Material And Store Management.pdf

Material and Store Management

This book is a part of the course by MITSDE, Pune. This book contains the course content for Material and Store Management.

MITSDE, Pune First Edition 2011 The content in the book is copyright of MITSDE. All rights reserved. No part of the content may in any form or by any electronic, mechanical, photocopying, recording, or any other means be reproduced, stored in a retrieval system or be broadcast or transmitted without the prior permission of the publisher. MITSDE makes reasonable endeavours to ensure content is current and accurate. MITSDE reserves the right to alter the content whenever the need arises, and to vary it at any time without prior notice.

Index Content................................................................................................................................................................... II List of Figures........................................................................................................................................................ V List of Tables.........................................................................................................................................................VI Abbreviations.......................................................................................................................................................VII Applications.......................................................................................................................................................... 80 Bibliography......................................................................................................................................................... 83 Self Assessment Answers...................................................................................................................................... 85 Book at a Glance

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Contents Chapter I........................................................................................................................................................ 1 Material Management.................................................................................................................................. 1 Aim................................................................................................................................................................. 1 Objectives....................................................................................................................................................... 1 Learning outcome........................................................................................................................................... 1 1.1 Introduction to Material Management...................................................................................................... 2 1.2 Classification of Inventory........................................................................................................................ 2 1.3 Meaning of Material Management............................................................................................................ 3 1.4 Objectives of Materials Management....................................................................................................... 3 1.5 Motives of Materials Management........................................................................................................... 4 1.6 Scope of Material Management................................................................................................................ 5 1.7 Material Planning...................................................................................................................................... 5 1.8 Technique of Planning Materials.............................................................................................................. 5 1.9 Process of Codification............................................................................................................................. 6 1.10 Standardisation........................................................................................................................................ 7 1.11 Scheduling . ............................................................................................................................................ 7 1.12 Procurement ........................................................................................................................................... 8 1.13 Purchasing . ............................................................................................................................................ 8 1.14 Inspection . ............................................................................................................................................. 9 1.15 Quality Control ...................................................................................................................................... 9 1.16 Packaging . ............................................................................................................................................. 9 1.17 Storage.................................................................................................................................................... 9 1.18 Inventory Control . ................................................................................................................................. 9 1.19 Distribution ............................................................................................................................................ 9 1.20 Disposal ............................................................................................................................................... 10 1.21 Functions of Material Manager............................................................................................................. 10 1.22 Effects of Over Stocking and Under Stocking . ................................................................................... 10 Summary.......................................................................................................................................................11 References.....................................................................................................................................................11 Recommended Reading...............................................................................................................................11 Self Assessment............................................................................................................................................ 12 Chapter II.................................................................................................................................................... 14 Material Cost Management....................................................................................................................... 14 Aim............................................................................................................................................................... 14 Objectives..................................................................................................................................................... 14 Learning outcome......................................................................................................................................... 14 2.1 Introduction to Material Cost Management............................................................................................ 15 2.2 Material Cost........................................................................................................................................... 15 2.3 Economic Order Quantity (EOQ) Models.............................................................................................. 17 2.4 Determination of various Inventory Levels ........................................................................................... 20 2.4.1 Maximum Level . ................................................................................................................... 20 2.4.2 Minimum Level...................................................................................................................... 20 2.4.3 Re-order Level........................................................................................................................ 20 2.4.4 Danger Level........................................................................................................................... 20 2.4.5 Calculation of Various Levels . .............................................................................................. 20 2.5 ABC Analysis . ....................................................................................................................................... 23 2.6 XYZ Analysis ........................................................................................................................................ 25 Summary...................................................................................................................................................... 27 References.................................................................................................................................................... 27 Recommended Reading.............................................................................................................................. 27 Self Assessment............................................................................................................................................ 28

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Chapter III................................................................................................................................................... 30 Inventory Models........................................................................................................................................ 30 Aim............................................................................................................................................................... 30 Objectives..................................................................................................................................................... 30 Learning outcome......................................................................................................................................... 30 3.1 Introduction to Inventory Models........................................................................................................... 31 3.2 Models for Accepting/Rejecting Discounts on Purchases...................................................................... 31 3.3 Fixed Order vs. Fixed Interval System................................................................................................... 35 3.3.1 Cyclical Ordering or Fixed Period System (Time Based) ..................................................... 35 3.4 Material Requirement Planning (MRP) ................................................................................................. 38 3.4.1 Applicability of the MRP System........................................................................................... 39 3.4.2 Inputs for MRP ...................................................................................................................... 39 3.4.3 MRP Process........................................................................................................................... 39 3.4.4 Outputs of MRP ..................................................................................................................... 39 3.4.5 Benefits of MRP .................................................................................................................... 40 3.5 Inventory Turnover ................................................................................................................................ 40 3.5.1 Interpretation of Inventory Turnover...................................................................................... 41 Summary...................................................................................................................................................... 42 References.................................................................................................................................................... 42 Recommended Reading.............................................................................................................................. 42 Self Assessment............................................................................................................................................ 43 Chapter IV................................................................................................................................................... 45 Purchase Management............................................................................................................................... 45 Aim............................................................................................................................................................... 45 Objectives..................................................................................................................................................... 45 Learning outcome......................................................................................................................................... 45 4.1 Introduction to Purchase Management................................................................................................... 46 4.1.1 Objectives of Material Management....................................................................................... 46 4.2 Functions of Purchase Department......................................................................................................... 46 4.2.1 Purchasing Function vs. Purchase Department ..................................................................... 47 4.2.2 Procurement vs. Purchasing . ................................................................................................. 48 4.2.3 Objectives of Purchasing........................................................................................................ 48 4.3 Purchase Requisition............................................................................................................................... 48 4.3.1 Types of Purchase Requisitions.............................................................................................. 48 4.4 Purchase Procedure . .............................................................................................................................. 49 4.5 Types of Purchasing ............................................................................................................................... 49 4.5.1 Forward Buying ..................................................................................................................... 49 4.5.2 Tender Buying......................................................................................................................... 50 4.5.3 Systems Contract ................................................................................................................... 51 4.5.4 Speculative Buying ................................................................................................................ 52 4.5.5 Rate Contracts . ...................................................................................................................... 52 4.5.6 Reciprocity in Buying . .......................................................................................................... 52 4.5.7 Zero Stock Buying ................................................................................................................. 53 4.5.8 Blanket Orders ....................................................................................................................... 53 4.6 Vendor Management .............................................................................................................................. 53 4.7 Inspection of Materials........................................................................................................................... 54 4.7.1 Pre Dispatch Inspection.......................................................................................................... 55 4.7.2 Stage Inspection / Final Inspection......................................................................................... 55 4.7.3 Document Inspection.............................................................................................................. 55 4.7.4 Stores/Receipt Inspection....................................................................................................... 55 4.7.5 Third Party Inspection............................................................................................................ 56 Summary...................................................................................................................................................... 58 References.................................................................................................................................................... 58 Recommended Reading.............................................................................................................................. 59 III/MITSDE

