Many vendors offer larger discounts when you buy more of their products. But how do you know whether these offers are really good deals? This month we will show you a quick and easy way to decide whether or not to take advantage of a price break.
In our example the vendor offers us three price breaks:
|Price Break||Discount||Net Invest|
If we order $1,000 worth of material at the standard replacement cost we will get a 5% discount. A $2,500 order will give us a 6.5% discount and a $5,000 order will provide us with a 7.5% discount.
To determine which is the “best buy” (i.e., the purchase that provides with the lowest total cost) we must compare the discount offered at each price break to the cost of carrying larger amounts of inventory in our warehouse.
Determine the number of month’s supply of material we will buy at each discount level. Assume that we sell $750 worth of this vendor’s products each month:
|Price Break||Formula||Month’s Supply|
|$1,000||$1,000 ÷ $750||1.3|
|$2,500||$2,500 ÷ $750||3.1|
|$5,000||$5,000 ÷ $750||6.2|
Calculate the average inventory investment we will have on-hand during the time it takes to sell each purchase quantity. This will be half the net investment. For example, if we buy $950 worth of inventory, during the time it takes to sell the entire amount half the time we will have more than one-half of the purchase quantity (i.e., $475) and half the time we will have less than this amount:
|Price Break||Net Invest||Avg. Invty Value|
Calculate the actual cost of carrying this average inventory value during the time it takes to sell the entire shipment. To do this, we need to know your company’s cost of carrying inventory. You can have us calculate your company’s actual inventory carrying cost by filling out the questionnaire in the article, The Mysterious Cost of Carrying Inventory. Currently the carrying cost for the average company will be somewhere between 17% and 23% per year. This means that it costs 17% and 23% to maintain a dollar’s worth of inventory in your warehouse for an entire year. Let’s use an 18% annual carrying cost in this example. This means that it costs 1.5% per month (18% ÷ 12 Months) or 1.5 cents to maintain a dollar’s worth of inventory in your warehouse each month. If we multiply this monthly carrying cost percentage by the average inventory investment for each price break (calculated above) we will calculate the actual cost of carrying each price break quantity during the time it takes to sell the entire quantity purchased:
|Price Break||Formula||Carrying Cost $|
|$1,000||$475 * 1.5%||$9.03|
|$2,500||$1,168.75 * 1.5%||$54.64|
|$5,000||$2,312.50 * 1.5%||$213.91|
Add the Carrying Cost $ to the Net Investment results in our total cost of inventory for each price break opportunity:
|Price Break||Net Investment||Carrying Cost $||Total Cost|
Divide the Total Cost by the amount of inventory we will receive at each price break results in the cost of $1 of material at each price break:
|Price Break||Total Cost||Formula||Cost per $|
|$1,000||$959.03||$959.03 ÷ $1,000||$0.959|
|$2,500||$2,392.14||$2,392.14 ÷ $2,500||$0.957|
|$5,000||$4,838.91||$4,838.91 ÷ $5,000||$0.968|
This analysis shows that based on the offered discounts and our current usage, the $2,500 price break results in the lowest total cost of inventory. In order to effectively buy at the $5,000 level, we would have to increase our sales of the vendor’s products or convince the vendor to give us a larger discount.
Remember that part of achieving effective inventory management is to maximize your company’s profitability. In order accomplish this goal your buyers have to understand that the lowest cost per piece does not always result in the lowest total cost of inventory.