Incremental Cost Analysis: A Quick Way to Save Money on Quantity Purchases

This simple analysis can save you a lot of money when buying inventory in quantity.

Analyze your incremental costs at different quantity levels when you purchase in volume. It takes only a few minutes and makes it clear which order volume will give you the best per-unit price and the most savings.

To illustrate, let's assume you order 1,000 widgets every quarter and your supplier just faxed you the following price quotation (Table 1):

Average Cost

Quantity Total Cost Per Unit

1,000                   $2,850                  $2.85

2,000                   $5,250                  $2.63

3,000                   $7,150                  $2.38

4,000                   $9,050                  $2.26

From the quote provided by your supplier, let's add two more columns: incremental cost and incremental cost per unit. These data will show you much more than the average cost-per-unit data provided by your supplier.

Complete the Total Incremental Cost Column

To calculate total incremental (additional) cost for an additional 1,000 units after the first 1,000 widgets, simply subtract total cost quoted for 1,000 units ($2,850) from total cost shown for 2,000 units ($5,250). The difference is $2,400, which is the incremental cost of an additional 1,000 units (after the first 1,000 ordered). Now do the same for the third 1,000 units ($7,150 minus $5,250 equals $1,900) and the fourth 1,000 units ($9,050 minus $7,150 equals $1,900). Great! You've completed the Total Incremental Cost column.

Complete the Incremental Cost Per Unit Column

To complete the second supplemental column, simply divide incremental cost by additional units to get your incremental cost (in our case, additional units are 1,000 in each case). So for the second 1,000 units, incremental cost per unit is 1,000 divided by 2,400 or $2.40 per unit. The third 1,000 is $1.90 per unit, as is the fourth (Table 2).

Incremental             Incremental

Quantity Cost Cost Per Unit

1,000                 N/A                    $2.85

2,000                $2,400                  $2.40

3,000                $1,900                  $1.90

4,000                $1,900                  $1.90

At the 3,000-unit level, your incremental cost per unit is $1.90. Compared to cost at the 1,000 level, you can save $0.95 per unit ($2.85 less $1.90), which is a savings of 33% ($0.95 divided by $2.85). Thus, you should consider ordering 3,000 units to get the 33% savings.

If you use only average cost data, which drops every 1,000 units, you would not have sufficient information to make a prudent decision on which volume is the best buy. For example, the $1.90 incremental cost at the 3,000-unit level is below your average cost of $2.38 at the 3,000-unit level. So the 3,000-unit order is a much better buy than the average cost figures would indicate. You save $0.48 per unit or 25%.

Now compare the 3,000 and 4,000 quantity levels in Table 1. Your average

cost is lower with a 4,000-unit order ($2.26 vs. $2.38 for 3,000 units). But that's deceptive. The incremental cost of $1.90 (Table 2) is exactly the same for both levels. Increasing your order to 4,000 units isn't necessary because there are no additional per-unit savings by ordering 1,000 more units. So why tie up your capital with excess inventory?

What You Can Do

Refer this advisory to your purchasing department. It should be calculating its own supplemental columns for volume purchases. If your suppliers are not giving you price quotes at different quantity levels, ask them to do so. You will find them receptive because they like to sell in volume. And you might find that their volume price breaks provide an opportunity for you to save some money. Of course, before you buy in bulk, consider other things, such as cash flow and inventory obsolescence/spoilage issues, but at least now -- with the incremental cost-analysis tool -- you'll be armed with better financial decision-making data.