Self Assessment............................................................................................................................................ 60 Chapter V..................................................................................................................................................... 62 Stores Management.................................................................................................................................... 62 Aim............................................................................................................................................................... 62 Objectives..................................................................................................................................................... 62 Learning outcome......................................................................................................................................... 62 5.1 Introduction to Stores Management........................................................................................................ 63 5.1.1 Motive to Hold Inventory....................................................................................................... 63 5.2 Functions of Stores Department ............................................................................................................ 63 5.2.1 Receipt of Material................................................................................................................. 63 5.2.2 Issue of Material..................................................................................................................... 64 5.2.3 Return of Material................................................................................................................... 65 5.2.4 Transfer of Materials............................................................................................................... 66 5.2.5 Proper Storage Function ........................................................................................................ 66 5.3 Valuation of Material ............................................................................................................................. 68 5.4 Valuation of Receipts.............................................................................................................................. 68 5.5 Valuation of Issues.................................................................................................................................. 69 5.5.1 First In First Out (FIFO) Method . ......................................................................................... 70 5.5.2 Last In First out (LIFO) Method . .......................................................................................... 71 5.5.3 Highest In First Out (HIFO) Method...................................................................................... 71 5.5.4 Average Rate Method ............................................................................................................ 72 5.5.4.1 Simple Average (SAR) Method .............................................................................. 73 5.5.4.2 Weighted Average Rate (WAR) Method.................................................................. 73 5.5.5 Market Rate............................................................................................................................. 74 5.6 Valuation of Returns .............................................................................................................................. 75 Summary...................................................................................................................................................... 77 References.................................................................................................................................................... 77 Recommended Reading.............................................................................................................................. 77 Self Assessment............................................................................................................................................ 78

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List of Figures Fig. 1.1 Inventory classification...................................................................................................................... 2 Fig. 2.1 Process from procurement to realization of money......................................................................... 17

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List of Tables Table 1.1 List of classification of inventories................................................................................................. 7 Table 3.1 Model developed for accepting/rejecting discounts on purchases in excel spread sheet.............. 32 Table 4.1 Purchasing function vs. purchase department............................................................................... 47 Table 4.2 Matrix of price and quality of the tenders..................................................................................... 50

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Abbreviations BOM DGS & D DIL EDI EOQ ERP FIFO GC GRN GRR HIFO IR IRF IT LIFO LTE Mfg. TC MPS MRO MRP MTC PO PO QA ROI ROL SAR STE VDC WAR

- - - - - - - - - - - - - - - - - - - - - - - - - - - - - -

Bill of Materials Directorate General of Supply & Disposal Desired Inventory Level Electronic Data Interchange Economic Order Quantities Enterprise Resource Planning First In First Out Guarantee Certificate Goods Returned Note Goods Received Report Highest In First Out Inspection Request Inventory Record File Information Technology Last In First Out Limited Tender Enquiry Manufacturing Certificate Master Production Schedule Maintenance, Repair and Operating Inventories Materials Requirement Planning Material Test Certificate Purchase Order Purchase Order Quality Assurance Return on Investment Re-Order Level Simple Average Rate Single Tender Enquiry Vendor Development Cell Weighted Average Rate

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Chapter I Material Management Aim The aim of this chapter is to: •

introduce the students to material management

•

explain the scope of material management

•

elucidate the various motives of inventory

Objectives The objectives of this chapter are to: •

discuss the classification of inventory

•

recognise the key objectives of material management

•

enlist the functions of material manager

Learning outcome At the end of this chapter, students will be able to: •

understand the materials requirement planning technique (MRP)

•

know about the process of purchasing

•

know the effects of overstocking and under stocking

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Material and Store Management

1.1 Introduction to Material Management Every organization depends on materials and services from other organizations to varying extents. These materials and services are obtained through exchange of money. Various materials are used as inputs such as raw materials, consumables & spares. These are required to be purchased and made available to the shops/users as and when needed to ensure uninterrupted production. Efficient management of input materials is of paramount importance in a business organization for maximizing materials productivity, which ultimately adds to the profitability of the organization. Material cost is probably the most important element of cost. In the case of certain industries like cement, sugar, chemicals, iron and steel etc., the materials cost forms a very significant portion of the overall cost of production.

1.2 Classification of Inventory The term material refers to all commodities which are consumed in the production process. The materials which can be consumed in the production process can be basically classified as; •

Direct Materials

•

Indirect Materials

Material is generally called raw material. Inventory is a name collectively given to raw material; work in process and finished goods. Even though Material and Inventory are used as synonyms, material usually means raw material and inventory means raw material along with work in process plus finished goods.

Fig. 1.1 Inventory classification Raw Material is first subjected to a manufacturing process before it becomes finished goods. Raw material is also present with work in process and finished goods. It is a continuous process. Inventory classification Inventory includes idle resources that have future economic value. It indicates that it may be available in different forms depending upon the production cycle stage it is in. Classification of inventory is done on this basis and thus, the different classifications of inventory are as follows: •

Raw materials: Raw materials are input goods intended for combination and/or conversion through the manufacturing process into semi-finished or finished goods. They change their form and become part of the finished product.

•

Components and parts: Just as raw materials are converted to finished goods in a manufacturing operation, components and parts are assembled into finished goods in an assembly operation.

•

Maintenance, repair and operating inventories (MRO): These include parts, supplies and materials used in or consumed by routine maintenance and repair of operating equipment, or in support of operations.

•

Work-in-process goods: These include goods in the process of manufacturing and only partially completed. They are usually measured for accounting purposes in between significant conversion phases. In-process inventories provide the flexibility necessary to deal with variations in demand between different phases of manufacturing.

•

Finished goods: These represent the completed conversion of raw materials into the final product. They are goods ready for sale and shipment.

•

Resale goods: These are goods acquired for resale. Such goods may be purchased by a wholesaler for resale to

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distributors, or by distributors for resale to consumers, etc. •

Capital goods: These are items (such as, equipment) that are not used or consumed during a single operating period, but have extended useful lives and must be utilized over multiple operating periods. Tax laws require that such an item be capitalized, and a predetermined percentage of its cost be recognized as an expense, each operating period, over a predetermined time frame, according to equipment classes.

•

Construction materials: These are raw materials and components for construction projects such as a building, bridge, etc.

•

Hard goods/soft goods: What one identifies as hard goods and soft goods will vary depending on the industry involved. For example, in data processing, hard goods include apparatus such as, computers and terminals, while soft goods include software, data storage media and the like.

•

Fuel and lubricants: Fuel and lubricants are used for the oiling purpose for the equipment used in the process which again varies with the type of industry.

•

Stationery goods: It includes writing material like, paper, pen, ink etc., which are used by the people involved in the process.

•

Primary packing material: Packing material like, plastic, paper etc. are used to pack the finished goods for sale.

1.3 Meaning of Material Management Materials management can be defined as "an integrated management approach to planning, acquiring, processing and distributing production materials from the raw material state to the finished product state." Materials management is a key business function that is responsible for the coordination of planning, sourcing, purchasing, moving, storing and controlling materials in an optimum manner, so as to provide pre-determined service to the customer at a minimum cost. Materials management has such sub-fields as: •

inventory management

•

value analysis

•

receiving

•

stores and management of the obsolete

•

slow moving and non moving materials

Materials management is the branch of logistics that deals with tangible components of a supply chain. It covers the acquisition of spare parts and replacements, quality control of purchasing and ordering such parts, and the standards involved in ordering, shipping, and warehousing the said parts. The physical arrangement of materials/spare parts is called materials management. Planning and control of the functions supporting the complete cycle (flow) of materials, and the associated flow of information is called materials management. Materials management is concerned with the control of materials in such a manner which ensures maximum return on working capital. Materials management is concerned with the location and purchase of materials needed, their storage and movement. It also arranges to keep an account of them. It is also responsible for planning their movement through manufacturing processes, store rooms and distribution channels. Materials management provides an integrated systems approach to the coordination of the materials activities and the control of total material costs. The materials management function ranges from receiving the material requisitions from user department to placement of purchase orders and then, on the other hand, receiving the materials from vendors and making it available to the users departments.

