Procurement decisions are a matter of dollars and sense

March 15, 2005

Ordering systems must address the questions of how much to order and when to place an order.

Physicians and staff alike should understand the theoretical underpinnings of an excellent ordering system. Frequently, there is a potential for magnificent gains in this area. According to the National Association of Procurement Management, a 5% reduction in procurement costs is approximately equivalent to a 30% increase in sales.

Ordering systems must address the questions of how much to order and when to place an order. In general, such systems require data on demand and its variability, lead time (the time between placement of an order and receipt of a shipment) and its variability, and costs.

Ordering costs include those of invoice preparation and those of shipment inspection at time of receipt of the goods. Ordering costs are generally expressed as a fixed dollar amount per order, regardless of the size of the order.

Shortage costs are those related to customer inconvenience. An optical shop that cannot immediately meet customer demand for a particular style of frames incurs shortage costs. It is frequently difficult to assign monetary value precisely to shortage costs, given their nature.

The traditional approach in a fixed quantity system is to calculate the so-called Economic Order Quantity (EOQ). The EOQ is the amount that is ordered each time under a fixed quantity system. It is based on the concept of minimizing the total costs of inventory.

Holding cost is the cost of holding all inventory over the period of concern (usually 1 year). It is found by multiplying the yearly cost of holding a single inventory item (H) by the average level of inventory on hand over the year. Q is the amount that is ordered in one shipment, and average inventory is Q/2. Therefore, the equation for holding cost is Holding Cost = H * (Q/2).

Ordering cost is the cost of ordering all shipments over a year. It is found by multiplying the cost of ordering one shipment (S) by the number of shipments in a year. The number of shipments in a year is annual demand (D) divided by the average number of items ordered in a shipment. The equation for ordering cost is thus Ordering Cost = S * (D/Q).

The crucial inventory level at which to reorder the EOQ will vary depending upon demand, lead time, variability in demand, and the tolerable level of stockout risk.