How Much Does It Cost You To Buy?

A few months ago, in an article entitled “The Mysterious Cost of Carrying Inventory,” we published a questionnaire that you can fill out, return to us, and have us calculate your specific company’s inventory carrying cost percentage – that is, what it costs to maintain a dollar’s worth of stocked inventory in your warehouse for an entire year. The carrying cost is used in many inventory analysis and planning formulas including the economic order quantity formula, the calculation that is designed to determine your “best buy” replenishment quantity.

We published the questionnaire in response to the contention of many inventory consultants and “gurus” that it is too difficult to accurately calculate your company’s inventory carrying cost and that a “rule of thumb” (e.g. the prime rate plus 20%) or default value (e.g. 25%-35%) should be used in all formulas requiring a carrying cost percentage. Based on your response in sending completed questionnaires back to us and the resulting carrying cost percentages, we have concluded that:

• It is fairly easy to calculate a distributor’s or manufacturer’s inventory carrying cost.
• There is no single accurate default value for the inventory carrying cost.

The carrying cost percentages we calculated from the questionnaires ranged from a low of 18% to a high of 42%. This is very significant, as the cost of carrying inventory is an integral part of many inventory analyses, including the economic order quantity (EOQ) formula:

	24 x Cost of Ordering Stock x Forecast Monthly Demand Carrying Cost % x Unit Cost

How much of an effect does the carrying cost percentage have on calculated replenishment quantities? Well, using a 25% carrying cost in the EOQ formula results in 20% greater replenishment quantities than a 35% carrying cost. Just think of what 20% more inventory would cost your company. Remember that the EOQ is supposed to be the quantity that provides you with the lowest total cost. Replenishing inventory with quantities other than this “best buy” quantity will cause your company to experience higher costs and/or excess inventory.

There is no way to determine which order quantity represents the “best buy” without accurately calculating your company’s specific carrying cost percentage and cost of ordering stock. The cost of ordering stock is the cost of issuing and processing a line item on replenishment order. I have read many articles stating that, as with the inventory carrying cost, this number is also too hard to calculate. Many analysts suggest that you should just pick a value between $5.00 and $6.00. As with using rules of thumb for the inventory carrying cost, if you just guess at your company’s cost of ordering stock, the resulting economic order quantity will not represent your company’s best buy quantity. In fact, utilizing “rules of thumb” for the carrying cost percentage and cost of ordering stock results in an economic order quantity formula that probably won’t maximize your company’s profits:

	24 x Rule of Thumb Guess x Forecast Monthly Demand Another Rule of Thumb Guess x Unit Cost

So this month we publish a questionnaire that allows us to calculate your company’s cost of ordering a line item of stock material. As with the carrying cost questionnaire, if you will answer these questions and send your responses to us by email, mail, or fax, we will calculate your cost of ordering stock and send you the results. If we have relevant data in our files, we’ll include a comparison of your answers on each question to others in your region and industry. There is no charge for this service as long as you agree to let us add your information to our database. Please note that all responses are confidential. Data we present to other companies will not identify your company name or location.

1. How many purchase order line items for stocked products were issued in the past 12 months (approximate by taking one month’s total and multiplying by 12)? _______
2. What percentage of all items purchased are stocked products as opposed to special order or catalog items? _______
3. What percentage of all items purchased are consumed internally by the company and not resold or are used as components in products that are resold? _______
4. What is your total purchasing and expediting department’s labor expense (wages, taxes, and benefits) during the past 12 months? _______
5. What is your total accounts payable labor expense (wages, taxes, and benefits) during the past 12 months? _______
6. What is the total annual expense for supplies used by your purchasing department? _______
7. What is the total annual expense for accounts payable supplies? _______
8. What is your total annual data processing expense? _______
9. How many line items are received in each warehouse each month? _______
10. What is your total labor expense (wages, taxes, and benefits) per month for the person (or people) who verifies the accuracy of stock receipts? _______
11. What percentage of this person (or these people’s) time is spent verifying stock receipts? _______

Please use this information to calculate a cost of ordering stock inventory for our company. We agree to allow Effective Inventory Management, Inc. (EIM) to use this data for comparative purposes, but acknowledge that EIM will not reveal our company name or location to any other party without our expressed written permission.
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Signed by Company Representative

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