1.4 Objectives of Materials Management The fundamental objectives of the materials management function are acquisition of materials and services: 3/MITSDE

Material and Store Management

•

of the right quality

•

in the right quantity

•

at the right time

•

from the right source

•

at the right time

The key objectives of material management are as follows: •

Buying at the lowest price, consistent with the desired quality and service

•

Maintaining a high inventory turnover, by reducing excess storage, carrying costs and inventory losses occurring due to deteriorations, obsolescence and pilferage

•

Maintaining continuity of supply, preventing interruption of the flow of materials and services to users

•

Maintaining the specified material quality level and a consistency of quality. This permits efficient and effective operation

•

Developing reliable alternate sources of supply to promote a competitive atmosphere in performance and pricing

•

Minimizing the overall cost of acquisition by improving the efficiency of operations and procedures

•

Hiring, developing, motivating and training personnel and providing a reservoir of talent

•

Developing and maintaining good supplier relationships in order to create a supplier attitude and desire furnish the organisation with new ideas, products, and better prices and service

•

Achieving a high degree of cooperation and coordination with user departments

•

Maintaining good records and controls that provides an audit trail and ensures efficiency and honesty

•

Participating in 'Make or Buy' decisions

1.5 Motives of Materials Management A company may hold the inventory with the various motives as stated below: Transaction Motive The company may be required to hold the inventories in order to facilitate the smooth and uninterrupted production and sales operations. It may not be possible for the company to procure raw material whenever necessary. There may be a time lag between the demand for the material and its supply. Hence, it is needed to hold the raw material inventory. Similarly, it may not be possible to produce the goods immediately after they are demanded by the customers. Hence, it is needed to hold the finished goods inventory. The need to hold work in progress may arise due to production cycle. Precautionary Motive In addition to the requirement to hold the inventories for routine transactions, the company may like to hold them to guard against the risk of unpredictable changes in demand and supply forces. For example, the supply of raw material may get delayed due to the factors like strike, transport, disruption, short supply, lengthy processes involved in import of the raw materials etc. Hence the company should maintain sufficient level of inventories to take care of such situations. Similarly, the demand for finished goods may suddenly increase (especially in case of seasonal types of products) and if the company is unable to supply them, it may indicate gain for the competitions. Hence, the company will like to maintain sufficient stock of finished goods. Speculative Motive The company may like to purchase and stock the inventory in the quantity which is more than needed for production and sales purpose. This may be with the intention to get the advantages in terms of quantity discounts connected with bulk purchasing or anticipated price rise. 4/MITSDE

1.6 Scope of Material Management The scope of material management includes the following aspects: •

Material planning

•

Cataloguing or coding the materials

•

Standardisation

•

Scheduling

•

Procurement

•

Inspection

•

Quality control

•

Packaging

•

Storage

•

Inventory control

•

Distribution

•

Disposal

1.7 Material Planning Material management involves the process of planning to get the materials. It is the starting point for the whole material management function. Material planning is a scientific way of determining the requirements starting with raw materials, consumables, spare parts and all other materials that are required to meet the given production plan for a certain period. Material planning is derived from overall organisational planning and hence, it is always a subplan of the broad organisational plan. What it does is forecast and initiate the procurement of materials. Factors affecting Material planning The factors affecting Material planning are: •

Macro factors: Global factors such as price trends, business cycles, government’s import and export policies etc are called macro factors. Credit policy of the government is a critical factor as banks follow these guidelines only while extending financial support to a business entity.

•

Micro factors: These are essentially the factors existing within the organisation such as corporate policy on inventory holding, production plan, investments etc. For any organisation, factors such as lead time of procurement, acceptable inventory levels, working capital, seasonality, delegation of power are micro factors

1.8 Technique of Planning Materials Materials Requirement Planning (MRP) Materials requirement planning considers the annual production plan of the manufacturing concern. Once a firm determines its annual production plan, the over all material requirement to meet the given production plan is worked out. It is a detailed analysis encompassing the materials and quantities available for use, materials with quantities not available and hence, needing procurement, the actual lead time of procurement etc. It is always possible to have a situation where some parts of an assembly are available and some others are not available. The Bill of Materials (BOM) is prepared. It quantifies all the materials (components) needed for various assemblies as per the production plan. BOM is thus a list displaying the code, nomenclature of an item, its unit and quantity, location of use and also the estimated price of each component. An explosion chart is a series of bills of materials grouped together in a matrix form so that combining the requirements for different components can be made. Once the BOM is ready, the same is handed over to the Purchasing wing which initiates the purchasing activities. MRP, thus, keeps in view the lead time also. Using computers, preparation of BOM through explosion of lists is quite easy and smooth. Materials required for any operation are based on the sales forecasts and production plans. Planning and control is done for the materials taking into account the materials not available for the operation and those in hand or in the 5/MITSDE

Material and Store Management

pipe line. This involves estimating the individual requirements of parts, preparing materials budget, forecasting the levels of inventories, scheduling the orders and monitoring the performance, in relation to production and sales. Cataloguing or coding the materials For easy procurement, storage, retrieval and the distribution of the inventories, it is essential to classify them into different categories. This classification can be done through codification or cataloguing. Codification or cataloguing is basically an identification system for each item of the inventory. There are three broad approaches to developing a suitable identification system. These are: •

Arbitrary approach

•

Symbolic approach

•

Use of drawing numbers

Arbitrary approach As and when an item is received by stores in its receiving bay, a running and unique serial number is assigned to it. This number becomes the code of the item for subsequent use at different stages. It does not help in the scientific management of inventory. Arbitrary approach is useful only where perhaps items are non-repetitive and the inventory management need not be scientific. Symbolic approach It assigns code in such a manner that the same item number is not allotted to two different materials. The code is designed such that it can be used to tell many things about an item of material. The system uses either a numeric codification system or an alphanumeric system. Under the numeric system, a set of numeric code (length pre-decided) is assigned to each item where different parts of the code describe different aspects of an item: class, subclass, unique running number of that item, location of the storage suppliers’ code etc. Example: 2

145

098

344

Class

Subclass

Running number

Location code

Thus, the code of this item shall be a 10 digit code, 2145098344 and it shall always remain so for this item. It shall then be easy to communicate about this item among the concerned agencies. Similarly, there can be a code using alpha numeric value like AA223B234 with different alpha and numerical value describing some pre-decided meaning. It is also called mnemonic system. Since this code has certain logic, it is also called intelligent code and this system is widely used everywhere. Use of drawing numbers Many firms use drawing numbers as codes to identify an item. Since the drawing number for a firm remains unique, assigning a code on this basis assumes a unique code for that item and hence, confirms the requirement of a unique identification for the item.

1.9 Process of Codification •

Decide if the firm wants to go for arbitrary system, symbolic system or engineering drawing system

•

List the inventory items

•

Define the class of items

•

Define the sub class under each class

•

Depending upon the number of classes, their subclasses and probable number of items under each sub class decide the length of codes which shall remain fixed for all the inventory items (10 digit, alphanumeric etc.)

