Ordinarily, manufactured offer discounts on bulk purchases. Quantity discounts are realized when a firm buys in larger quantities than the Economic Order Quantity (EOQ).
To evaluate whether to take the discount or not, two methods may be used. These are:
a. One price level/cost comparison approach
b. Multiple price break model
a. One price level/cost comparison approach
In such situations, one should calculate the total costs for both EOQ situations and quantity discount situation and compare the two total costs. The components of the total cost are the purchase cost, holding costs and ordering costs.
Reject the discount offer if the total cost related to the quantity discount is more than the total cost related to the EOQ situation. But if the total cost related to discount situation is less than accepted.
b. Multiple Price Break Model
In here, there are several prices quoted for different batches. At each price, there is a discount offer. To determine the optimal EOQ for the firm, determine the EOQ at each price. If the EOQ calculated given the data of a specific class does not fall within that class, disregard the class and proceed to the next class with the higher price.
>>> Illustration
Tim’s Solutions limited wishes to achieve excellent stock management so as to achieve a marvelous profit this year. Its management estimates the demand for its product to be 1000 units per annum with a purchase price of Shs10 per unit, a holding cost of Shs0.75 per unit (7.5 % of purchase costs) and ordering costs of Shs 15 per order. The supplier of the stock has presented Tim’s Solutions with the following range of prices of stocks.
Due to its storage capacity, the Company can only purchase an amount of up to 600 units. Currently, the company is purchasing at optimum stock quantity to enable it achieve its objectives. The management is considering whether to shift from the current stock purchase policy to purchase the maximum stock.
Required:
a. Calculate the current EOQ in units
b. Determine the total cost of stock that arises due to the EOQ purchased (include the
discount opportunity cost)
c. Advise the company whether it should change its policy.
Solution
(a) Current EOQ
Data given: Cost of holding 0.75 per unit (7.5% of purchase cost )
Cost of ordering Shs15 per order Purchase cost Shs10 per unit Annual demand
(c) Disregard the classes above, the 600-799 units, since we are told that the firm’s storage capacity is only 600 units. When calculating the other EOQ values, use the lower figure in the range (lower boundary)
The minimum total costs are incurred at the 600-799 bracket. Therefore, the company should take advantage of the discounts and procure 600 units each time it wants to buy. The company will save Shs411.25 each year by adopting the new policy.