What is the Ordering Cost? Definition, Formula, Example, and How Does It Work?

Definition

The ordering costs are a combination of a bunch of costs bundled together. The ordering cost refers to the combination of administrative costs, inspection costs, and the cost of placing an order with the supplier.

Basically, ordering costs are the expenses associated with creating and processing orders to a supplier.

The ordering costs are added to the total costs. Ordering cost is a widely used accounting tool.

Take, for example, a car company that is looking for specific parts. The company places an ad on T.V and in newspapers at the cost of thousands of dollars. Three interested parts companies reply to this ad. One company is selected to supply this part.

Now, the part company has to retool its factory and it would also have to send some factory workers to the retool plant. The administrative cost to the part maker comes at about five hundred dollars and it charges a fixed fifty dollars for the documentation of the part.

So, the total ordering cost for the car company will be the sum of all these costs.

The formula of ordering cost

The formula for calculating ordering costs is very long as it contains many other cost factors. The order cost formula is as follows:

Order cost = tax+ insurance premiums + Staff cost + inspection cost + payment fee + other incurred costs

Where

Tax = Any import of ordering tax.

Insurance premiums = Insurance paid on the product.

Staff cost = The labor costs associated with the handling and transporting of the order.

Inspection cost = Any inspection costs incurred as a result of order transportation.

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Payment fee = These are to be paid if any incurred payment fees are incurred.

Any other incurred costs = any tool taxes, maintenance costs, etc.

How do ordering costs work?

Five main steps determine the ordering cost of a particular product. All five steps are shown in figure 1.

Figure 1: The five main steps that determine the ordering cost

The five main steps involved are finding the right supplier, negotiating the price, preparing a purchase order, inspecting the order, and then making a final payment to the supplier. All of these steps are explained in great deal below:

Finding the right supplier

This is the first and most important step in ordering cost evaluation. You should be looking for a high-quality supplier with a proven track record. This will save you a lot of headaches in the future. A good and reliable supplier who always delivers products on time is a must.

For a new company, the first step is also the most difficult. The purchasing department of the new company has to expend a lot of time and effort in collecting the information.

A new company will not have the right connection. This step can be a trial and error process; as a result, this step can incur great costs for a new company.

Negotiating price

After choosing the right supplier, the company must now negotiate prices for the product. The people negotiating on behalf of the company must possess the necessary knowledge and experience required for such negotiation.

They must know about the market conditions, competitors’ prices, and how much the company is able to afford to pay the supplier.

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The price negotiations with suppliers are multi-year long contact and these negotiations are concluded through a legal agreement.

So, if a company is unable to negotiate a better agreement, it will get stuck paying higher prices for years to come which will drag its operating margin and hurt its profits.

Preparing Purchase order

This is the third step in managing the ordering costs. After finding the right supplier and negotiating the price, a purchase order has to be created.

A purchase order is a document provided to the seller by the buyer that indicates the number of products, and specifications on agreed prices.

The purchase order should be checked carefully. This is the step where a lot of mistakes take place. The person managing the purchasing order must carefully check the document. A single zero added at the end by mistake would increase the size of the order tenfold.

Inspection

The inspection happens in the fourth step. After placing the order, the supplier makes the order and then ships the order. The company then receives the order. The order must be inspected to ensure the product is made according to the specifications.

The inspection is the job of the inspecting inspector. His/ her duties include checking the order for specifications and making sure it meets company standards.

Then, the product is sent to the department in the company that requires it. The department may also do all the checks and inspections.

Payment to supplier

After inspecting the order and ensuring it meets the company’s standards, the supplier is paid. It is a standard practice to pay the supplier with a thirty to the ninety-day gap. So, the suppliers are not paid immediately. This is done to maintain a positive cash flow for the company.

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But, the suppliers give discounts on products or future products if they are paid immediately. It depends upon the company and whether it wants a higher positive cash flow or low-cost products.

Many companies want a higher positive cash flow in case any issues to occur so that they can manage that issues.

4. Managing order cost

A business must choose the optimal options at every step of the way. It does not necessarily mean choosing the cheapest option or supplier, but the right option or supplier.

As the cheapest option may end up causing a lot more than the right option due to the hidden costs associated with the cheapest option.

5. Conclusion

A company can reduce its operating costs exponentially by focusing on better management of order costs. Order cost is not a fixed cost, but a flexible cost. So, it can be reduced through better management.