About Forward Buying

Forward Buying provides an analysis of purchasing situations just before a cost increase, or when a vendor offers an extra discount or extended terms.

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Forward Buying refers to the opportunity to make extra profit when a vendor offers temporary special terms, or when a cost increase is about to become effective. In these situations a merchant can take advantage of the situation by buying more than the usual amount. The financial gain can be measured against the incremental costs of temporarily carrying more inventory. This can be a significant source of incremental profit for merchants.

ALL of these conditions must be true for a purchase to qualify as a Forward Buy:

• This offer is not likely to be repeated soon.  (If the incentives are always available, use other analysis to decide whether to take advantage of them all the time.)
• The merchant does not pass the special terms on to customers. (If the terms are passed on to customers, this is a Promotion, not a Forward Buy.)
•  For cost increases, the merchant will implement a matching selling price increase concurrently with the cost increase, so that the amount of the price increase is captured as additional margin on goods purchased before the increase goes into effect. (If the merchant does not raise selling prices promptly, it is another form of Promotion.)
• Cash and warehouse space are available to handle extra inventory, and the cost of those will be included in the calculations.
• The wholesaler has the flexibility to decide how much to buy now, and this will not impact future availability.
• See the “Real World Considerations” below for more detail.
  

Here are some types of Forward Buying opportunities:

• Deals and Extra Discounts: When a vendor offers an extra discount for a limited time. If the vendor offers free goods, that can be converted into an equivalent discount. For example, a “baker’s dozen” is one free with twelve. You get 13 units for the price of 12. The equivalent discount is 1/13, or 7.69%. 
• Cost Increases: Placing an order just before a cost increase can be viewed as getting a corresponding discount off the new cost. A 4% price increase gives the opportunity to buy goods for 1.00 that will cost 1.04 just after the increase. 4% is equivalent to .04/1.04 or a 3.85% discount off the new cost.
• Deferred Payment Terms: Some vendors occasionally offer deferred or extended payment terms on single orders. It is tempting, but not accurate, to just view the interest savings as a discount on the order. The value of the terms depends on the merchant’s use of the funds generated by the temporarily deferred payments. If the merchant uses this cash flow to temporarily reduce debt, the savings is based on their borrowing interest rate. If the merchant uses the cash flow to temporarily invest in some other activity, the savings is based on the “alternate investment earning rate”. If the merchant does not use the funds for some other purpose, there are no savings from the deferred payment terms. Be sure to just input the EXTRA days of deferred terms. Net 60 Days instead of the regular NET 30 Days is an EXTRA 30 Days of payment terms. Some vendors occasionally offer installment terms. They might have normal terms of Net 30 Days, and a special offer of NET 30-60-90 Days, meaning that 1/3 of the payment is due in each of the next three months. Note that is equivalent to deferring the entire payment for 30 EXTRA days.
• Combinations of Deals: Sometimes a vendor offers several elements at one time – such as an extra discount combined with extended terms. These combinations can be very valuable Forward Buying opportunities.

• Normal Order Size: This is the average size of a normal replenishment order for this category, in dollars.
• Normal Frequency: This is the normal number of days between replenishment orders. If you order weekly, use seven days, even if your firm is not open seven days per week.
• Days to Next Regular Order: Ideally, the skus in the category are just at their reorder points, and you are just ready to place a normal replenishment order. If the deadline for the Forward Buying order comes before that, enter the number of days until the next regular order. This is used in the analysis to assess a bit of extra carrying cost, as you have to carry inventory for that number of extra days.

