Question

4. Advice on how to determine to purchase materials at larger quantities with quantity discounts or smaller quantities (or at economic ordering quantity) but without discounts.

Answer 1

Answer :

To determine whether to purchase materials at larger quantities with quantity discounts or smaller quantities (or at economic ordering quantity) we need to calculate the Total cost of the Materials for year under both alternatives.

The total cost of Materials includes :

(1) Material purchase cost less quantity discounts.

(2) Material ordering Cost.

(3) Material handling Costs.

The material purchase cost is = (Purchase price per unit x no. of units purchased) - quantity discounts.

The Material ordering Cost = No.of orders during the year x ordering cost per unit.

The Material handling Cost = Average no. of units in inventory x Material handling Cost per unit per annum

Average no. of units in inventory = Units ordered per order / 2

So. after taking the Total cost of the Materials for year under both alternatives we will select the alternative at which Total cost of the Materials for year is less.

Lets take an Example :

Suppose a Company needs 8,000 units of a Product for the year. The cost per unit of Product is $400. The ordering cost for placing an order is $200 per order. The Material handling cost per annum is 20% of product price.

The company will receive a quantity discount of 4% on the product if order size is 4,000 units per order. we have to determine that whether to purchase materials at 4,000 units per order with quantity discounts or smaller quantities (or at economic ordering quantity) but without discounts.

So, if Company orders 4,000 units per order, the total material cost for the year will be:

Material purchase cost = (Purchase price per unit - quantity price per unit) x No. of units purchased per year

= (400 - 4%) x 8,000 = 384 x 8,000 = $3,072,000

Material ordering Cost = No.of orders during the year x ordering cost per unit

= (8,000 / 4,000) x 200 = $400

Material handling Cost = Average no. of units in inventory x Material handling Cost per unit per annum

= (4,000 / 2) x 384 x 20% = $153,600

The total cost of Materials under first alternative = $30,72,000 + $400 + $153,600 = $32,26,000

If material is purchased at economic ordering quantity but without discounts

Economic order quantity =

= 200 units per order

The total material cost for the year will be:

The material purchase cost is = Purchase price per unit x no. of units purchased = $400 x 8,000 = 3,200,000

Material ordering Cost = No.of orders during the year x ordering cost per unit

= (8,000 / 200) x 200 = $8,000

Material handling Cost = Average no. of units in inventory x Material handling Cost per unit per annum

= (200 / 2) x 400 x 20% = $8,000

The total material cost for the year under second alternative = $3,200,000 + $8,000 + $8,000 = $3,216,000

The total material cost for the year under second alternative is less than first alternative, we will select second alternative of purchasing materials.

So, in this way we can determine whether to purchase materials at larger quantities with quantity discounts or smaller quantities (or at economic ordering quantity) but without discounts.