Often vendors offer a bigger discount or other considerations for placing a larger order. It is tempting to always increase the size of a replenishment order to “get the extra five percent discount” or “qualify for free freight”. Sure, buying at a lower unit cost will always increase your gross margins and profitability. But, will taking advantage of every vendor incentive always increase your overall net profitability?
In your quest to maximize your organization’s success, you must carefully evaluate each vendor offer. To do this you must compare the price reduction you will receive for buying more inventory to the cost of carrying the purchased inventory during the time it takes to sell the shipment. This is a relatively simple task that can be accomplished by following these simple steps:
- Know your Cost of Carrying Inventory. This is the cost of maintaining a dollar’s worth (or any other currency) of inventory in your warehouse for an entire year. Currently typical carrying costs range between 14% and 23%. This means that it costs between 14 and 23 cents to maintain a dollar’s worth of inventory in your facility for an entire year. Your monthly carrying cost will be your annual carrying cost divided by 12. In this example we will use an 18% annual carrying cost (or 1.5% per month). You can have EIM calculate your organizations specific carrying cost by filling out the questionnaire in the Resources section on our web site, www.EffectiveInventory.com.
- Calculate your Net Investment if you Take Advantage of the Vendor’s Offer. Let’s say you would get an additional 5% discount for placing a $1,000 order (net investment = $950.00), a 6.5% discount for placing a $2,500 order (net investment = $2,337.50) and a 7.5% discount for placing a $5,000 order (net investment = $4,625.00).
- Determine How Long it Will Take to Sell Each Potential Purchase Quantity. If you sell $750 worth of the vendor’s product’s each month, it will take 1.3 months to sell $1,000 worth of material ($1,000 ÷ $750 = 1.3 month supply), 3.3 months to sell $2,500 worth ($2,500 ÷ $750 = 3.3 month supply) and 6.7 months to sell $5,000 worth of material ($5,000 ÷ $750 = 6.7 month supply).
- Calculate the Total Carrying Cost You will Incur During the Time It Takes to Sell Each Potential Purchase Quantity. This will be equal to (the month’s supply you are purchasing) X (the monthly carrying cost) X (the average investment you will have on hand during the time it takes to sell the shipment). This average investment is equal to half the net investment. After all, during the time it takes to sell the entire shipment, half the time you will have more than half the quantity you purchased and half the time you will have less than half the quantity you purchased:
$1,000 order → 1.3 months * 1.5% * ($950 ÷2) = $9.26
$2,500 order → 3.3 months * 1.5% * ($2,337.50 ÷2) = $57.85
$5,000 order → 6.7 months * 1.5% * ($4,625.00 ÷2) = $232.41
- Calculate Your Total Cost (i.e., Investment + Carrying Cost) at Each Level and Divide by the Net Cost of Purchased Inventory to Determine the Total Cost per Dollar’s Worth of Material:
$1,000 Order → ($950.00 + $9.26) ÷ $1,000 = .959 cents per $1.00 of material
$2,500 Order → ($2337.50 + $57.85) ÷ $2,500 = .958 cents per $1.00 of material
$5,000 Order → ($4,625.00 + $232.41) ÷ $5,000 = .971 cents per $1.00 of material
You can see that the $2,500 order results in the lowest cost per dollar’s worth of material. Considering the total cost of carrying inventory during the time it takes to sell the quantity you purchase as well as the discount offered by the vendor will ensure that you always take advantage of the best buy offered!