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THE ECONOMICS OF ORDERING INVENTORY
THE ECONOMICS OF ORDERING INVENTORY CHARLES PATTERSON, D.D.S., M.B.A.
Supplies constitute a major overhead expense in every dental
practice. The real cost of supplies includes the ordering cost,
the carrying cost and the acquisition cost. At the ideal ordering
volume, the impact of these three factors Is minimized and the lowest true cost is realized. This article describes two formu-
las that will help dental practices In determining their correct
ordering volume and making accurate purchase decisions.
Practices can achieve significant cost reductions by using these
two simple techniques.
jhere are two popular philosophies regarding the management of inventory control; surprisingly, the two are completely opposite. - The first is to order items in bulk quantities in return for substantial manufacturer discounts. Businesses that use this approach are less vulnerable to price increases and delivery strikes (because their inventory postpones the need for reordering), but much of their capital is tied up in unused supplies. - At the other end of the spectrum are just-in-time, or JIT, systems also called "inventoryless systems"-which tie up very few dollars. JIT systems are not perfect, however, in that they unrealistically assume that suppliers grant identical discounts for all order quantities. In addition, a significant lead time often is required to ensure timely deliveries; this leaves businesses vulnerable to strikes (because they have little or no inventory), stock shortages or incorrect deliveries. In this system, wholesale price increases are felt immediately. The most economically efficient inventory control system is a combination of the popular bulk ordering and JIT methods. At a specific point, the total cost of inventory is minimized. That point is described by the economic order quantity, or EOQ, formula. The impact that quantity discounts and promotional gifts have on purchase decisions is accounted for by the total annual cost, or TAC, formula. REAL COST
An item's real cost takes into account three factors: carrying cost, ordering cost and acquisition cost. Carrying cost. Carrying cost, also called opportunity cost, is incurred when supplies remain unused. There is no universal agreement on how to compute carrying costs, as they vary from business to business and even from item to item. One technique simply equates carrying costs with a firm's equity costs (the expected return on its common stock). Another method, more appropriate to dentistry, equates carrying costs with the cost to obtain a shortterm unsecured loan (a loan necessitated by tying up capital in the overstock of supplies). A current estimate for a dental practice's carrying costs is 12 percent.' JADA, Vol. 128, September 1997 1293
PRACTICE MANAGEMENT-
Figure. The ideal minimum inventory cost for a given volume.
Ordering cost. There also are costs associated with the process of ordering supplies: inspecting the inventory, writing up and placing the order, checking stock in, restocking and doing paperwork and accounting. Someone has to be paid to perform these tasks, and doing them may take him or her away from other tasks. One estimate places the cost of an order at $3.' Bar code, keypad entry or other point-ofpurchase systems are too expensive for the relatively few items an average practice carries. Acquisition costs. The acquisition cost for dental inventory includes the purchase price and the cost of shipping, minus the value of any promotional discounts or gifts. As the quantity of supplies kept in stock rises, the cost of maintaining those supplies also rises, but fewer orders need to be placed. When fewer supplies are ordered at a time, less money is tied up in stock. More orders are placed, however, thus increasing the ordering cost. The optimal and lowest 1294 JADA, Vol. 128, September 1997
cost condition strikes a balance between ordering costs and carrying costs (Figure). THE EOQ FORMULA
At a specific supply volume, the total of carrying costs and ordering costs is minimal. That is the most efficient ordering volume for a specific price-the EOQ. The derivation of the formula can be found in standard business management texts.2 In fact, this concept of minimization is used to manage large amounts of corporate capital.3 This is summarized in the following equation: EOQ = (2) (F) (U) i (C) (P) where F = costs incurred with a single order, U = annual use in units, C = carrying cost as a percentage of the item's cost expressed as a decimal and P = acquisition cost per unit (purchase price plus shipping charge per unit minus the value of promotional gifts and discounts). Based on the previous discussion, the fixed cost factor is 3 and the carrying cost factor is
0.12. With these numbers, the formula is simplified to the following equation: EOQ = (50) (UP) Suppose a practice uses 25 carpules of anesthetic per day, 5 days a week, 47 weeks a year, or, in other words, 59 boxes per year. A box of 100 carpules costs $20. If an order of 12 boxes costs an additional $6 in shipping charges, the acquisition cost per box would be $20.50. How many boxes should you order at a time for maximum efficiency? EOQ = -1 (50) (59/20.50) = 12 According to the formula, you should order 12 boxes at a time. It is possible to test the effects of different cost assumptions on the EOQ. For example, if you halve the carrying cost to 6 percent, the EOQ becomes 17. If you either double the carrying cost or halve the ordering cost, the EOQ becomes 9. Suppose your supplier offers you a 10 percent discount for ordering 20 boxes (more than the optimal amount). What' should you do? To solve this problem, you must figure the TAC for both the nondiscounted item (Example 1) and the discounted item (Example 2).3 Example 1: the nondiscounted item. TAC = annual carrying cost + annual ordering cost + annual purchase price TAC = (C)(P)(EOQ/2) + (U/EOQ)(F) + (U)(P) TAC = (.12)(20.50)(12/2) + (59/12)(3) + (59)(20.50) = $1,239 Example 2: the discounted item. Discount cost per unit = $18.50 ($20 regular price -10 percent, or $2, plus $0.50 shipping charge) TAC = (C)(P)(EOQ/2) +
(U/EOQ)(F) + (U)(P) TAC = (.12)(18.50)(20/2) + (59/20)(3) + (59)(18.50) = $1,122
PRACTICE MANAGEMENI The answer is to accept the offer and save $117 on an annual basis. Notice that taking the 10 percent discount is the correct choice, even though it is less than the carrying cost of 12 percent. This problem shows that you should not allow your carrying cost to determine whether you accept a discount. The value of additional promotions, such as gifts, may be taken into account. Simply deduct the per-unit value of the gift from the acquisition cost per unit. For example, if you received $50 in bonding supplies in addition to the 10 percent discount, the acquisition cost per unit would be $18.50 -(50/20) = $16. The EOQ and TAC calculations can be done manually each time an order is prepared. A more efficient method, however, which is useful for multiitem orders, is to set up the cal-
culation on the spreadsheet feature of an inventory software package. The calculations need not be performed more than once a month per item.
