Buying Before a Vendor Price Increase

by | Jul 10, 2021 | Analysis, Best Practices, Forecasting, General, Order Cycles, Purchasing, Replenishment Parameters, Stocking Decisions

Buying Before a Vendor Price Increase

By Jon and Matt Schreibfeder

Over the past several months, we have been discussing replenishment related challenges in these times of erratic demand of products and disruptions in the supply chain.  The disruption has caused our clients to experience numerous vendor price increases.  This trend is likely to continue in the foreseeable future.  This month, we discuss a method for deciding how much of a vendor’s products to buy before a price increase.

Often vendors will allow distributors to place one more purchase order before a price increase goes into effect.  The big question is how much of what products should be ordered?  Alan “Buddy” Silver, an inventory “guru” of the mid-20th century, developed a method to quickly provide an accurate answer to this question.  Though Silver is no longer with us, his price increase analysis continues to provide a fast answer to the question of how much to buy before a price increase.  As with other “price break” topics we’ve previously discussed, this analysis balances the cost of carrying inventory for a longer period of time against the additional discount (in this case the result of buying before costs go up).  The formula is:

(24 * % Increase)

ROAI + KCost%

The constant of “24” will never change (note that we also used a constant of 24 in the previously discussed economic order quantity formula).  The “%Increase” is the percentage that the price of goods will go up.  The KCost% is your annual cost of carrying inventory (see the section in the “Resources” section of our web site to calculate your inventory carrying cost).  The “ROAI” is the return on added investment.  When you buy in advance of a price increase, you’re speculating that:

  • Demand for the product(s) involved will not decrease in the future
  • The price increase is not temporary.  That is, prices won’t go back down in the future
  • If you make a large purchase, you will not have to issue any “fill in” purchase orders from the vendor for non-stock products or items that experience an unexpected increase in demand

You need a significant return on your investment to justify these risks.  This is the ROAI.  It is the percentage profit you are willing to accept for the added investment.  It is subjective.  Many distributors will set their ROAI equal to two to three times their average gross margin.  The higher the ROAI, the less risk you are willing to take and the smaller the additional purchase.  Here is an example of a “pre-price increase” purchase calculation:

%Increase  =  3.8% ($1.31 to $1.36)

ROAI         =  50% (twice the average GM% of 25%)

KCost%     =  20%

(24 * .038)   =   .912  =   1.3 Month’s Supply

.50 + .20           .70

The formula is suggesting you order a quantity of each affected item so that your net available quantity (i.e., On-Hand – Committed + On-Replenishment-Order) is equal to a 1.3-month supply above the Line Point (Safety Stock + Anticipated Lead Time Demand + Anticipated Order Cycle Demand).  Please note that when buying before a price increase:

  • Only products with recurring usage (i.e., those that are sold on a regular basis) be included in this speculative buy
  • Adequate warehouse space is reserved for the additional inventory

Replenishment challenges are nothing new.  We must utilize effective tools to compensate for these predicaments.