Relevant Costs of JIT Purchasing

JIT purchasing is not guided solely by the EOQ model because that model only emphasizes the tradeoff between relevant carrying and ordering costs. Inventory management, however, also includes accounting for a company’s purchasing costs, stockout costs, costs of quality, and shrinkage costs. Glare Shade’s managers are concerned that ordering and storing large quantities of UX1 units have contributed to defective and broken units and shrinkage. So, the company begins implementing JIT purchasing by asking the supplier of UX1 units to make more frequent deliveries of smaller sizes. Glare Shade has recently established an online business-to-business purchase-order link with its supplier, Rytek. Glare Shade triggers a purchase order for UX1s by a single computer entry. Payments are made electronically for batches of deliveries, rather than for each individual delivery. These changes reduce the company’s ordering costs from $200 to only $2 per purchase order! Glare Shade will use the online purchase-order link whether or not it shifts to JIT purchasing. We next evaluate the effect JIT purchasing has on quality and costs.

Description of ItemCurrent Purchasing PracticeJIT Purchasing Practice
Deliveries1,000 units purchased 13 times per year100 units purchased 130 times per year (5 times every 2 weeks)
Purchasing costs$14 per unit$14.02 per unit (Note: Many companies do not pay a higher price for more frequent deliveries.)
Inspection of unitsUnits not inspected at the time of receipt because Rytek ensures delivery of high-quality UX1 sunglasses.Units not inspected because Rytek ensures that high-quality UX1 sunglasses are delivered to support Glare Shade’s JIT purchasing.
Required rate of return on investment15%15%
Relevant carrying cost of insurance, materials handling, storage, etc.$3.10 per unit of average inventory per year$3.00 per unit of average inventory per year (lower insurance, materials handling, and storage rates)
Customer return costs$10 for shipping and processing a unit returned by a customer. The high quality of units supplied by Rytek will result in no units being returned by customers.$10 for shipping and processing a unit returned by a customer. The high quality of units supplied by Rytek will result in no units being returned by customers.
Stockout costsNo stockout costs because demand and purchase-order lead times during each 4-week period ( 52   weeks ÷ 13   deliveries ) are known with certainty.More stockouts because demand variations and delays in supplying units are more likely in the short time intervals between orders under JIT purchasing. Glare Shade expects to incur stockout costs on 150 units of UX1 per year under the JIT purchasing policy. When a stockout occurs, Glare Shade must rush-order units at an additional cost of $4 per unit.

Should Glare Shade implement the JIT purchasing option of 130 deliveries of UX1 per year? Exhibit 21-5 compares Glare Shade’s relevant total costs under the current purchasing policy and the JIT policy. It shows net cost savings of $1,251 per year by shifting to a JIT ­purchasing policy. The benefits of JIT purchasing arise from lower carrying costs. JIT purchasing also gives Glare Shade’s managers immediate feedback about quality problems by reducing the “safety net” large quantities of inventory provide.

Exhibit 21-5

Annual Relevant Costs of Current Purchasing Policy and JIT Purchasing Policy for UX1 Sunglasses

Spreadsheet screenshot shows annual relevant costs of current purchasing policy and JIT purchasing for UX1 sunglasses from Rytek and Denton.

Details are as follows:

Rytek

1. Purchasing costs

2. Relevant Cost per Unit: $14.02

3. Quantity per Year: 13000

4. Total Costs (product of above 2 and 3): $182260

1. Ordering costs:

2. Relevant Cost per order: @2.00

3. Quantity per Year: 130

4. Total Costs (product of above 2 and 3): 260

1. Inspection costs:

2. Relevant Cost per unit: n/a

3. Quantity per Year: n/a

4. Total Costs (product of above 2 and 3): n/a

1. Opportunity carrying costs:

2. Relevant Cost per unit of average inventory per year: $2.10 (product of Purchasing cost per unit and 0.15 per year)

3. Quantity per Year:50 (Order quantity divide by 2 = 100 divide by 2 = 50 units)

4. Total Costs (product of above 2 and 3): 105

1. Other carrying costs (insurance, materials handling, etc.)

2. Relevant Cost per unit of average inventory per year: $3.00

3. Quantity per Year: 50 (Order quantity divide by 2 = 100 divide by 2 = 50 units)

4. Total Costs (product of above 2 and 3): 150

1. Customer return costs:

2. Relevant Cost per unit returned: $10.00

3. Quantity per Year: 0

4. Total Costs (product of above 2 and 3): 0

1. Stockout costs:

2. Relevant Cost per unit: $4.00

3. Quantity per Year: 150

4. Total Costs (product of above 2 and 3): 600

Denton

1. Purchasing costs:

5. Relevant Cost per Unit: $13.80

6. Quantity per Year: 13000

7. Total Costs (product of above 5 and 7): $179400

1. Ordering costs:

5. Relevant Cost per order: $2.00

6. Quantity per Year: 130

7. Total Costs (product of above 5 and 6): 260

1. Inspection costs:

5. Relevant Cost per order: $0.05

6. Quantity per Year: 13000

7. Total Costs (product of above 5 and 6): 650

1. Opportunity carrying costs:

5. Relevant Cost per unit of average inventory per year: $2.07 (product of Purchasing cost per unit and 0.15 per year)

6. Quantity per Year: 50 (Order quantity divide by 2 = 100 divide by 2 = 50 units)

7. Total Costs (product of above 5 and 6): 103

1. Other carrying costs (insurance, materials handling, etc.)

5. Relevant Cost per unit of average inventory per year: $2.90

6. Quantity per Year: 50 (Order quantity divide by 2 = 100 divide by 2 = 50 units)

7. Total Costs (product of above 5 and 6): 145

1. Customer return costs:

5. Relevant Cost per unit returned: $10.00

6. Quantity per Year: 325 (product of 2.5% of units returned and 13,000 units)

7. Total Costs (product of above 5 and 6): 3250

1. Stockout costs:

5. Relevant Cost per unit: $4.00

6. Quantity per Year: 360

7. Total Costs (product of above 5 and 6): 1440

Total annual relevant costs of Rytek: $183375

Total annual relevant costs of Denton: $185248

Annual difference in favor of Rytek: $1873.