- Forecast error has a specific cost to procurement.
- Why quantifying procurement costs from lower forecast accuracy is essential.
The background as to the overall topic of lower forecast accuracy cost estimation is explained in this article. This article contains the calculator for one of the expenses associated with lower forecast accuracy, which is the cost of reduced premium procurement.
See our references for this article and related articles at this link.
Why Quantifying Premium Procurement Costs from Lower Forecast Accuracy is Important
Companies that provide last-minute requests often pay a price premium. The higher the forecast error, the more of this premium charge will be applied. Therefore, just as there is not a single price for an item by volume (volume discounts are of course quite common), there is often not a single price based on the lead time provided by the customer from the supplier.
Interestingly, there is very little written on the increased procurements costs, which are directly traceable to forecast accuracy/forecast error. On the other hand, the price reduction, which can be obtained from volume discounts, is quite frequently covered in books on procurement. Suppliers most often publish these volume prices. Short lead-time orders, on the other hand, are not published, and in textbooks which often tend to assume that companies don’t have problems forecasting or performing supply planning. Therefore, the procurement premium paid by businesses tends to be greatly under-emphasized.
Regarding the exact mechanism for procurement premium — the premium comes from two directions. The first is that the costs are higher for suppliers when they receive short lead-time orders. They may have to adjust their production schedule if the order is too large for their safety stock. The second direction is negotiating leverage. If one thinks about negotiation, if products are required as soon as possible, it is tough to negotiate on price — it is also harder to check with multiple vendors to obtain the best price. In some cases, this second dimension is less of an issue because the supplier is a single source. Overall, short lead-time procurement removes all of the flexibility from the procurement department that they ordinarily have under normal procurement circumstances.
Separating the Reasons for Procurement Cost Variability
Unfortunately (for the ease of obtaining data) there are other reasons for acquisition price changes aside from last-minute requests. Another primary reason for price variability – volume discounts — is just one of the other possible causes. Naturally, short lead-time orders must be differentiated from orders that are unable to qualify for volume discounts. The trick is in distinguishing these reasons for price increases — which again will only in rare circumstances be coded with some reason code. Without specific data, it can make sense to go off of estimates by people that work in the business as to the percentage that should be allocated to forecast error for upward purchasing variances.
Note: The fields below start off with default values. All but the final field — which is the output field, can be changed. The output field continually updates based upon the input fields – and there is no button to hit to get the output field to update.