Horse Sense #102

Economic Order Quantities

(Otherwise Known As

Purchasing Volume and Value)

Do You Need It?

Business is about making money and spending the money you have wisely. But those expenses need to be carefully considered.  For every item or service that you order, there is an economic order quantity.  If you ask for too little, the price for each item goes up, but if you ask for too much and do not use enough or use it slowly or ineffectively, you waste money.  So how do you determine what the economic order quantity for something is?

If you truly need something, postponing that need until you can lump it together with other things to get a discount is often chasing a false saving.  Leaving one toilet clogged until you have some more plumbing work to do is not a good idea.  The inconvenience and later expense will easily wipe out any savings you might hope for.  People often ask me “When should I buy…?”  I always tell them, “When you need it.”  You may need it because (ranked from easy to see to harder to see):

(1) The old one is broken.

(2) It does not do the job it used to do as well.

(3) It is not doing the job as fast or as well as you want it to today.

(4) It is not up to doing the occasional tasks you have in a timely fashion.
(5) You use a different method rather than the one you are supposed to (it can be very hard to see bad habits).

(6) It will soon fall short or has reached its natural replacement time when it will cost more to use it than its replacement will (most people do not deal with the future well, so this is hard for them to evaluate).

There are some easy ways to tell if you have waited too long.  Imagine giving the product or denying the service to your wife, child, or a very valued employee.  If you think that they would be disappointed, you have waited too long to do it for yourself or your business.

How Do You Satisfy Your REAL Need?

Once you have decided you need something, the question becomes “How much do I need?”  The answer is often, “More than you think.”  If you ever have a question as to whether a certain feature or function is necessary, think of the future.  Now, imagine having to deal with that issue at a future time and going through the same decision making and other processes you have to go through now.  Will it be worth it?  Here are some examples:

(1) Recently, I needed to apply for a personal line of credit.  I had to fill out exactly the same paperwork no matter how big the line was to be.  Since it was a line of credit, I did not have to pay anything if I did not borrow any money.  The solution was simple; I imagined the largest expenditure I might have.  I also asked the lending agent what was reasonable and would not trigger more paperwork, hassle, or a rejection.  I then asked for a much larger limit than I needed at the moment.  It was granted and now I know I have a lending safety net already in place should I need it.  Getting more of something may require little in the way of actual effort or resources.

(2) I "bought" that credit line by committing time, energy, and other resources I have now and the commitment to pay interest later.  Having something in place when you need it is easy, inexpensive, and causes little disruption compared to having to deal with an "emergency."  While you may not consider not having a toner on hand to be a big deal, what if you cannot print the $3 million invoice you need to print to get paid?  Not having what you need can be very expensive (basically the reverse of (1)).

(3) Whenever I am asked, “Do I need this less capable product, component, or warranty, or this one?” I always reply, “Buy the more capable one.”  You do not know what the future will hold.  Buying more than you actually need is inexpensive when stacked against a wholesale replacement and/or expensive services later.  It is not "gold plating" if you think you might later use it.

(4) Buying less than you need or know you will need is almost never a good choice.  Settling for a less expensive tool or service that does not do all the things you need it to do will cost you a bundle.  I said need here, not want.  Having to go through the purchasing office again in very short order or having to trash what you have done and rework something is wasting more money than you could ever save.  That said, the future is unknown.  If you have 70% confidence that an off the shelf product or service will do what you need, it is probably enough to go ahead with the buy.  Often people feel pressured to resolve a situation and "buy something."  I will often advise my clients that if they want to get from here to there, a bridge too small will not do it.  Instead, they need to figure out something else to do or save their money until they can buy a bigger bridge.

(5) Budgeting is similar to buying.  I find the most expensive numbers I can possibly find when preparing a budget.  Circumstances change. Sometimes you may need to buy two, or a more expensive component, or the market price goes up, or the unit you want is replaced with a more expensive one, or your brother-in-law runs off with a waitress and is not available to paint your house.  If you budget at the higher end and allow for contingencies, then your chances of success and actually lowering your costs are better.  Never budget off what something currently costs.  Assume it will cost more to be safe.  It is easy to spend less than your budget but may be impossible to spend more.

Budgeting is not just about money.  It is about time and other resources as well.  Getting the phones installed two months after you have occupied a new space is not fun.  Time, people, availability, equipment, and other projects need to be allowed for as well or your costs will go up.  I often have to tell clients, “I’m good.  I’m not magic.  I cannot make stuff appear in negative time nor can I produce product that is not available.”  Oh, and please remember that budgets should not take too much time as they are often bullshit.  The federal government is a very budget driven organization and I have done business with them for many years.  However, today’s needs and expenses may have very little to do with a budget thought up even a short time ago.

