Competitive purchasing policies under price volatility.

Publication: Advances in Competitiveness Research

Publication Date: 01-JAN-05

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COPYRIGHT 2005 American Society for Competitiveness

ABSTRACT

Consider the repeated purchase of a commodity whose price fluctuates over time. There are several purchase (replenishment) policies we may adopt, such as buying as much as storage space would allow, or buying more when price is low. Among different purchasing policies, some are found to be better than others in terms of the total cost of purchase. The results are supported by simulations done on a spreadsheet.

INTRODUCTION

There has been an increasing realization that purchasing is a strategic function for firms (Rajagopal, 1993). Although cost of input material is not the only criteria in purchasing, it is an important one, and a simple arithmetic exercise illustrates the impact 0f cost reduction on competitiveness--consider a firm with revenue of $100, 80 percent of which is its cost (which is $80). A 10 percent increase in sales leads to a revenue of $110 at a cost of $88, an improvement of profits from $20 to $22. Instead, a 10 percent reduction in cost (so cost goes from $80 to $72) leads to an improvement of profits from $20 to $28, a 40 percent increase.

The operational issues in purchasing have long been considered in inventory management literature. The basic economic order quantity model (Harris, 1915) is an attempt to minimize overall costs taking into account the cost of ordering (replenishment) and the cost of holding stock. This model assumes a uniform rate of usage of the material over time. When the usage is not uniform but probabilistic (random), other models such as the reorder point method (stock level is continually monitored, and when it reaches a certain level--called reorder point--an order for replenishment is made), the fixed order interval method (orders are placed at regular intervals in time), or the (s,S) policy (when the stock falls below 's' units, a replenishment order is placed to bring the stock level up to 'S' units) are used (Silver, Pyke, and Peterson, 1998).

In all of the above models, the purchase price of material does not figure prominently (it does affect the holding cost, and hence has an impact), except for models that take into account quantity discounts. Generally the price of the material is considered to...

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