ANALYSIS OF QUANTITY DISCOUNTS - Working Capital Management

There are occasions when a firm is able to take advantage of quantity discounts provided the order size reaches a certain level.It is possible to analyze and decide on such cases.

For instance, in the preceding example, we found that the usage per year is 2000 units, the holding cost per unit per year is N10 and the ordering cost is N100. Let us now consider what would be the solution if it was known that a quantity discount of 10% in price is available if the order size is raised to 250 units.

Whether or not the quantity discount should be availed of depend on an assessment of the cost and benefits involved. The saving resulting from the quantity discount = N1 x 0.10 x 2000 = N2000.The cost is the additional holding cost minus savings in ordering cost stemming from fewer orders being placed.

While the cost was CO*⁄2 = 10 (200)⁄2 = N1000.
The cost would now be Cq⁄2 = 10 (250)⁄2 = N1250.
Where q* = new order size
There would be a difference of N250.

The savings in ordering cost can be arrived at as follows:
Total ordering cost when 200 units are ordered each time
= 2000 (100)⁄200 = N100
Total ordering cost when 250 units are ordered each time
= 2000 (100⁄250) = N800
Therefore, the saving in ordering cost would be N200 i.e. (N1000 – 800).

Thus, while the saving in ordering cost would be N200, the escalation in holding cost would be N250, that is to say that the net increase in cost would be N50.

In this particular instance, it would be advisable to avail of the quantity discount option because the saving of N200 exceeds the net increase in cost of N50.