If you run a business, you probably make many different kinds of purchasing decisions. You might buy some items infrequently and only one at a time (for example, computers). At the other extreme,
there are probably some items that you buy regularly and in relatively large quantities. For a print shop, paper might be your highest volume purchase. For a manufacturing business, it might be plastic or steel.
If you are responsible for buying large quantities of a single item, you’ll want to become familiar with the concept of “incremental cost.” It sounds forbidding, but it’s relatively easy to understand, and it can be a powerful tool.
Example: Product X is a vital part of your business, and it’s available at the following prices:
|Units of X||1,000||2,000||3,000||4,000|
Based on average price per unit, an order of 4,000 would seem to offer the best deal, at $2.19 per unit. But take a closer look. In this example, it costs an additional $2,000 to order 4,000 units instead of 3,000 units, which means that each of the additional 1,000 units has an incremental cost of $2.00.
However, the incremental cost to go from 2,000 to 3,000 units is exactly the same – $2.00 per unit, or a total of $2,000. In this example, your incremental cost does not decline after 3,000 units, so that’s the quantity you might decide to order.
In real life, your purchasing decisions may be more complex, and you may need to consider issues like cash flow and storage costs. Even so, the concept of incremental cost can be a help. For assistance with cost decisions in your business, give us a call.