time to initiate the work order, time associated with picking and issuing components excluding time associated with counting and handling specific quantities, all production scheduling time, machine set up time, and inspection time. Production scrap directly associated with the machine setup should also be included in order cost as would be any tooling that is discarded after each production run. There may be times when you want to artificially inflate or deflate set up costs. If you lack the capacity to meet the production schedule using the EOQ you may want to artificially increase set up costs to increase lot sizes and reduce overall set up time. If you have excess capacity you may want to artificially decrease set up costs, this will increase overall set up time and reduce inventory investment. The idea being that if you are paying for the labor and machine overhead anyway it would make sense to take advantage of the savings in reduced inventories.For the most part Order cost is primarily the labor associated with processing the order however you can include the other costs such as the costs of phone calls, faxes, postage, envelopes, etc.
Carrying cost also known as inventory holding costs is the cost associated with having inventory on hand. It is primarily made up of the costs associated with the inventory investment and storage cost. For the purpose of the EOQ calculation, if the cost does not change based upon the quantity of inventory on hand it should not be included in carrying cost. In the EOQ formula, carrying cost is represented as the annual cost per average on hand inventory unit. Below are the primary components of carrying cost.
Interest.
If you had to borrow money to pay for your inventory, the interest rate would be part of the carrying cost. If you did not borrow on the inventory however have loans on other capital items, you can use the interest rate on those loans since a reduction in inventory would free up money that could be used to pay these loans. If by some miracle you are debt free you would need to determine how much you could make if the money was invested.Insurance. Since insurance costs are directly related to the total value of the inventory, you would include this as part of carrying cost. Taxes. If you are required to pay any taxes on the value of your inventory they would also be included. ("Economic order quantity," 2009)
Storage Costs. Mistakes in calculating storage costs are common in EOQ implementations. Generally companies take all costs associated with the warehouse and divide it by the average inventory to determine a storage cost percentage for the EOQ calculation. This tends to include costs that are not directly affected by the inventory levels and does not compensate for storage characteristics. Carrying costs for the purpose of the EOQ calculation should only include costs that are variable based upon inventory levels. ("Economic order quantity," 2010)
If you are running a pick/pack operation where you have fixed picking locations assigned to each item where the locations are sized for picking efficiency and are not designed to hold the entire inventory, this portion of the warehouse should not be included in carrying cost since changes to inventory levels do not effect costs here. Your overflow storage areas would be included in carrying cost. Operations that use purely random storage for their product would include the entire storage area in the calculation. Areas such as shipping/receiving and staging areas are usually not included in the storage calculations, however if you have to add an additional warehouse just for overflow inventory then you would include all areas of the second warehouse as well as freight and labor costs associated with moving the material between the warehouses.

Economic order quantity (eoq). (2009). Retrieved from http://www.accountingformanagement.com/economic_order_quantity

Economic order quantity (eoq). (2010). Retrieved from http://www.inventoryops.com/economic_order_quantity

Economic order quantity. (2010). Retrieved from http://www.investopedia.com/terms/e/economicorderquantity.asp

Economic order quantity (eoq). (2009). Retrieved from http://en.wikipedia.org/wiki/Economic_order_quantity

Economic order quantity (eoq). (2008). Retrieved from http://scm.ncsu.edu/public/inventory/6eoq.html