•

Start assigning codes as per the detailed list of inventory

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An illustrative list of classification of inventories: Abrasives Bolts, nuts & washers Cans & containers Electrical Oil & lubricants Rolls Safety items

Bearings Brooms & brushes Chemicals & reagents Gases Pipe & pipe fittings Refractory Tools & tackles

Belt and beltings Building materials Cloth, leather & rubber Glassware Raw materials Stationery Photographic items

Table 1.1 List of classification of inventories Codification is usually done by a team consisting of representatives drawn from stores, user department and industrial engineering department. The major responsibility lies with the stores department. Codification identifies an item. Also it acts as a communicating medium for an item among the different users of that item in whatever way such as stores, user department, planning department, finance, purchasing etc. As soon as the item is received in the stores (if the item is a new one), it is codified. Once codified, the same code is used in the cycle of procurement, throughout and for ever.

1.10 Standardisation Standardisation means “formulation, publication and implementation of guidelines, rules and specifications for common and repeated use, aimed at achieving optimum degree of order or uniformity in a given context, discipline, or field”. Publication means communication of a message, statement, or text through any means such as audio, video, print, electronically as an e-book or on the web. Specification means exact statement of the particular needs to be satisfied or essential characteristics that a customer requires in goods, material, method, process, service, system, or work and which a vendor must deliver. Specifications are written usually in a manner that enables both parties (and/or an independent certifier) to measure the degree of conformity Specifications are divided generally into two main categories: •

Performance specifications: conform to known customer requirements such as keeping a room’s temperature within a specified range.

•

Technical specifications: express the level of performance of the individual units, and are subdivided into the following: ‚‚ Individual unit specifications which state boundaries (parameters) of the unit’s performance consisting of a nominal (desired or mandated) value and tolerance (allowable departure from the nominal value) ‚‚ Acceptable quality level which states limits that are to be satisfied by most of the units, but a certain percentage of the units is allowed to exceed those limits, and ‚‚ Distribution specifications which define an acceptable statistical distribution (in terms of mean deviation and standard deviation) for each unit, and are used by a producer to monitor its production processes

1.11 Scheduling Scheduling means “assigning an appropriate number of workers to the jobs during each day of work and determining when an activity should start or end”. Schedule depends on the following: •

duration

•

predecessor activity (or activities)

•

predecessor relationships

•

resource availability 7/MITSDE

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•

target completion date of the project

1.12 Procurement Procurement means acquisition. It includes the complete process of obtaining goods and services from preparation and processing of a requisition to receipt and approval of the invoice for payment. It is also called sourcing. Procurement involves the following activities: •

purchase planning

•

standards determination

•

specifications development

•

supplier research and selection

•

value analysis

•

financing

•

price negotiation

•

making the purchase

•

supply contract administration

•

inventory control and stores, and

•

disposals and other related functions

1.13 Purchasing Basically, the job of a materials manager is to provide to the user departments, right material at the right time in right quantity of right quality at right price, from the right source. To meet these objectives, the activities undertaken include selection of sources of supply, finalisation of the terms of purchase, placement of purchase orders, follow up, maintenance of relations with vendors, approval of payments to vendors, evaluating, rating and developing vendors. Before deciding the quantity to be purchased, the following factors should be taken into consideration: •

Quantity already ordered

•

Quantity reserved - It may happen that a particular quantity, though in hand, might have been reserved for a particular job which is not available for other purposes. In such cases, this quantity is such, as if it is not in stock

•

Funds availability - Amounts which are kept aside for drawing up purchase budget should be considered

Normally, the process of purchasing the materials involves the following stages: •

Requisitioning: At this stage, the purchasing officer should receive an accurate description of the goods or service required. The requisition form by which a member of staff notifies purchasing officer of a need for goods or services should be simple, but clear. The more accurate and detailed the requisition form is, the more are the chances that the purchase will meet the expectations.

•

Financial approval: Here, the purchasing officer must be given the approval from a responsible person. It should be done before the purchasing commitment is made, and the purchasing system should ensure that this is done at the right time and by the right person.

•

Market assessment: The purchasing officer receives an approved requisition and starts market research in this stage. He should check that the item is not already in stock, that there is a competitive market for the item, if there is a list of “approved suppliers” for the item, if a lower price can be negotiated, and so on.

•

Purchase decision: During purchase decision stage, after the purchasing officer completed the market assessment and determined the method of purchase, he decides on the supplier or suppliers. To avoid internal customer complaints or audit reproof, the decision must be well documented to provide clear reasons as to why a particular supplier has been chosen.

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•

Ordering: At the ordering stage, the main instrument purchasing officer works with is an order form. The order form is an official, numbered document which details the purchase requirements and authorizes the supplier to deliver the goods or services to the company. Also, it can fulfil other important functions.

•

Delivery: At the delivery stage, the purchasing officer controls the method, terms and time of delivery established while ordering. In case there is a competitive transport market, wise freighting decisions can lead to considerable cost savings.

•

Receipting and accounting: At this stage, the purchasing officer should check whether the quality and quantity of delivered goods or services are relevant to ones in the purchase order. Usually, suppliers are not paid until the goods are checked; however, this procedure should be taken up without unnecessary delays to ensure that payment terms are met.

•

Payment: At the payment stage, the purchasing officer makes sure that the payments are made on the dates they are due, because maintaining good supplier relations is very important. Also, he should control the terms of payment in case, they include previously negotiated discounts, progress payments or postponement of payment during warranty period.

1.14 Inspection Inspection involves critical appraisal involving examination, measurement, testing, gauging, and comparison of materials or items. An inspection determines if the material or item is in proper quantity and condition, and if it conforms to the applicable or specified requirements.

Inspection is generally divided into three categories: •

Receiving inspection,

•

In-process inspection, and

•

Final inspection.

1.15 Quality Control A subset of the quality assurance (QA) process, it comprises of activities employed in detection and measurement of the variability in the characteristics of output attributable to the production system, and includes corrective responses. In quality control, the role of inspection is to verify and validate the variance data.

1.16 Packaging Packaging includes processes (such as cleaning, drying, and preserving) and materials (such as glass, metal, paper or paperboard, plastic) employed to contain, handle, protect, and/or transport an article. The role of packaging is expanding and may include functions such as to attract attention, assist in promotion, provide machine identification (barcodes, etc.), impart essential or additional information, and help in utilization.

1.17 Storage Storage means non-transitory, semi-permanent containment, holding or placement of goods or materials, usually with the intention of retrieving them at a later time. It does not include the interim accumulation of a limited amount during processing, maintenance, or repair.

1.18 Inventory Control Inventory control covers aspects such as setting inventory levels, doing various analyses such as ABC, XYZ etc, fixing economic order quantities (EOQ), setting safety stock levels, lead time analysis and reporting.

1.19 Distribution Distribution means movement of goods and services from the source through the distribution channel, right up to the final customer, consumer, or user.

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1.20 Disposal Disposal means final placement or riddance of wastes, excess, scrap, etc., under proper process and authority with (unlike in storage) no intention to retrieve. Disposal may be accomplished by abandonment, destruction, internment, incineration, donation, sale, etc.