I
Using
these two sim-
dise reveal that discount offers may or may not be advantageous. Using these two simple decision formulas, you will experience a real reduction in your supply costs and make better decisions about whether to accept add-on promotions. .
p-e you wniN
epe
a your
real reducton in supply costs and make better decisons about whthr to accept
add-on promotons. CONCLUSION
Many firms successfully use inventory control techniques that are diametrically opposed. However, the most cost-effective technique strikes a balance. Comparisons between discounted and nondiscounted merchan-
Dr. Patterson is a lieutenant commander, U.S. Naval Dental Research Institute, Great Lakes, Ill. Address reprint requests to Dr. Patterson at 1221 Silo Hill Drive, Grayslake, Ill. 60030.
This article is a work of the U.S. government. The views expressed in this article are those of the author and do not reflect the official policy of the U.S. Navy, the U.S. Department of Defense or other departments of the U.S. government. 1. Robert Morris and Associates. Annual statement studies. Philadelphia: Robert Morris and Associates Inc.; 1996. 2. Baumol W. Economic theory and operations analysis. Englewood Cliffs, N.J.: Prentice-Hall; 1977:9. 3. Ross S, Westerfield R. Corporate finance. St. Louis: Mosby; 1988:621. 4. Turban E, Meredith J. Management science. Homewood, Ill.: Business Publications; 1988:587, 603.
JADA, Vol. 128, September 1997 1295
Supplies constitute a major overhead expense in every dental
practice. The real cost of supplies includes the ordering cost,
the carrying cost and the acquisition cost. At the ideal ordering
volume, the impact of these three factors Is minimized and the lowest true cost is realized. This article describes two formu-
las that will help dental practices In determining their correct
ordering volume and making accurate purchase decisions.
Practices can achieve significant cost reductions by using these
two simple techniques.
jhere are two popular philosophies regarding the management of inventory control; surprisingly, the two are completely opposite. - The first is to order items in bulk quantities in return for substantial manufacturer discounts. Businesses that use this approach are less vulnerable to price increases and delivery strikes (because their inventory postpones the need for reordering), but much of their capital is tied up in unused supplies. - At the other end of the spectrum are just-in-time, or JIT, systems also called "inventoryless systems"-which tie up very few dollars. JIT systems are not perfect, however, in that they unrealistically assume that suppliers grant identical discounts for all order quantities. In addition, a significant lead time often is required to ensure timely deliveries; this leaves businesses vulnerable to strikes (because they have little or no inventory), stock shortages or incorrect deliveries. In this system, wholesale price increases are felt immediately. The most economically efficient inventory control system is a combination of the popular bulk ordering and JIT methods. At a specific point, the total cost of inventory is minimized. That point is described by the economic order quantity, or EOQ, formula. The impact that quantity discounts and promotional gifts have on purchase decisions is accounted for by the total annual cost, or TAC, formula. REAL COST
An item's real cost takes into account three factors: carrying cost, ordering cost and acquisition cost. Carrying cost. Carrying cost, also called opportunity cost, is incurred when supplies remain unused. There is no universal agreement on how to compute carrying costs, as they vary from business to business and even from item to item. One technique simply equates carrying costs with a firm's equity costs (the expected return on its common stock). Another method, more appropriate to dentistry, equates carrying costs with the cost to obtain a shortterm unsecured loan (a loan necessitated by tying up capital in the overstock of supplies). A current estimate for a dental practice's carrying costs is 12 percent.' JADA, Vol. 128, September 1997 1293
PRACTICE MANAGEMENT-
Figure. The ideal minimum inventory cost for a given volume.