(6) Savings may not be obvious.  Buying energy efficient equipment can pay you back over time.  Employee training can pay huge dividends. Paying a consultant to point out what needs to be fixed can pay you back well, too.  Maintaining your equipment and being nice and supportive to your people will pay big dividends.  Buying a five year maintenance deal might not fit well into a yearly budget, but if you intend the product to last for that period of time and you get a good deal buying it up front and do not have to go through the purchase process another four times, you can save gobs of cash.  Keeping someone or something (like malware) from soaking up your entire Internet bandwidth or keeping people from spending too much time on unproductive Internet sites could improve the productivity of your entire organization.  People *think* that hardware, software and services are expensive.  You just buy these things to help people do what needs to get done.  If they cannot get it done easily, well, or at all, you hemorrhage money.  The best way to find out about potential savings is to ask a professional sales representative about them.  He will often ask what your people are doing.  That is where the rubber meets the road.

(7) Buying a lot may not be a good deal.  You might not be able to use it all at once.  You then shoulder market, technological, and businesses risks you do not need to.  While it may be less expensive to buy a bunch, it is not always.  Sometimes, the price for quantity 1 is $X and so is every one after that.  Build a relationship with your salesperson.  If that person is a professional, they are looking to do business with you over and over.  They know they can do that best by taking care of you and NOT assuming “the customer is always right.”  They may tell you to buy 25 software licenses instead of the 23 you know you need and asked for because you will not only get a price break, but you will have two extra licenses to use if you need them.  If you need only one license more than the 23 you bought later, you may have to buy five or more licenses and that would hurt.  As another example, you may need to buy 1000 printers to distribute through your company, but the difference in price between 100 and 1000 per unit may be nil while your up front costs, storage costs, risk of technological obsolescence and vulnerability to product issues and business risks increase.

(8) Think about the future.  What do you expect to get out of your purchase?  One common mistake I have seen is that governments will make a sexy buy of 1000 cameras or laptops one year.  But they do not buy the maintenance.  Worse, they do not think about them wearing out or needing to be replaced or the carry bags and other accessories they need. Buying 333 over three years and looking at a three year lifetime for the products decreases business and technological risks immensely.  It also lowers the barrier in terms of supporting and maintaining the fleet of items and the "gotcha" costs of the accessories will become more glaringlyobvious.

(9) Do not ignore the present or be afraid to think small.  It can be hard to buy an extra charger or a carry bag for a laptop, but the benefits can be amazing.  While some organizations make it difficult to hire consultants or run pilot or demonstration projects, you can lower your risks greatly and increase your success markedly.  Waiting to do something you need to do costs you monetarily and in terms of morale.

(10) Partner with people you trust.  If you only want cheap prices, you can get that, even from good companies.  Do not expect the company or its people to do much else for you.  A rule of thumb to always follow is that “No business is better than bad business.”  The federal government used to have a buying system that “demonstrated” savings of 2-5% on procurements.  The problem was that the error rate was something like 30%.  The system only valued the lowest price.  There was no real incentive to deliver on time, deliver what the customer wanted, ask any questions about the procurement (they would not be answered), or even bid the correct amount, among other issues.  That error rate ended up costing them far more than they ever saved and the buying system got scrapped.  Treating your business partners as disposable “vendors” encourages them to treat you the same way.  Look at the long term relationship and the value you can get out of working with a particular business partner.  After all, you are buying something not because it costs only so much, but for the value it gives you having boughtit.

(11) Sometimes the economic order quantity is zero or less than what you have now.  I will often get someone saying, "I need this."  If they have given me the chance to know them well enough, I may be able to say, "You don't need it.  You have this and it can do the same thing."  It is natural to want to "do something."  But sometimes the best thing to do is NOT to do it at all.  I have often been able to say to my consulting clients, "What is the best thing about hitting your head against the wall?  When you stop."  Sometimes you need someone to point it out to you.  Sometimes you may need to do more in one area to save in another.  You might purchase a software inventory program and find that you have 1250 licenses of software in use, but you are really only using 500. Next time, you should only buy 500 units worth and spend the money you save elsewhere.

(12) Sometimes there is NO economic order quantity or it is not what you think.  Everyone makes mistakes.  The question is, how will you recover from it?  In logistics, if everything goes as planned, consider yourself lucky.  But, if it does not or something is difficult, then having good business relationships with your vendors is key.  If you treat them as a disposable commodity or do not value customer service, be prepared for a nasty and expensive road ahead.  At Iron Horse, we can document a 0.2% or less product return rate for any reason over 20 years.  Some of the Internet mass marketers have return rates more than 100 times that.  Be as diligent as you can on the front end, but work with people who really value you and your business.  An easy example of an economic order quantity being not what it seems is buying insurance or a warranty that is very difficult to deal with or does not pay.  The entire purpose of those agreements is to mitigate your potential loss.  If they add to it at a more critical time, the "savings" of a couple of bucks in premiums or fees is not justified.  As another example, your brother might be happy to pull your tooth for a quarter, but the dentist at $100 may be a better value.

(13) It can be advantageous to buy everything you need in one place. These are all or none orders.  Then again, it might not.  Some suppliers are better at some things than others.  And, you may want to encourage vendors to keep doing business with you.  Put yourself in their shoes. If you never order from them or only turn to them as a vendor of last resort or treat them as a disposable commodity, then would you be all that excited about doing business?  And, if you are a pain to deal with, any vendor may well "fire" you or raise their rates so you end up firing yourself.  A professional salesperson would rather have no business than bad business which costs him time, money, and resources that would be better spent elsewhere.  If you only buy one or two from one company and then thousands from someone else once they have proved their value, do not be surprised if they do not want to take your call.  Look to develop long term, mutually beneficial business relationships.