1.21 Functions of Material Manager The functions of a material manager are as under: •

materials planning and control

•

purchasing

•

management of stores

•

inventory control

•

use of information technology for efficient material management

1.22 Effects of Over Stocking and Under Stocking The objective of material is to maintain optimum stock. The principle which should be kept in mind is that there should not be any over stocking or under stocking of materials, as both these situations involve costs. Overstocking will result into the following consequences: •

blocking of working capital, resulting in escalating cost of capital investment

•

risk of deterioration of quality and obsolescence resulting in the material being unfit for use

•

more storage facilities, resulting in higher rental cost

•

additional insurance cost

•

more material handling and up-keeping

•

risk of breakage/pilferage etc.

•

price of raw material may go down in future

•

in a nut-shell, carrying cost goes up

•

however, ordering cost goes down

Understocking will result into the following consequences: •

production hold-ups, resulting into disturbed delivery schedules

•

frantic eleventh hour purchases which may result in unfavourable prices and quality

•

payment for idle time to workers

•

increase in the number of orders which will result in more transportation cost

•

in nut shell ordering cost goes up

•

however carrying cost goes down

Overstocking or understocking of materials results in losses, hence a manufacturer should go for optimum stock.

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Summary •

The term material refers to all commodities which are consumed in the production process. The materials which can be consumed in the production process can be basically classified as direct materials and indirect materials.

•

Material is generally called as raw material. Inventory is a name collectively given to raw material; work in process and finished goods.

•

Inventory includes idle resources that have future economic value. It indicates that it may be available in different forms depending upon the production cycle stage it is in.

•

Materials management can be defined as “an integrated management approach to planning, acquiring, processing and distributing production materials from the raw material state to the finished product state”.

•

The fundamental objectives of the materials management function are - acquisition of materials and services: of the right quality, in the right quantity, at the right time, from the right source, and at the right time.

•

A company may hold the inventory with the various motives such as: transaction motive, precautionary motive, and speculative motive.

•

Material planning is a scientific way of determining the requirements starting with raw materials, consumables, spare parts and all other materials that are required to meet the given production plan for a certain period.

•

Materials requirement planning (MRP) considers the annual production plan of the manufacturing concern.

•

Codification or cataloguing is basically an identification system for each item of the inventory. There are three broad approaches to developing a suitable identification system: arbitrary, symbolic, and use of drawing numbers approach.

•

Standardisation means the formulation, publication, and implementation of guidelines, rules, and specifications for common and repeated use, aimed at achieving optimum degree of order or uniformity in a given context, discipline, or field.

•

Scheduling means assigning an appropriate number of workers to the jobs during each day of work and determining when an activity should start or end.

References •

Purchasing Process Structure [Online] (Updated on 16th March 2011) Available at [Accessed on 8th April, 2011]

•

Materials Management [Online] (Updated on 16th March, 2011) Available at [Last accessed on 16th March 2011]

•

Inventory Management [Online] (Updated on 16th March, 2011). Available at [Last accessed on 16th March 2011]

Recommended Reading •

Muller, M., 2003. Essentials of Inventory Management. AMACOM

•

Piasecki, David J., 2009. Inventory Management Explained: A focus on Forecasting, Lot Sizing, Safety Stock, and Ordering Systems. 1st ed., Ops publishing.

•

Piasecki, Edward A., 1998. Inventory Management and Production Planning and Scheduling. 3rd ed., Wiley.

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Material and Store Management

Self Assessment 1. Which of the following is defined as “assigning an appropriate number of workers to the jobs during each day of work and determining when an activity should start or end”? a. Procurement b. Scheduling c. Planning d. Disposal 2. ________________provides an integrated systems approach to the coordination of the materials activities and the control of total material costs. a. Material management b. Planning and control c. Cost management d. Scheduling 3. Inventory is a name collectively given to raw material; work in process and __________. a. services b. equipments c. resources d. finished goods 4. Which of the following statement is false? a. Over stocking or under stocking of materials results in losses, hence a manufacturer should go for optimum stock. b. Specifications are written usually in a manner that enables both parties (and/ or an independent certifier) to measure the degree of conformity. c. Codification is usually done by a team consisting of representatives drawn from stores, user department and industrial engineering department d. The code is designed such that it can be used to tell one thing about an item of material. 5. In quality control, the role of inspection is to verify and validate the ________data. a. system b. optimum c. variance d. material 6. ________ is first subjected to a manufacturing process before it becomes finished goods. a. Procurement b. Planning c. Raw material d. Purchasing

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7. What do the idle resources have in an inventory? a. Future economic value b. Future purchasing value c. Future profit value d. Future manufacturing value 8. The materials which can be consumed in the production process can be basically classified as: a. raw material and finished material b. direct material and indirect material c. minimum material and maximum material d. spare material and optimum material 9. Which of the following statements is true? a. In-process inventories provide the flexibility necessary to deal with variations in demand between different phases of manufacturing. b. What one identifies as hard goods and soft goods will remain same with every industry. c. Materials management is the branch of statistics that deals with the tangible components of a supply chain. d. Material management is not concerned with the location and purchase of materials needed, their storage and movement.



10. There are three broad approaches to developing a suitable identification system: a. arbitrary, symbolic and use of drawing numbers approach b. arbitrary, random and use of drawing numbers approach c. arbitrary, supply and use of drawing numbers approach d. arbitrary, symbolic and use of prime numbers approach

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Chapter II Material Cost Management Aim The aim of this chapter is to: •

introduce the concept of economic order quantity

•

explain the material cost management

•

elucidate the various inventory levels

Objectives The objectives of this chapter are to: •

discuss material cost

•

recognise the drawbacks of economic order quantity model (EOQ)

•

understand the ABC analysis

Learning outcome At the end of this chapter, students will be able to: •

assimilate the XYZ analysis

•

learm about AX control

•

identify the advantages of ABC analysis

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2.1 Introduction to Material Cost Management The object of inventory control is to reduce the investment in the inventory without affecting the efficiency in the area of production and sales. If a sufficient stock of raw material is not available, the production activity is likely to be interrupted. If sufficient stock of finished goods is not available, it may not be possible for the organisation to serve the customers properly and they may shift to the competitors. The objective of inventory control is to avoid the situation of over stocking as well as under stocking. The level of inventories should be maintained at the optimum level. Excess stock results in higher carrying cost and less stock results in excess ordering cost. In case of a typical manufacturing type of operation, the activity may consist of conversion of raw material in the form of finished goods with the help of labour and other services and selling the finished goods in the market to earn the profits. Though inventory is an idle resource, it is almost essential to keep some inventory in order to promote smooth and efficient running of business. For example: Consider the case – an enterprise that does not have any inventory. Clearly, as soon as the enterprise receives a sales order, it will have to order for raw materials to complete the order. This will keep the customers waiting. It is quite possible that sales may be lost. Also the enterprise may have to pay high price for some other reasons. On the other hand, inventory may promote sales by reducing customers waiting time. It is essential to maintain the inventories in order to enhance the stability of production and employment levels. Consider the case of seasonal items. Any fluctuation in demand can be met if possible, by either changing that part of production or with inventories. If the fluctuation is not followed by changing the rate of production, one has to take into account the following costs. Cost of increasing production and employment level, involves the following: •

employment and training

•

additional staff and service activities

•

added shifts

•

overtime costs

Cost of decreasing production and employment level, involves the following: •

employee compensation

•

other employee costs

•

staff, clerical and service activities

•

total time costs

The functions of inventories are to: •

protect against unpredictable variations (fluctuations) in demand and supply

•

take advantage of the price discounts by bulk purchases

•

take the advantage of batches and longer production run

•

provide flexibility to allow changes in production plans in view of change in demands, etc.

