Supply & Logistics Management Association

By William Prior

This paper is primarily directed toward Supply and Logistics Management (SLM) students and those who wish to know more about the basics of SLM. This paper will focus on different purchasing models, types of discounts and the dynamics involved. Topics covered will include: Lot size purchases; Economic Order Quantity (EOQ); Just-In-Time (JIT) supply model; and the Price Discount Problem. As with most decisions in the business environment there are tradeoffs between what is desired and what is attainable.

Purchasing has a great effect on how a business is able to manage its cash flow and productivity. Different models can save money at different stages of the purchasing and manufacturing process. Purchasing different quantities and selecting delivery times has a direct impact on lowering inventory and improving lead times.

Clarifying what needs to be purchased will naturally help to determine how much and when purchases and deliveries need to be made. However there are never simple answers to these problems. Some simple factors to keep in mind are delivery lead times, order costs, availability, discounts, potential disruptions.

Knowing how long it will take to receive an order after it is placed is crucial to know what level to set the safety stock at and determine the reorder point of the inventory. Knowing what costs are associated for placing an order regardless of size will help to determine what variable costs are associated with the inventory. Knowing how available the product is to acquire is another key factor. Is the part industry standard, such as nuts and bolts, or is it highly specialized with a few suppliers able to fill the request? Discounts are common and can vary in a number of types. Negotiating with a supplier for the right type of discount is essential for reducing cost and shortening lead times. Finally, potential disruptions along the supply chain are important to understand. Every step or hand off of the supply creates a potential problem. Some risks are greater than others.

Determining the size of inventory comes in all styles and maybe combined or modified depending on the circumstances. Here are a few of the most common and basic lot sizing techniques.

Lot for lot

The “Lot for Lot” sizing model does not attempt to minimize any cost, it is a direct reflection of demand forecast. It is one of the most popular sizing models in use mainly due to its simplicity. This simplicity however does not account for setup costs, purchase order costs, carrying costs or capacity limitations.

EOQ

The Economic Order Quantity sizing model is one of the most useful but slightly more complicated models. It does take into account the inventory carrying costs, variable costs, direct labor, and purchase order costs. The EOQ model attempts to minimize the overall cost of ordering and carrying a product.

*Annual carrying costs per unit is calculated by finding the annual carrying cost percentage and multiplying it by the annual delivered purchase costs.
An example would be:
2* 900(Annual usage in units)* $50 (The cost of a single purchase order) = $90,000
.25 (Annual carrying cost percentage) * $45 (Per unit Delivered purchase cost = $11.25
$90,000 / $11.25 = $8000
√ 8000 = 89 Units
89 Units would be your EOQ and you would make this purchase 10 to 11 times in a year.

LTC

Least Total Cost sizing model attempts to reduce the ordering costs per piece and the inventory carrying costs per piece to nearly equal. This model does take into account inventory carrying cost, and purchase order costs.

LUC

Least Unit Cost sizing model attempts to reduce the cost per unit. This model does take into account inventory carrying costs and purchase order costs. It does not account for inventory capacity.

These four different sizing or ordering models attempt to satisfy varying needs. Depending on internal and external circumstances a company may be locked into using a particular model.

Just-In-Time (JIT) or Lean Supply models are becoming more popular as companies look to increase overall performance. In an ideal JIT environment supplies would arrive directly at the workstation precisely as they are needed. This type of supply model is incompatible with the previous supply models based on cost reduction. Product design also plays a key part in the ability of a company to optimize its production line to accommodate the JIT model. Several responsibilities need to be addressed to keep the JIT environment running smoothly.

The 1st responsibility is that quality must be the responsibility of the part maker. By the time a part is found to be less than the quality demanded it is already needed to be used. This does not preclude QA testing but heightens the need for part makers to either assume the QA before sending the parts or to control their production process to a point where quality is near 100%.

The 2nd responsibility is that workers must have the ability to stop the production line when quality is not being met. By integrating quality inspection into the production line, workers inspect every piece of output. This underscores the need that quality is more important than pure output.

The 3rd responsibility is that JIT relies more heavily on quality than other production models. Producing many small lot sizes helps reduce large lots with poor quality.

Kanban systems are most commonly found in conjunction with the JIT supply model. Simply put, kanban is the Japanese word for “card.” The model operates by pulling material through the production line based on demand requests. Each customer request is identified with a card be it one unit or one batch. This is analogous to the demand-pull model. Kanban systems are primarally an attempt to control the flow of materials through the production process.

JIT is a way for companies to optimize their production model. It requires that their suppliers be willing and able to meet stringent quality and delivery standards. As the model is optimized the room for error either through quality or delivery time is reduced. JIT models are incompatible with price reducing purchasing models.

Many types of discounts can be negotiated with suppliers. Depending on the contract, suppliers may be willing to offer discounts specifically to distributors or for any customer. Cash discounts are applied when a company pays within a particular timeframe. Some discounts are when a particular quantity is purchased either over a period of time or in a particular order.

Quantity discounts also tend to affect supplier selection. As more units are purchased to receive the reduced price the increased volume puts downward pressure on the number of suppliers a company may need to contract with. The incentive is to streamline the supply chain however the backlash may be that a logistics or production problem with that supplier will work its way through the supply chain to your company.

Some suppliers only want to deal with particular distributors to reduce their own costs of managing sales. They will offer channel distributors a discount to encourage other companies to purchase through them instead of directly as the wholesale level.

Cumulative or Volume discounts are different from quantity discounts in that they are for a particular period usually a quarter or annually instead of a single or discrete order. This allows the purchaser the flexibility to maintain internal supply levels while still taking advantage of discount pricing.

Cash discounts are common and add incentive for purchasers to pay their bills on or ahead of time. Since cash flow is of supreme importance for business heath the earlier a business receives payment for goods or services the more funds it will have to pay its own bills and make investments. Commonly a cash discount will be termed 2/10 net 30. This implies that a 2% discount will be figured in the price during the first 10 days after delivery and that the net amount will be due if paid within 30 days of the receipt of invoice.

Multiple discounts are figured by applying each discount in turn, figuring the cost and then applying the next discount. A quantity discount of 5%, a cash discount of 2% on an order totaling $100 would end up totaling $93.10.

Trying to manage between reducing costs by buying in bulk and reducing inventory cost by buying smaller quantities presents a particular problem. This problem could be analyzed as a Return On Investment (ROI) decision. In this conundrum the EOQ model cannot be applied because it does not account for the purchase price differential directly. The EOQ model can help to evaluate the final decision however. Each step of the price discount must be evaluated separately and then applied to the EOQ model.

There are many different types of discounts that purchasers may be able to negotiate from a supplier. Depending on specific company constraints some discounts are more desirable than others. Sometimes companies are unable to attain a particular discount because of internal processes.

Within every business there are competing sets of objectives. Matching the particular purchasing model with desired and attainable discounts represents a crucial set of strategic problems for all businesses. Understanding internal company processes as they stand and what they are capable of is only half of the strategic equation. Being able to match internal ability to take advantage of negotiable discounts from suppliers is the other half of the strategic equation.