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Inventory Management with the COVID-19 Part 6

In the last issue, we looked at balancing the savings you receive by buying a larger quantity of a product at a lower cost per piece with the cost of carrying that extra inventory in your warehouse for a longer period of time. But, you also have to consider your cost of actually purchasing and receiving a replenishment shipment. If you purchase a lot of an item, you have to buy the item less often.

The total annual cost of ordering includes all the expenses involved in issuing, processing and receiving a replenishment order during the past 12 months. These costs include the time and materials spent:

• Deciding what products need to be replenished
• Issuing the purchase order
• Expediting the purchase order (if necessary)
• Processing the receiving paperwork for the shipment
• Approving the vendor’s invoice for payment
• Processing the vendor payment

The “R” cost of ordering or Replenishment Cost is expressed as the amount (e.g., in dollars, euros, pesos or some other currency) necessary to process a line item on a purchase order. This is based on the idea that you spend about the same amount of time reordering a product regardless of the quantity ordered. But, processing a purchase order with 100 line items will almost always take more time than processing a five line purchase order.

The “R” cost is calculated by dividing the total annual cost of ordering stocked products by the total number of purchase order line items for stocked products issued in the past 12 months:

Total Annual Cost of Ordering Activities for Stocked Products
Number of Purchase Order Line Items Issued for Stocked Products in the Past 12 Months

For example, if the annual cost of all ordering activities is \$125,000 and a total of 25,000 stocked line items were listed on purchase orders issued during the last 12 months, the “R” cost of ordering each line item would be:

Total Annual Cost of Replenishment Activities   =     \$125,000     =     \$5 per line item
Purchase Order Line Items Issued (12 Months)           25,000

For most distributors, the “R” cost of ordering is currently between \$5.00 and \$8.00 (US) for each purchase order line item. A questionnaire for calculating the R cost for your organization is available in the resource section of the Effective Inventory Management web site (www.effectiveinventory.com).

Again, notice that the “R” cost of ordering is expressed per purchase order line item. It is not the cost of issuing an entire purchase order or the cost of obtaining a single piece of a product. If you order one piece or one hundred pieces of an item on a single line of a purchase order, the cost of ordering is the same. But, the larger the purchase quantity, the lower the cost of ordering per piece. If only one piece is ordered, that piece must absorb the entire ordering cost. If two pieces are ordered, each piece absorbs half the cost of ordering. If 1,000 pieces are ordered, each piece absorbs 1/1000 of the ordering cost.

In order to best manage your inventory during these challenges economic times, it is vital that you know your costs of doing business. In the next issue, we will show you how to utilize both the cost of replenishing inventory and the inventory carrying costs in making intelligent purchasing decisions. In the meantime, please utilize the questionnaires in the resources section of our web site to calculate these costs for your organization.