•

facilitate intermittent production

2.2 Material Cost Material cost is the cost of commodities and materials used by the organization. It can be direct or indirect. •

Direct Material is indicative of material which can be identified with the individual product and which becomes an integral part of the finished goods. It basically consists of all raw materials, either purchased from outside or manufactured in-house.

•

Indirect Material indicates that material which cannot be identified with the individual product. This material assists the manufacturing process and does not become an integral part of finished goods. The examples of indirect material may be consumable stores, cotton waste, oils and lubricants, stationery material, primary 15/MITSDE

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packing material etc. Material cost is categorized as variable cost. The cost increases with the increase in the level of production activity and vice versa. The heart of inventory analysis resides in the identification of relevant costs. Some of the important costs that apply to inventory situation are as follows: •

Ordering or set up costs: These are the costs associated with ordering or manufacturing goods through purchasing or manufacturing and are known as set up costs or cost of ordering. Set up costs are generally assumed to be independent of the quantity ordered or produced.

•

Purchase cost or production cost (Material cost): When large production runs are in process, these results in reduction of production cost per unit. Often, discounts are offered for the purchase of large quantities. In other words, often the unit cost of an item depends on the quantity procured or produced.

•

Inventory holding cost or carrying cost: The cost associated with carrying or holding the goods in stock are known as carrying or holding costs. These costs arise due to the storage costs, property taxes on the items in inventory, interest on the invested capital (interest on value of the inventory items, spillage of the inventory items, depreciation of the inventory items, transportation and handling of the items in inventory, etc).

•

Shortage or stock out costs: The costs that are incurred as a result of running out of stock are known as stock out or shortage costs. As a result of shortages, sales or goodwill may be lost. If the unfulfilled demand for the items can be satisfied at a later date (back order case). In this case, the cost of back orders are assumed to vary directly with the shortage quantity (in rupee value) and the delaying time. However, if the unfulfilled demand is lost (lost-sales case), in this case, the cost of shortages are assumed to vary directly with the shortage quantity.

Example: For calculating material costThe following is the information about a manufacturing unit, M/s Vishal IndustriesElements of cost Raw material

80

Direct labour

30

Overheads

60

Total cost

170

Profit

30

Selling Price

200

The following further particulars are available: •

Raw materials are in stock for one month

•

Materials are in process for an average of half month

•

Finished Goods are in stock for an average of one month

•

Credit allowed to customers is two months

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Amount per unit

You are requested to prepare a statement showing the material cost needed to manufacture 1, 20,000 units per annum. Solution: Estimates of Raw Material Cost Rs. Amount of S. Current Period of No of Units for which working material cost No. Assets holding capital required 1

Raw Material

1 Month

10,000

8,00,000

2

Work in Process

0.5 month

5,000

4,00,000

3

Finished Goods

1 Month

10,000

8,00,000

4

Debtors

2 Months

10,000

16,00,000

Total

36,00,000

Working notes S. Category No. 1 Raw material 2 Work in Process 3 Finished Goods 4 Debtors Total

Period of holding 1 Month 0.5 Month 1 Month 2 Months

No of units for which working capital required 10,000 5,000 10,000 10,000

Amount of Material cost 8,00,000 4,00,000 8,00,000 16,00,000 36,00,000

Cash Raw Material Debtors

Finished Goods

Work in Process

Fig. 2.1 Process from procurement to realization of money Note: We have not considered the labour cost and other cost, since it is outside the purview of material cost. From the above example, it is clear that the cost of raw material is present in raw material stage, work in process stage, finished good stage and debtors. Raw material is like a life blood of the industry which flows through out the process from procurement stage to realization money from debtors. The following diagram will illustrate this.

2.3 Economic Order Quantity (EOQ) Models Economic Order Quantity (EOQ) models are the most basic models of inventory management. EOQ model is essentially a trade-off between various relevant costs and derive an order quantity and time for placing an order in such a way that the total costs are minimized. Economic lot size or economic order quantity model assumptions are: •

The rate of demand for the item is deterministic and is constant D units per annum, independent of time 17/MITSDE

Material and Store Management

•

Production rate is infinite, i.e. production is instantaneous

•

Shortages are not allowed

•

Lead time is zero or constant independent of demand and the quantity ordered

•

The entire quantity is delivered as a single package (or production in a single run)

Objective of the EOQ The prime objective of EO is to minimise the average annual variable cost. Economic Order Quantity (EOQ) indicates that quantity, which is fixed in such a way that the total variable cost of managing the inventory, can be minimised. Such cost basically consists of two parts: •

First, ordering cost (which in turn consists of the costs associated with the administrative efforts connected with preparation of purchase requisitions, purchase enquiries, transportation cost and handling of more number of bills and receipts)

•

Second, carrying cost i.e., the cost of carrying or holding the inventory (which in turn consists of the cost like godown rent, handling and upkeep expenses, insurance, opportunity cost of capital blocked i.e., interest etc.)

There is a reverse relationship between these two types of costs i.e., If the purchase quantity increases, ordering cost may get reduced but the carrying cost increases and vice versa. A balance is to be struck between these two factors and it is possible at Economic Order Quantity (EOQ), where the total variable cost of managing the inventory is the least. The following is the formula for calculating Economic Order Quantity: EOQ = √ (2 A O)/C Where, Q = Economic Order Quantity A = Annual Requirement in Units O = Cost of Placing an Order C = Cost of Carrying One Unit per Year Example: A manufacturer uses 4,000 units of a component every year and he buys them entirely from outside supplier. The order placing and receiving cost is Rs. 100 per order and annual carrying cost is Rs. 10%. Unit cost of raw material is Rs 200/-. Calculate Economic Order Quantity. Solution: EOQ = √ (2 A O)/C = √ (2 x 4,000 x 100)/ 10% of 200 = √ (8, 00,000/20) = √40,000 = 200 units Annual Requirement: Ordering cost per order: Carrying Cost: Price per unit:

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4,000 100 10% 200

Lot size 1 50 100 150 200 250 500 1000 2000 Number of Orders Ordering Cost Carrying Cost Total Cost

No. of orders 2 2=4000/col. 1 80 40 27 20 16 8 4 2

Ordering cost 3 3=100xcol.2 8,000 4,000 2,667 2,000 1,600 800 400 200

Carrying cost 4 4=col.1x100x0.10/2 500 1,000 1,500 2,00 2,500 5,000 10,000 20,000

Total cost 5 5=3+4 8,500 5,000 4,167 4,000 4,100 5,800 10,400 20,200

= Annual Requirement/Size of the order = 4,000/200 = 20 = Number of Orders x Ordering Cost per order = 20 x 100 = Rs. 2,000 = Carrying Cost% x Size of the Order x Price per Unit /2 = 10/100 x 200 x 200/2 = Rs. 2, 000 = Ordering Cost + Carrying Cost = Rs. 2, 000 + Rs. 2, 000 = Rs. 4, 000

It can be observed from the above table that the order size of 200 units proves to be the most economic one, in terms of minimum total cost. If the purchases are made in any other way, the same may not necessarily result in minimial total cost. From the above table, we can find that for the order size of 200 units, the total cost is lowest i.e. Rs. 4, 000/- . We can also observe that as the size of the order increases, the number of orders decreases and hence, the ordering cost decreases but the carrying cost increases. Thus, the ordering cost is inversely proportion to the size of the order and the carrying cost is directly proportion to the size of the order.