Ordering cost. There also are costs associated with the process of ordering supplies: inspecting the inventory, writing up and placing the order, checking stock in, restocking and doing paperwork and accounting. Someone has to be paid to perform these tasks, and doing them may take him or her away from other tasks. One estimate places the cost of an order at $3.' Bar code, keypad entry or other point-ofpurchase systems are too expensive for the relatively few items an average practice carries. Acquisition costs. The acquisition cost for dental inventory includes the purchase price and the cost of shipping, minus the value of any promotional discounts or gifts. As the quantity of supplies kept in stock rises, the cost of maintaining those supplies also rises, but fewer orders need to be placed. When fewer supplies are ordered at a time, less money is tied up in stock. More orders are placed, however, thus increasing the ordering cost. The optimal and lowest 1294 JADA, Vol. 128, September 1997
cost condition strikes a balance between ordering costs and carrying costs (Figure). THE EOQ FORMULA
At a specific supply volume, the total of carrying costs and ordering costs is minimal. That is the most efficient ordering volume for a specific price-the EOQ. The derivation of the formula can be found in standard business management texts.2 In fact, this concept of minimization is used to manage large amounts of corporate capital.3 This is summarized in the following equation: EOQ = (2) (F) (U) i (C) (P) where F = costs incurred with a single order, U = annual use in units, C = carrying cost as a percentage of the item's cost expressed as a decimal and P = acquisition cost per unit (purchase price plus shipping charge per unit minus the value of promotional gifts and discounts). Based on the previous discussion, the fixed cost factor is 3 and the carrying cost factor is
0.12. With these numbers, the formula is simplified to the following equation: EOQ = (50) (UP) Suppose a practice uses 25 carpules of anesthetic per day, 5 days a week, 47 weeks a year, or, in other words, 59 boxes per year. A box of 100 carpules costs $20. If an order of 12 boxes costs an additional $6 in shipping charges, the acquisition cost per box would be $20.50. How many boxes should you order at a time for maximum efficiency? EOQ = -1 (50) (59/20.50) = 12 According to the formula, you should order 12 boxes at a time. It is possible to test the effects of different cost assumptions on the EOQ. For example, if you halve the carrying cost to 6 percent, the EOQ becomes 17. If you either double the carrying cost or halve the ordering cost, the EOQ becomes 9. Suppose your supplier offers you a 10 percent discount for ordering 20 boxes (more than the optimal amount). What' should you do? To solve this problem, you must figure the TAC for both the nondiscounted item (Example 1) and the discounted item (Example 2).3 Example 1: the nondiscounted item. TAC = annual carrying cost + annual ordering cost + annual purchase price TAC = (C)(P)(EOQ/2) + (U/EOQ)(F) + (U)(P) TAC = (.12)(20.50)(12/2) + (59/12)(3) + (59)(20.50) = $1,239 Example 2: the discounted item. Discount cost per unit = $18.50 ($20 regular price -10 percent, or $2, plus $0.50 shipping charge) TAC = (C)(P)(EOQ/2) +
(U/EOQ)(F) + (U)(P) TAC = (.12)(18.50)(20/2) + (59/20)(3) + (59)(18.50) = $1,122
PRACTICE MANAGEMENI The answer is to accept the offer and save $117 on an annual basis. Notice that taking the 10 percent discount is the correct choice, even though it is less than the carrying cost of 12 percent. This problem shows that you should not allow your carrying cost to determine whether you accept a discount. The value of additional promotions, such as gifts, may be taken into account. Simply deduct the per-unit value of the gift from the acquisition cost per unit. For example, if you received $50 in bonding supplies in addition to the 10 percent discount, the acquisition cost per unit would be $18.50 -(50/20) = $16. The EOQ and TAC calculations can be done manually each time an order is prepared. A more efficient method, however, which is useful for multiitem orders, is to set up the cal-
culation on the spreadsheet feature of an inventory software package. The calculations need not be performed more than once a month per item.
I
Using
these two sim-
dise reveal that discount offers may or may not be advantageous. Using these two simple decision formulas, you will experience a real reduction in your supply costs and make better decisions about whether to accept add-on promotions. .
p-e you wniN
epe
a your
real reducton in supply costs and make better decisons about whthr to accept
add-on promotons. CONCLUSION
Many firms successfully use inventory control techniques that are diametrically opposed. However, the most cost-effective technique strikes a balance. Comparisons between discounted and nondiscounted merchan-
Dr. Patterson is a lieutenant commander, U.S. Naval Dental Research Institute, Great Lakes, Ill. Address reprint requests to Dr. Patterson at 1221 Silo Hill Drive, Grayslake, Ill. 60030.
This article is a work of the U.S. government. The views expressed in this article are those of the author and do not reflect the official policy of the U.S. Navy, the U.S. Department of Defense or other departments of the U.S. government. 1. Robert Morris and Associates. Annual statement studies. Philadelphia: Robert Morris and Associates Inc.; 1996. 2. Baumol W. Economic theory and operations analysis. Englewood Cliffs, N.J.: Prentice-Hall; 1977:9. 3. Ross S, Westerfield R. Corporate finance. St. Louis: Mosby; 1988:621. 4. Turban E, Meredith J. Management science. Homewood, Ill.: Business Publications; 1988:587, 603.
JADA, Vol. 128, September 1997 1295