• Total Inventory Carrying Cost: This is the annual cost of warehousing and financing inventory, expressed as a percentage of the average inventory investment. Typically, a value of 25% to 50% is used by most merchants. This is used in Forward Buying situations to assess the incremental cost of carrying any extra inventory for the duration of the Forward Buy. Forward Buying affects the size of the “cycle stock” and usually does not affect “safety stock” inventory. For the analysis, the average cycle stock (1/2 the size of the order) is used as the inventory investment.
• Borrowing Interest Rate: This is the merchant’s interest rate for borrowing short term funds. It is used to compute the interest savings in Deferred Payment Terms situations when the merchant will temporarily use the funds to reduce borrowing until the vendor payments become due.
• Alternate Investment Earning Rate: This is the annualized rate of return your company expects to earn on short term investment opportunities.   This will be used to compute the savings in Deferred Payment Terms situations if you indicate the temporary cash from the deferred payments will be invested. 
  • For example, in our auto parts business, our bank arranged to “sweep” our main business checking account each day, and place excess funds over a preset amount into overnight investments. This won’t earn much in earnings in the current market, but your firm might have opportunities to place very short term cash for some earnings.
  • You should make sure you know, and stay up to date, on your firm’s cash position, and borrowing and alternate investment rates. 
• Handling Costs for Normal Order: This is the “per order” cost for the full purchasing/receiving process. It should include the costs per order in purchasing, tracking orders, receiving and stocking shipments, and processing the shipment for inventory accounting and payment.  In many firms it might be on the order of $10-$50 per order. 
• Handling Costs for Large Order: If a merchant can receive a larger than usual order without incremental handing costs, then Forward Buying will result in an overall handling cost reduction.  For example, if a merchant orders a 4-week supply instead of the normal 1-week supply, (and if the forecasts are accurate), the merchant could skip the next three regular orders and save their handling cost. However, in some cases, a merchant may encounter additional handling cost when receiving larger than normal shipments. This might involve having to move merchandise into and out of “surplus” locations, etc. The Large Order Cost will be used as the handling cost for the one Forward Buying order/shipment in the analysis.
• Forecast Standard Deviation: Forecast accuracy generally declines as forecasts are extended over longer time spans into the future. With a perfectly accurate forecast (Standard Deviation = 0%), the Forward Buying Analysis assumes your firm will sell through the extra inventory exactly on time.  The analysis slightly increases the carrying cost for the forward buying quantity when the Forecast Standard Deviation is greater than 0%. Larger Forward Buy orders result in both larger temporary inventory and a longer time span to sell it down, and both increase the carrying cost during the Forward Buy period. This adjustment adds an additional slight increase in the carrying cost as the estimate of forecast Standard Deviation increases.   
  • It is suggested that you use the Standard Deviation for typical skus in the category. The aggregate forecast is likely to be more accurate, just from the law of large numbers, while individual skus are likely to show more demand deviations. The default is set to 0%, but you can set a value from 0-75%.
  • If your forecasting system reports the Mean Absolute Deviation, MAD or MADP, you can estimate the Standard Deviation as approximately 1.25 times the MAD.
  • If you want to base the analysis on the “pure” forecast carrying cost, use 0% for the forecast deviation.
• Savings Weighting Factors for Discounts and Price Increases: If a Forward Buy includes all the skus in the category, and doesn’t disrupt future orders, then your firm should realize all the savings. But, that is not always the case. Here are some examples: 
  • A Forward Buy opportunity only applies to some of the skus you order in one category. You might have to include other skus that don’t get the extra deal or cost increase to make a logical order. Or, if you only order the skus with the incentive, it might distort your ability for normal replenishment orders on the rest of the category. 
  • You might have to pass through part of the deal to your customers. 
  • You might not be able to raise selling prices immediately after your cost increase. 
  • In any of those cases and others like them, set these weighting factors to something less than 100%. This is used to scale down the savings in the Forward Buying Analysis. 

