Efficient Purchasing; how does it work?

Oct 25, 2016

As described in our previous blog, when the moment comes to buy new products, the quantity and price is determined by the expected demand during the delivery time.
Selling while your new stock is on its way should be the exception, rather than the rule. Therefore it is essential to consider how much stock needs to be bought, and two variables must be considered to determine this, order costs and inventory costs.

Order costs
Order costs are the costs incurred to get the products into the warehouse, regardless of the size of the order. If these costs are 0 euros, you can stop reading now. In this scenario, you can order as much as you like, as many times as you like, because it costs nothing. The most profitable strategy would be to order a small number of products every day, which reduces the stock costs, but more about that later.

To wake you up from your dream; ordering costs are never zero. With every order, several fixed operational costs cannot be avoided.

 How do you determine these costs?

Because of the order costs, it is cheaper to order more products when placing an order so that the cost per individual unit is less. However, how do you calculate order costs, and what are they made up of? It is crucial to check what needs to be done internally before receiving new stock in your warehouse. For example, you spend time (and therefore money) on placing an order and receiving the delivery.

Bestelkosten bestaan onder andere uit:

  • Internal costs incurred when placing an order (hours)
  • Internal costs incurred when accepting a delivery (hours)
  • Start-up costs of the supplier when processing an order
  • Fixed logistics costs

 

Internal ordering costs

To determine the internal order costs, add the budget of the purchasing department and the value of the goods, and divide it by the number of orders. If there is no specific purchasing department, you must identify how much time is taken up by these operations and multiply it by an internal hourly rate, e.g. 25 euros per hour.

Stock costs
Stock costs are the costs incurred, directly or indirectly, to keep products in stock. Stock costs are always expressed as a percentage per euro of the stock value. The cost of stock consists of three parts: space, risk and interest. However, how are these factors calculated?

Space relates to the size of the warehouse or storage facility. After all: the more products you keep in stock, the more space is required. Also, large products, such as drones, take up more space than pens, for example. Therefore, ordering these large products in lower quantities but more frequently means less warehouse space is required, which ultimately reduces stock costs.

Risks are the costs incurred when stock becomes obsolete. In other words: the damage suffered if products cannot be sold for any reason. Fire or theft can contribute to these risks, but there is also the risk that the product simply does not catch on. The more products you stock, the higher the chance that the products will no longer sell. Depending on the product, the risk percentage varies between 5 and 10 per cent of the stock value. Competitor activity and sales trends, among other factors, influence the risk percentage.

 Interest is the cost of your capital, and it can come from the costs incurred by borrowing money from the bank to buy goods. However, interest can also consist of opportunity costs: the money you miss out on because of an inability to invest in, for example, marketing or AdWords. After all, you can only spend money once. As a rule of thumb, interest can be calculated at between 5 and 10 per cent.

To calculate the total stock costs, you add the percentages for space, risk and interest. Interest and risk are independent of the type of products, but they differ from company to company. As previously mentioned, the percentage for space differs per product. 

Order costs vs. Stock costs

In order to determine the order size, as a webshop owner, you choose an optimal ratio between order costs and stock costs to minimise costs. With larger orders (scenario 1), you save on order costs, but the stock costs increase. In contrast, smaller orders (scenario 2) usually mean higher total order costs and less annual stock costs.

Scenario 1: ordering 40 drones twice at €72-
Order costs: 2 x € 45 = € 90.
Stock costs: 0,5 x 40 x € 72,- x 25 % = € 360,-
Total: € 450,-

Scenario 2: 8 times ordering 10 drones at €72,-
Order costs: 8 x € 45 = € 360.
Stock costs*: 0,5 x 10 x € 72,- x 25% = € 90,-
Total: € 450,-

*Explanation of stock costs:
To determine the stock costs, you use the average stock (0,5 x number of products ordered). In the case of scenario 1, in the period after an order, an average of 5 drones are in stock. At the beginning, there are 10, and at the end 0. To calculate the average stock value of this product, multiply the average stock with the purchase price (0,5 x 10 x € 72,-). To determine the final stock cost, we take the previously determined percentage for space, risk and interest (25%).

 

Optimal order size

How often you order new drones depends on many factors. In the calculation example above you can see that it does not matter if you order 10 drones 8 times a year or 40 drones twice a year. In both cases, the total costs (stock costs + order costs) are € 450-. The optimal order size is reached with 4 times 20 drones. The total costs are then minimised (€ 360,-).
Optimal: ordering 4 times 20 drones at €72-.
Order costs: 4 x € 45 = € 180.
Stock costs: 0,5 x 20 x € 72,- x 25 % = € 180,-
Total: € 360

Are we there now? Not quite yet. For example, quantity discounts, minimum order size (MOQ), and adding new products to the range may cause deviations from the above scenario. In the next blog, the influence of this will be discussed in further detail.

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