(14) Good business is often dull.  If something is exciting, there is a good chance it is because something went wrong.  And, it is often the dull things that mean the most.  You need to set appropriate goals and expectations, provide adequate training and maintenance, provide technical help and managerial support, ensure that there are resources available, provide policies and standards, and provide all the ancillary items (bags, install services, cloud services, power adapters, etc) to allow for the success of a "sexy" purchase like a new laptop.  Your car is not important, per se.  That it can get you to and from where you want safely is.  The fact that you know how to drive and maintain it is.  The fact that you know what to expect when you are on the road is. The same is true of your business purchases.  While it may be "sexy" to order 10, 100, or 1000 laptops at once, are all the other "little things" in place to make that a truly valuable purchase?

(15) Time and resources are both your friend and your enemy when it comes to a getting a good deal.  If you have to have it now, then your choices become more limited.  If your system forces you to buy a one year support agreement and will not let you buy a three year one for the price of two, then you may be stuck.  Or are you?  Given enough time, you could fight the system to change the rule or negate it in your specific case.  Without enough time, you still have options.  One tactic I have often used in the past, though it almost always caused short term issues, was to ignore the rule and do what needed to be done.  The rule for an underling is that you can ask for permission or forgiveness.  It can be risky, but it can also be the best or only thing to do to get the job done to ask for forgiveness.

The shorter the time frame, the more likely asking for forgiveness will be necessary.  If the time frame is too short, you may not be able to accomplish what you want to no matter how much money or resources you throw at the problem.  You cannot make backordered product magically appear, for example.  Given more time and more flexibility, however, the prices and terms can come way down.  If you put in an emergency call for a plumber to come out and fix your toilet, it will be much more expensive than if you shut the water off and have a scheduled call to fix the same issue.

(16)  Shopping-itis and administritis are real problems.  It is easy to lose sight of what you are doing, especially if you approach shopping as a game show where you are looking for the lowest price.  Price says nothing about value or relationship.  Price is only one factor.  An overemphasis on price or cost is corrosive.  Don't believe me?  Please go see the lowest priced doctor you can find for your child's heart surgery.  Still don't believe me?  I will give you a lower price than you can find anywhere on the Internet....but, I will not deliver until I damn well feel like it, like 9 months later when I can buy in bulk. Need help with your product?  Fine, e mail me at this address which has an unhelpful autoresponder.  I can name lots of factors that matter more than price.

Spending a lot of time shopping can cost you.  We all do it, so do not say you do not.  I am sure you are not one of those who drives 30 minutes to buy cheaper gas for your car.  Those people find that in the gas costs alone they have probably lost money, not to mention the time and hassle of actually making that run.  OK, I will admit it.  I often look at what is available on the market and what other people charge for it.  It may or may not reflect what I charge for it or whether I sell it at all.  You do the same.  Gas may be $2.50 in East Texas, but if you want to fill your car in Virginia, it means little.

Sure it is fun to "play the price game."  It can also be a scary thing to finally pull the trigger and commit yourself to an alternative, so you might want to spend lots of extra time looking.  But, from a business and personal standpoint, you are wasting time, effort, and money.  You may need a salesman's help to "convince" you that what you really need to do you can do with them.  [Professional salespeople help you see what you need to do is OK, they do not really "convince" you of anything.]  Avoiding a decision is not OK.  Especially in business shopping, the goal is to do it quickly and easily.  If you know people you can trust, you can cut your time spent shopping to almost nothing.

Administritis is *showing* how much effort you made.  It may just be a way to cover yourself in case something goes wrong.  It may even be satisfying some procurement rules.  Governments are famous for this. They will happily spend $1,000,000 to document how they saved $5.  To them "accountability" is all important.  That is budget and bean counter thinking.  It is not a good way to actually save money, create value, or achieve business objectives.  Try to avoid procedures that will drive the total cost up dramatically.  Governments do not like to think in terms of cost, so for those in large organizations, look for the best method to realize a good Return on Grief (tm).  If you possibly can, look at procedures in your organization that make getting what you need far too hard and attack them.  Administritis is a debilitating long term illness that can sap morale and cost a ton of money.  As a personal example, before I got married I had administritis.  I tracked all my expenses very closely.  That did not sit well with my wife. Pre-marriage it was "$0.05 for gum."  Now it is "$1000 for miscellaneous expenses."  My wife and I are both happier and I spend less time with my personal accounting program.  I resisted it, but it was a win all around.  Do NOT tell her she was right!

I would like to hear any thoughts or questions you have on this topic. You are welcome to use all of this thinking to improve your buying or you can simply call Iron Horse for your business computing needs.  We will be happy to apply what we have learned to make your experience a better one!

©2012 Tony Stirk, Iron Horse