• Pass On Impact: The Forward Buying analysis assumes the merchant will not pass any of the extra discounts or terms on to their customers. If the merchant does pass the savings on to their customers, or delays implementation of a selling price increase when cost increases, these are promotions, not forward buys. 
  • An exception is one Forward Buy order at the end of the promotion where the terms will not be passed on. That can be a valuable Forward Buying situation, as you may know the results of the promotion and have an accurate view of on hand inventory and the forecast.   See the additional notes under Promotions in this writeup.
• Time to Next Deal: Very large discounts or special terms could cause a merchant to consider ordering a lot of additional inventory. The merchant must judge when the next deal might be available, and should not buy more than the quantity needed to get to that time. 
  • In our auto parts business, a good example was the product line of headlamps and automotive light bulbs. If you’ve ever seen a light bulb factory, you know that they must run the glass furnace and the production line 24 hours a day, 365 days a year. They just can’t turn off the furnace for a while – all that molten glass would solidify. The finished goods inventory takes up a huge amount of space. So, light bulb vendors will do almost anything to sell their full production immediately, at just about any price. We never paid the regular cost for an automotive bulb in our 25+ years as an automotive distributor. One vendor or another was always running some special deal, and our regular vendor would usually match it. Even with a big extra discount, we never bought more than about a sixty-day supply, as we knew there would be another deal when we needed it.
• Forecast Accuracy: It is important to have confidence in item forecasts over the full duration of the special order to take full advantage of Forward Buying.   If the category is seasonal and the merchant has accurate seasonal forecasts, the Forward Buying analysis will still work. Use the seasonally adjusted forecast for the approximate span of the planned Forward Buy. If your forecasting system reports forecast deviations, set the Forecast Standard Deviation to the appropriate level. In this analysis, increasing the forecast standard deviation increases the carrying cost, as it increases uncertainty about “selling through” the extra quantity on time. 
• New items:  New items can pose a difficult Forward Buying situation. Vendors often offer special terms as an incentive for merchants to stock new items, but these can be the most unreliable forecasts, so a merchant must be cautious here.
• Product Line Balance: If the Forward Buying opportunity is only on a few items within a full category, it is important to consider what a Forward Buy of these items will do to the overall balance of the inventory and the normal replenishment process.
  • If a merchant places a Forward Buy order on just the key items, they might have to delay the next regular replenishment order. They might not be able to make the vendor’s minimum or prepaid freight for some time. This might cause stock outs and lost sales on the other items in the category.
  • If the merchant buys extra quantities on the other items in the line, too, to avoid stock outs on those items, it means additional carrying costs on the rest of the category, where there are no special deals or terms.
  • In either case, the full Forward Buying incremental profit will not be realized. Set the Weighting Factor to less than 100% to reduce estimated savings in these situations.
•  Handling Costs: The handling cost for a large Forward Buy might be higher than the cost for processing normal replenishment shipments. It may require additional handling cost to store and move the extra goods several times if the quantity ordered will not fit in the regular stock location. You can input a different Handling Cost for Large Orders in the Control Parameter section.

• Space and Funds: The Forward Buying analysis assumes you have space and funds available to handle the temporary additional inventory. The incremental costs are included in the analysis, but don’t go beyond your firm’s ability to successfully handle the larger than usual order.

Your decision about how much to order depends on your firm’s situation as well as the specifics of this one opportunity.

If your firm only has occasional offers, and your goal is to maximize profits, with the default control values you might place an order for as much as $5,500, 11 weeks’ supply, in the example situation. Your firm should realize an incremental profit of about $138 on this one deal, versus not ordering today at all, and after incremental costs are covered. On a $26,000 annual category, that’s more than 0.5% of sales, and it should flow straight through to income as the extra costs are already deducted. 

That doesn’t sound like much, but it can be a lot for many merchants. If your firm currently earns about 5% pretax income on sales, and if you took full advantage of an offer like this just once a year on each category, you would improve your firm’s overall profit by 10% - from 5% to 5.5%. That ought to earn a bonus…

• Note that the incremental profit curve is fairly flat around the optimum, so you might choose a slightly smaller Forward Buy – to achieve most of the incremental income with slightly less risk of forecast errors.  You can also temper this by setting the forecast deviation to greater than 0%, or by setting the weights to something less than 100%.

• If your firm has many Forward Buying opportunities, or has limited funds for Forward Buying, then the best answer would be to purchase a bit extra on each deal, up to whatever investment your firm can handle. The ROI calculation could be a guideline to apportion available investment across many opportunities.

• While it isn’t covered in this example, a third situation could be that your firm has limited cash, some offers for deferred payment terms, and could use the temporary funds to reduce borrowing. In that situation, you could order each Forward Buying situation to the maximum time that still yields a small or break-even Extra Profit. You wouldn’t lose any income on the deals themselves, and you could gain needed cash flow from the deferred terms.

Promotions and Forward Buying:

• “Loader” promotions might just fill the downstream pipeline of your firm’s regular customers, and result in LOWER sales for your firm for some period after the promotion – as your regular customers use up THEIR “Forward Buy” inventory. 
• “Lifter” promotions might capture new customers or more related item sales, and result in overall ongoing sales increases after as well as during the promotion.