When the Price Goes Down, How Much Do You Buy?

Sometimes the cost of an item will be dependent on how much is purchased. For example, Foyt’s Racing Supplies offers the following discount schedule for the #AJ 3000 Brake Pads:

The current usage rate for the item is 100 pieces per month. Which of the three quantities on the screen above represents the best buy? Your salespeople will tell you that’s an easy question… the best buy is the quantity of 1000 that provides the biggest discount and the lowest unit cost.

But in coming up with this answer, the salespeople are ignoring the fact that it costs your company something to maintain inventory in your warehouse. We refer to this amount as the inventory carrying cost. The inventory carrying cost, also known as the “K” cost, is the accumulation of all of the expenses you incur maintaining stocked inventory in your warehouse. These costs include:

• Moving material to the proper bin location and shifting it to other warehouse locations as necessary.
• Insurance and taxes on the inventory.
• Approximately 40% of your warehouse rent and utilities. The balance of these warehouse expenses is considered as part of the cost of filling customer orders.
• Physical inventory and cycle counting.
• Inventory shrinkage and obsolescence.
• Opportunity cost of the money invested in inventory. That is, how much could you make if the money tied up in inventory was invested in a relatively safe, income-producing investment.

The total cost of carrying inventory, in dollars, grows as the investment in inventory grows. If you have more inventory, you have more money tied up in your warehouse stock. Inventory taxes and insurance increase. You probably also experience more inventory shrinkage (lost, damaged, or stolen material) and product obsolescence.

Even apparently fixed expenses such as warehouse rent and utilities can vary with the amount of inventory maintained in your warehouse. Suppose you could eliminate 40% of your current inventory. Would you still need all of the warehouse space you now occupy? Could you lease or sub-lease part of the building? Remember that even if you own your warehouse building, you still have a rent expense. But instead of the rent being the amount of money you pay to the owners of the building, it is the amount of income you give up by not being able to lease the building to another business.

Because of the direct relationship between the total value of inventory and the cost of maintaining that warehouse stock, the inventory carrying cost is expressed as a percentage of the average value of stocked inventory. As a general rule, the annual inventory carrying cost will be between 25% and 35% of the average value of stocked inventory. For example, if a distributor has an average inventory investment of $1,000,000, the annual carrying cost will be between $250,000 and $350,000. Firms with lower operating costs, such as those that own their own building, should use a number close to 25%. Distributors with higher operating costs, such as those whose warehouse space is limited and very expensive, should use a higher carrying cost percentage.

In determining the quantity that results in the lowest total cost of inventory, we need to compare the net savings received at each discount level to the cost of carrying larger quantities of the product in your warehouse. We follow these steps in making this comparison:

1. Calculate the total incoming cost (i.e. what you pay the vendor plus freight and other miscellaneous expenses) at each discount level. This is done by multiplying each purchase quantity by the corresponding unit cost: 
   

   Purchase Quantity	Net Unit Cost	Total Incoming Cost
   1	10.00	10.00
   100	9.50	950.00
   500	9.25	4,625.00
   1000	9.00	9,000.00

    

2. Calculate the net carrying cost we will incur if we purchase each quantity:
   1. Calculate the average value we will have on-hand during the time it takes to sell the entire purchase quantity. We do this by dividing the Total Incoming Cost in half. After all, half the time we’ll have more than this amount, and half the time we’ll have less than this amount. 
      

      Purchase Quantity	Total Incoming Cost	Average Value of Inventory
      100	950.00	475.00
      500	4,625.00	2,312.50
      1000	9,000.00	4,500.00

       

   2. Calculate the amount of time it will take to sell each purchase quantity. Remember that the usage rate for the item is 100 pieces per month: 
      

      Purchase Quantity	Monthly Usage Rate	Month’s Supply
      100	100	1.0
      500	100	5.0
      1000	100	10.0

       

   3. Determine the net carrying cost for each purchase quantity. For this example, the annual carrying cost is 30%, or 2.5% per month. This is done by multiplying the average value of inventory by the appropriate holding cost percentage: 
      

      Purchase Quantity	Average Value of Inventory	Holding Cost %	Net Holding Cost
      100	475.00	2.5% x 1 mnth = 2.5%	11.88
      500	2,312.50	2.5% x 5 mnth = 12.5%	289.06
      1000	4,500.00	2.5% x 10 mnth = 25%	1,125.00

       

3. Add the Net Carrying Cost to the Incoming Cost to equal your Total Cost for the material. 
   

   Purchase Quantity	Incoming Cost	Net Holding Cost	Total Cost
   100	950.00	11.88	961.88
   500	4,625.00	289.06	4,914.06
   1000	9,000.00	1,125.00	10,125.00

    

4. Divide the Total Cost of each Purchase Quantity by the total value of the material (Purchase Quantity x Unit Cost) to determine your net cost for each dollar’s worth of material purchased. 
   

   Purchase Quantity	Total Cost	Purchase Quantity x Unit Cost	Net Cost for $1 Worth of Material
   100	961.88	1,000.00	$0.962
   500	4,914.06	5,000.00	$0.983
   1000	10,125.00	10,000.00	$1.013

    

You achieve the lowest total cost by purchasing 100 pieces at a time. In fact, the total cost for the 1,000-piece bracket is higher than the non-discounted unit cost. That’s paying more than a dollar for a dollar’s worth of material!

Carefully examine discounts for buying larger quantities of an item. A lower price doesn’t always result in the best value!!