High Volume Purchases Versus a Company’s Inventory Carrying Costs:
Companies are always troubled by that nagging concern of whether they have too much or too little inventory. It’s this constant struggle that prohibits them from making sound decisions, decisions that could help reduce their procurement costs while providing them with the right amount of inventory at the right time. It’s a balancing act and one that causes many procurement professionals headaches. However, is there a way a company can measure the savings accrued through higher volume purchases against their costs to retain inventory? In fact, there is and it involves determining the savings on price and freight relative to the company’s carrying costs.
Understanding inventory carrying charges & turnover rates
Inventory carrying costs include all costs pertaining to a company’s financing costs of inventory, its costs of inventory obsolescence, damage and ruined inventory, its costs of warehousing, electricity and rent, its costs of freight on incoming shipments of raw materials and ultimately, its costs of manage inventory over time. Most companies assume their inventory carrying costs to be 3% of the inventory value on hand. This is the value we will use as part of our analysis.
A company’s inventory turnover rates are an assessment of how successful it is at selling its inventory. When companies purchase and sell inventory within a short period, such as a day, week or month, they are able to reduce their financing costs of inventory. The faster the company invoices their customer, the faster the company gets paid and consequently, the lower its financing costs. In essence, reducing financing costs involves the company paying its own vendors and creditors right around the same time it gets paid by its own customers. However, this is only possible if the company sells inventory within the same month they purchased it. Faster inventory turnover rates means reduced inventory carrying costs and better cash flow management. So, what role does both play in determining how much a company should hold in inventory?
- Inventory turnover rates: The first portion of this analysis involves determining your product’s inventory turnover rate. How fast do these products move? More importantly, what is the amount of time, in days, that your company holds this inventory before finally selling it? In this case, you must define the average number of days your company holds this inventory before it’s finally sold.
- Net savings on freight and purchase price: Every company understands that higher volume equates to lower prices. However, higher volumes also reduce the per-unit costs on incoming freight. Unfortunately, the concern companies have is whether these savings will be eroded by the company’s monthly carrying costs of 3%. In addition, there is also the constant concern of cash flow and damage that could occur to the inventory should it be retained for too long.
- Impact of monthly carrying costs: Finally, your company must be able to determine the costs of holding that inventory relative to the savings accrued from higher volume purchases. If your savings from larger volume purchases and economies of scale, outweigh your company’s inventory carrying costs for the time you hold that inventory, then your company will save money.
An example of measuring savings versus the carrying costs of inventory
Let’s assume a company sells a product with an inventory turnover rate of one month. Its vendor offers the company a reduction of 15% on price and 7% on freight provided the company triples their volume. The company knows that higher volume means a lower purchase price, but they also know that shipping a higher volume also means their per-unit cost of incoming freight will be reduced. Unfortunately, purchasing this higher volume means the company will retain inventory for three months, or 90 days. The question that must be answered is how much these aforementioned savings are relative to how long the company will have to hold that inventory, and consequently, how much their holding costs will erode the total savings accrued through the larger volume purchase. First, we’ll show the price and freight cost for the volumes the company is currently purchasing. Second, we’ll what savings the company gets from the reduction in price and freight versus the costs of carrying that inventory for three months, instead of just one.
A. Original price & freight cost
|Per-unit freight||+ $4.00|
|Incoming cost (subtotal)||$29.00|
|3% carrying cost of inventory||+ $0.87|
The above table “A” outlines the company’s purchase price and per-unit freight costs on incoming parts. Since the company’s turnover rate is one month, its carrying costs of inventory are 3% of $29.00, or $0.87 for each unit. This means the total cost is $29.87 for each unit.
B. New price & freight cost with increased volume
|Per-unit freight||+ $3.72|
|Incoming cost (subtotal)||$24.97|
|3% carrying cost of inventory month 1||+ $0.75|
|Cost month 1 (subtotal)||$25.72|
|3% carrying cost of inventory month 2||+ $0.77|
|Cost month 2 (subtotal)||$26.49|
|3% carrying cost of inventory month 3||+ $0.79|
|Total cost (end of month 3)||$27.29|
In the second table “B”, the company has applied its 15% reduction in price and 7% reduction in freight, giving a new incoming cost of $24.97. The company will now hold inventory for three months before ordering again. Therefore, it must determine its monthly carrying costs for month 1, 2 and 3. However, it must add the previous month’s carrying cost to the most recent month in order to ascertain its true carrying costs. For instance, at the end of the first month, the company’s monthly carrying costs of 3% total $0.75 which means its total cost is $25.72. In the second month, the 3% monthly carrying costs are applied to the previous month’s total of $25.72, which gives a total carrying cost of $0.77 and a new second month total cost of $26.49.
When looking at the above example, it’s important to note that the company actually has a net savings of $2.58 for each unit. This is the difference between the total cost of $29.87 found in the first table “A” at the end of month 1, and the total cost of $27.29 found in the second table “B” at the end of month 3. Granted, this is merely a simple example. In order to truly benefit, the company must protect this inventory against damage and obsolescence. Regardless of the outcome, the basic rule still applies. Determine the product’s inventory turnover rate. Next, determine the potential savings accrued from placing a higher volume order. Finally, determine the net savings when taking into consideration the company’s inventory carrying costs.