Drawback of EOQ model In the above modal, various parameters are used such as demand, inventory carrying charges, ordering cost. These parameters are estimated and though they are assumed to be known, in real life what we have is an estimated value which may be different than real value for various reasons.

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2.4 Determination of various Inventory Levels Fixation of various inventory levels facilitates the initiating of proper action in respect of the movement of various materials in time so that the various materials may be controlled in a proper way. However, the following points should be remembered. •

Only the fixation of inventory levels does not facilitate the inventory control. There has to be a constant watch on the actual stock level of various kinds of materials so that proper action can be taken in time.

•

The various levels fixed are not fixed on a permanent basis and are subject to revision regularly.

The various levels which can be fixed are as below: ‚‚ Maximum Level ‚‚ Minimum Level ‚‚ Re-order Level ‚‚ Danger Level 2.4.1 Maximum Level It indicates the level above which the actual stock should not exceed. If it exceeds, it may involve unnecessary blocking of funds in inventory. While fixing this level, following factors are considered: •

maximum usage

•

lead time

•

storage facilities available, cost of storage, and insurance etc..

•

prices for the material

•

availability of funds

•

nature of the material

•

government regulations in respect of import of goods

•

economic order quantity

2.4.2 Minimum Level It indicates the level below which the actual stock should not reduce. If it reduces, it may involve the risk of nonavailability of material whenever it is required. While fixing this level, the following factors are considered: •

lead time

•

rate of consumption

2.4.3 Re-order Level It indicates that level of material stock at which it is necessarily to take the steps for procurement of further lots of material. This is the level falling in between the two extremes of maximum level and minimum level and is fixed in such a way that the requirements of production are met properly till the new lot of material is received. 2.4.4 Danger Level This is the level fixed below minimum level. If the stock reaches this level, it indicates the need to take urgent action in respect of getting supply. At this stage, the company may not be able to make the purchases in a systematic manner, but may have to make rush purchases which may involve higher costs of purchases. 2.4.5 Calculation of Various Levels The various levels can be decided by using the following mathematical expressions. Re-order Level = Maximum Lead Time x Maximum Usage

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Maximum Level = Reorder Level + Reorder Quantity - (Minimum Usage x Minimum Lead Time) Minimum Level = Reorder Level - (Normal Usage x Normal Lead Time) Average Level = (Maximum Level + Minimum Level)/2 Danger Level = Normal Usage x Lead-time for emergency purchases Note: It should be noted that the expression of the reorder quantity in the calculation of maximum level indicates economic order quantity. Illustration 1 Normal usage Minimum usage Maximum usage Reorder quality Reorder period

50 units per week 20 units per week 80 units per week 500 units 5 to 7 weeks

Compute from the above: 1. Re-order level 2. Minimum level 3. Maximum level 4. Average stock level Solution Reorder Level = Maximum Lead time x Maximum Usage 7 weeks x 80 units = 560 units Minimum Level = Reorder Level – (Normal Usage x Normal Lead-time) = 500 units – (50 units X 6 weeks) = 200 units. Maximum Level = Reorder Level+Reorder Quantity - (Minimum Usage x Minimum Lead time) = 560 units + 500 units – (20 units x 5 weeks) = 960 units. Average Stock Level = (Minimum Level + Maximum Level)/2 = (200 units + 960 units)/2 = 580 units Illustration 2 Swarupa Industries manufactures a special product ‘Vick’. The following particulars are collected for the year 1986. •

Monthly demand of 'Vick' - 1000 units

•

Cost of placing an Order - Rs. 100

•

Annual carrying cost per unit - Rs. 15

•

Normal Usage 50 units per week

•

Minimum Usage 25 units per week

•

Maximum Usage 75 units per week

•

Re-order period 4 to 6 weeks

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Compute the following: 1. Re-order Quantity 2. Re-order Level 3. Minimum Level 4. Maximum Level 5. Average Stock Level Solution Reorder Quantity; EOQ = √(2 A O)/C = √(2 X 12,000 X 100)/ 15 = √(24,00,000/15) = √1,60,000 = 400 units Reorder Level = Maximum Lead Time x Maximum Usage = 6 weeks x 75 units = 450 units Minimum Level = Reorder Level - (Normal Usage x Normal Lead time) = 450 units – (50 units x 5 weeks) = 200 units Maximum Level = Reorder Level + Reorder Quantity – (Minimum Usage x Minimum Lead-time) = 450 units + 400 units – (25 units x 4 Weeks) = 750 units. Average Stock Level = (Minimum Level + Minimum Level)/2 = (200 units + 750 units)/2 = 475 units There may be one more way in which the various inventory levels may be fixed and for this determination of the safety stock (also called as minimum stock or buffer stock) is essential. Safety stock is that level of stock below which the actual should not be allowed to fall. The safety stock may be calculated as; Maximum Usage x Maximum Lead-time) - (Normal Usage X Normal Lead-time) According to this method, the various inventory levels as discussed above may be fixed as below. •

Minimum Level

= Safety stock

•

Maximum Level

= Safety Stock + EOQ

•

Reorder Level

= Safety Stock + (Normal Usage x Normal Lead-time)

•

Average Stock Level

= (Minimum Level + Minimum Level)/2

= (Safety Stock + Safety stock + EOQ)/2

Illustration 3 Calculate the various levels from the information given hereunder: 1. Total cost of purchasing relating to the order Rs. 20 2. Number of units to be purchased during the year 5,000 3. Purchase price per unit including transportation costs Rs. 50 4. Annual cost of storage of one unit Rs. 5 •

Lead time: ‚‚ Average ... 10 days ‚‚ Maximum... 15 days ‚‚ Minimum... 6 days ‚‚ Maximum for emergency purchases... 4 days

•

Rate of consumption:

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‚‚ Average... 15 units per day ‚‚ maximum... 20 units per day Solution: Working Notes: •

Calculation of Safety Stock = (Maximum Usage x Maximum Lead-time) (Normal Usage x Normal Lead-time) = (20 units x 15 days) – (15 days x 10 days) = 300 units - 150 units = 150 units

• Calculation of EOQ EOQ = √(2 A O)/C = √(2 X 5,000 X 20)/ 5 = √40,000 = 200 units Reordering Level = Safety Stock + (Normal Usage x Normal Lead-time) = 150 units + (15 units X 10 days) = 150 units + 150 units = 300 units. Maximum Level

= Safety Stock + EOQ = 150 units + 200 units = 350 units

Minimum Level

= Safety Stock = 150 units

Danger Level

= Normal Usage x Lead-time for emergency purchases = 15 units x 4 days = 60 units

Average Stock Level = (EOQ + Safety Stock + Safety Stock)/2 = (200 + 150 + 150)/2 = 250 units

2.5 ABC Analysis The ABC classification process is “an analysis of a range of objects, such as finished products, items lying in inventory or customers into three categories”. This method usually categorizes inventory into three classes with each class having a different management control associated. •

A - Outstandingly important

•

B - of average importance

•

C - Relatively unimportant as a basis for a control scheme

Each category can and sometimes should be handled in a different way, with more attention being devoted to category A, less to B and still less to C. Popularly known as the '80/20' rule, ABC concept is applied to inventory management as rule-of-thumb. It says that “about 80% of the Rupee value, consumption wise, of an inventory remains in about 20% of the items”. This rule is frequently used by inventory managers to put their efforts where the benefits are most, in terms of cost reduction as well as maintaining a smooth availability of stock.

