MANAGING INVENTORY
PURCHASING MIX
-re
This formula assumes that inventory levels fluctuate evenly between the minimum (or safety) inventory level and the highest possible inventory level (the amount of inventory immediately after an order is received, safety inventory and reorder quantity).
Section summary
Business should consider at what level of inventory orders should be made, taking account of demand levels, delivery times and any uncertainties. Safety inventory may be held if uncertainties are particularly large.
Inventory holding and ordering costs can be minimised using the economic order quantity model. If discounts are offered for bulk purchases, the higher holding costs should be weighed against the lower ordering and purchasing costs.
2 Purchasing
Introduction
Purchasing may be centralised or decentralised. The optimal mix of quantity, quality, price and delivery arrangements should be sought.
2.1 The purchasing function
Purchases can account for a major part of a company's expenditure, but rarely get subjected to the planning and control constraints that are experienced by other business functions. This comment is not true of all branches of industry and commerce. In high street stores, 'buying' is recognised as one of the most important functions of the business.
The effectiveness of the purchasing function affects profit in three ways.
(a) Effective purchasing ensures the best value for money is obtained by the firm.
(b) Effective purchasing assists in meeting quality targets. Again this has an impact on a firm's long-term marketing strategy, if quality is an issue.
(c) An effective purchasing strategy minimises the amount of purchased material held in inventory.
2.2 The purchasing mix
The purchasing manager has to obtain the best purchasing quantity, quality, price, and delivery arrangements. Purchasing may be centralised or decentralised.
PURCHASING MIX
Quantity Size and timing of orders dictated by balance between delays in production caused by insufficient inventory and costs of inventory-holding
Quality Quality of goods required for the manufacturing process, and the quality of goods acceptable to customers
Price Short-term trends may influence, but best value over period of time is most important Delivery Lead time between placing and delivery of an order and reliability of suppliers' delivery
arrangements
2.3 Building supplier relationships
Many companies are seeking to build up long-term relationships with suppliers, often offering them advice and help with product development, manufacturing processes and quality. This often leads to a reduction in the number of suppliers a firm deals with. This policy is a means of ensuring consistency of bought-in component quality.
2.4 Centralised versus decentralised purchasing 9/12, 5/12
There are advantages to both centralised and decentralised purchasing. Each organisation will make this decision on the basis of their own business and their own business environment.
2.4.1 Advantages of centralised purchasing
• The firm will be buying in larger quantities and so will be able to negotiate more substantial discounts.
• The organisation as a whole should be able to arrange more favourable credit terms than an individual branch.
• Inventory handling functions will be mainly centralised, which should save costs – but some handling will still have to be done at branch level.
• It should be possible to hold lower overall levels of inventory than if inventory was being held at each branch.
• Only one buying department will be needed, which will save costs.
2.4.2 Advantages of decentralised purchasing
• Local branches will be more in control of their production and sales if they have local control of purchasing.
• The purchasing requirements of individual branches may vary. For instance, some lines of inventory may sell better in some areas than others.
• Local branches will be able to form their own relationships with suppliers. There may be more mutual co-operation between a smaller organisation and its supplier than between a large purchasing department and a supplier.
• A local branch can be made more accountable for its own profitability and cash management if it has control of its own purchasing function.
Exam alert
The May 2012 exam contained a 5-mark question in Section B asking for an explanation of the benefits of using a centralised purchasing system. The September 2012 exam contained a 5-mark question asking for the disadvantages of using a centralised purchasing system. The examiner commented that many students did not address the question asked and discussed the disadvantages of changing to central purchasing. Make sure that you always read the question carefully as you will not score marks for answering a different question from the one set.
Section summary
Purchasing may be centralised or decentralised. The optimal mix of quantity, quality, price and delivery arrangements should be sought.
Businesses should consider at what level of inventory orders should be made, taking account of demand levels, delivery times and any uncertainties. Safety inventory may be held if uncertainties are particularly large.
Inventory holding and ordering costs can be minimised using the economic order quantity model. If discounts are offered for bulk purchases, the higher holding costs should be weighed against the lower ordering and purchasing costs.
Purchasing may be centralised or decentralised. The optimal mix of quantity, quality, price and delivery arrangements should be sought.
1 The basic EOQ formula for inventories indicates whether bulk discounts should be taken advantage of.
True False
2 What are the elements of the purchasing mix?
3 The Economic Order Quantity can be expressed as follows:
h o
C D 2C
What does Ch describe in this formula?
A The cost of holding one unit of inventory for one year B The cost of placing one order
C The cost of a unit of inventory D The customer demand for the item
4 Calculate the maximum level of inventory using the following information:
Max lead time = 5 days Min lead time = 2 days Average lead time = 3 days Reorder level = 100 units Reorder quantity = 150 units Maximum usage = 60 units per day Average usage = 30 units per day Minimum usage = 20 units per day
5 Calculate the minimum level of inventory, using the information in question 4.
Quick Quiz
Chapter Roundup
1 False. It may be necessary to modify the formula to take account of bulk discounts.
2 Quantity, quality, price, delivery arrangements.
3 A The cost of holding one unit of inventory for one year
4 Maximum = re-order level + re-order quantity – (minimum usage × minimum lead time) level of inventory = 100 + 150 – (20 × 2)
= 210 units
5 Minimum = re-order level – (average usage × average lead time) level of inventory = 100 – (30 × 3)
= 10 units
5.1 Order quantity
The total annual cost at the economic order quantity of 500 units is as follows.
$
Purchases 4,000 × $96 384,000
Ordering costs $300 × (4,000/500) 2,400
Holding costs $96 × 10% × (500/2) 2,400
388,800 The total annual cost at an order quantity of 1,000 units would be as follows.
$
Purchases $384,000 × 92% 353,280
Ordering costs $300 × (4,000/1,000) 1,200
Holding costs $96 × 92% × 10% × (1,000/2) 4,416
358,896 The company should order the item 1,000 units at a time, saving $(388,800 – 358,896) = $29,904 a year.
5.2 EOQ
EOQ =
h 0
C D 2C
= 0.50
50,000 40
2× ×
= 2,828 units