Buying decisions / Price increases

Buying ahead of a supplier price increase

A supplier announces 4% on the first of the month. Buying extra stock at today’s price avoids that increase, but each added month ties up cash longer than the one before it. The useful question is not whether to buy ahead, but how many months pay for themselves.

The short answer

Judge each extra month on its own. Every month of stock bought early saves the increase once, on that month’s purchases. The first extra month is used quickly, so its saving is earned on money tied up briefly. The sixth month sits on the shelf for most of half a year and earns the same saving. Buy months in order while the return on the next one still clears your hurdle rate, then stop.

A worked example

• The line buys $18,000 a month at cost and orders monthly.
• The supplier raises prices 4%.
• Direct carrying cost is 10.25% a year: interest, insurance, inventory tax, and extra handling and obsolescence. Warehouse space is not included.
• The buyer’s hurdle rate is 20%. No credit-period benefit is counted.

The first month returns 37.8% and the second 21.8%. The third falls to 13.8%, under the hurdle, so the recommendation is 2 extra months. That adds $36,000 to the order at today’s cost and avoids $1,440 of increase. Across both months together the return is 29.8%.

If you ignore the hurdle and look only at carrying cost, the saving is used up entirely at about 9.4 total months of stock. That is where many buy-ahead decisions go wrong: the purchase still shows a gross saving long after it has stopped earning a worthwhile return.

What a stockout does to the return

The figure above assumes every item lasts until the extra stock is used. In practice, a fast-moving staple can run out early, and you reorder it at the new price. That fill-in purchase saves nothing and still carries cost, so it dilutes the return on the whole buy.

Suppose a fill-in covering one month is needed 40% of the time. The return on the 2-month buy drops from 29.8% to 23.1%. Here the buy still clears the hurdle. With a smaller increase or a more erratic line it often does not. The workbench estimates that probability item by item from your dated on-hand history instead of asking you to guess it.

Details that change the answer

• The normal order is not a saving. You were going to buy this month’s stock before the increase anyway. Only the months bought beyond your normal order cycle count as added investment and as savings.
• Not every item belongs in the buy. Slow movers whose extra stock would take more than a year to sell, items with no recent demand, and items already covered by on-hand and on-order stock should be left out. The cash required is the total of the items you actually include.
• Pack rounding adds cost. Rounding each item up to a carton or standard pack raises the investment above the simple months-times-usage figure.
• Quarterly buyers start further out. With a three-month order cycle, the first extra month is already month four on the shelf, so its return starts lower than it does for a monthly buyer.

A quantity discount works differently, because the discount applies to the normal order too. See quantity discount and freight threshold analysis.