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The ABC concept is derived from the Pareto’s 80/20 rule curve. It is also known as the 80-20 concept. Here, Rupee value of each individual inventory item is calculated on annual consumption basis. It is a determination of the relative ratios between the number of items and the value of the items consumed on a repetitive basis. ‘A’ class items are closely monitored because of the value involved (70-80%); High value (A), Low value (C) and intermediary value (B). ABC Analysis is the basis for material management processes and helps define how stock is managed. It can form the basis of various activity including leading plans on alternative stocking arrangements (consignment stock), reorder calculations and can help determine at what intervals, inventory checks are carried out (for example A class items may be required to be checked more frequently than C class stores. The ABC classification system is grouping of items according to annual issue value, (in terms of money), in an attempt to identify the small number of items that will account for most of the issue value and that are the most important ones to control for effective inventory management. The emphasis is on putting effort where it will have the effect is most. All the items of inventories are put in three categories, as mentioned below: •

A Items: These Items are seen to be of high consumption volume. ‘A’ items usually include 10-20% of all inventory items, and account for 50-60% of the total Rupee consumption volume

•

B Items: ‘B’ items are those that are 30-40% of all inventory items, and account for 30-40% of the total Rupee consumption volume of the inventory. These are important, but not critical, and don’t pose sourcing difficulties

•

C Items: ‘C’ items account for 40-50% of all inventory items, but only 5-10% of the total

ABC classifications allow the inventory manager to assign priorities for inventory control. Strict control needs to be kept on A and B items, with preferably low safety stock level. Taking a lenient view, the C class items can be maintained with looser control and with high safety stock level. The ABC concept puts emphasis on the fact that every item of inventory is critical and has the potential of affecting, adversely, production, or sales to a customer or operations. The categorization helps in better control on A and B items. ABC classifications can be used to design cycle counting schemes. For example, A items may be counted 3 times per year, B items 1 to 2 times, and C items only once, or not at all. Suggested policy guidelines for A , B & C classes of items are given below: A items (High Cons. Val) • • • • • • • • • •

Very strict cons. Control No or very less safety stock Phased delivery (Weekly) Weekly control report Maximum follow up As many sources as possible Accurate forecasts Central purchasing/storage Max. efforts to control LT To be handled by Sr. officers

B items (Moderate cons. Val.) • • • • • • • • • • •

Moderate control Low safety stock Once in three months Monthly control report Periodic follow up Two or more reliable Estimates on past data Combination on past data Combination purchasing Moderate Middle level

C item (Low cons. Val) • • • • • • • • • •

Loose control High safety stock Once in 6 months Quarterly report Exceptional Two reliable Rough estimate Decentralised Min. clerical efforts Can be delegated

ABC analysis assumes the principle of “Vital Few Trivial Many” while considering the inventory structure of any organisation and is popularly known as “Always Better Control”. It is an analytical method of inventory control which aims at concentrating efforts in those areas where attention is required most. It is usually observed that only a few numbers of items of inventory prove to be more important in terms of amount of investment in inventory or value of consumption, where as a very large number of items of inventory account for a very meagre amount of investment in inventory or value of consumption. ABC analysis classifies the various inventory items according to 24/MITSDE

their importance in terms of amount: •

‘A’ class consists of only a small percentage of a total number of items handled, but is most important in terms of amount

•

‘B’ Class items include relatively less important items.

•

‘C’ Class items consist of a very large number of items which are less important.

The importance of the various items may be decided on the basis of following factors: •

amount of investment in inventory

•

value of material consumption

•

critical nature of inventory items

An example of ABC Analysis is given below. Category A B C Total

No of items 150 1500 10000 11650

Percentage to total number 1.29% 12.88% 85.84% 100.00%

Value in Rs. 100000 20000 10000 130000

Percentage to total value 76.92% 15.38% 7.69% 100.00%

From the above example we can find that the 'A' category items are less in number i.e. 1.29% to total numbers but, the most important thing is value and they account for 76.92% of the total value. On the other hand, ‘C’ category items are very high in number since they account for 85.84% to total numbers but, in terms of value they are least important since they account for 7.69% of the total value. The Material Manager should concentrate on 'A' category items. Advantages of ABC Analysis are as under: •

A close and strict control is facilitated on the most important items which constitute major portion of overall inventory valuation or overall material consumption and due to this the costs associated with inventions may be reduced.

•

The investment in inventory can be regulated in a proper manner and optimum utilization of the available funds can be assured.

•

A strict control on inventory items in this manner helps in maintaining a high inventory turnover ratio. However, it should be noted that the success of ABC analysis depends mainly upon correct categorisation of inventory items and hence, should be handled by only experienced and trained personnel.

2.6 XYZ Analysis XYZ analysis is one of the basic supply chain techniques, often used to determine the inventory valuation inside a store. It’s also strategic as it intends to enable the Inventory manager in exercising maximum control over the highest stocked item, in terms of stock value. This method usually categorizes inventory into three bands with each band having a different management control associated. Although different criteria may be applied to each category the typical method of scoring an inventory item is that of annual stock value of said item (Quantity in stock X Price per unit) with the result then ranked and then scored (X, Y or Z). Bandings may be specific to the industry but typically follow a 70%, 90%, 100% banding, in that X class items represent 70% of the stock value (although they may account for 20% number wise), Y class items fall between 70% and 90% of the annual stock value with Z class the remaining. In practical terms the complex high cost materials typically fall into the X class items, with the consumable, low cost (and typically fast moving) classed as Z class. Not all stock is equally valuable and therefore doesn’t require the same management focus. The results of the XYZ analysis provide information that helps evaluate how each inventory part should be monitored and controlled. X 25/MITSDE

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class items which are critically important and require close monitoring and tight control – while this may account for large value these will typically comprise a small percentage of the overall inventory count. Y class is of lower criticality requiring standard controls and periodic reviews of usage. Z class requires the least controls. Classification of inventory in terms of XYZ is also quite strategic as it can form the basis of various activity including leading plans on alternative stocking arrangements (consignment stock), reorder calculations and can help determine at what intervals inventory checks are carried out. For example X class items may require to be checked more frequently than Z class stores. The main difference between the ABC Analysis and XYZ Analysis is that in case of ABC Analysis, the materials are classified on the basis of value of materials consumed where as in case of XYZ Analysis; the materials are classified on the basis of value of materials held in the stock. Inventory plays an important role for any organisation as it blocks the working capital which otherwise would have earned the organisation some money. While the need for having inventory can’t be denied for any running plant / machinery, its availability in controlled measures too is highly desirable. Control techniques such as ABC and XYZ analyses try to ensure the maximum control of materials. AX control One of the ways to have still better (tight) control over the inventory with still less commitment of resources is by determining the AX category of items in a given inventory. Once ABC and XYZ analyses have been done and a list of A and X classes of items is drawn then AX category is a combination of the two categories. Going by the definition of A and X separately, AX category of items, normally, display a high consumption (A) as well as a high stock value (X). Essentially, these items are high value, in terms of overall procurement cost. Obviously, the measures that need to be taken to keep AX inventory under control is similar to that of A or X items that are: •

stock less number at any given time

•

have tight consumption control

•

more sources so that supply doesn’t become a constraint when needed etc.

Based on the ABC and XYZ analysis there is another control mechanism, popularly known as AX control. Materials falling under A category under ABC analysis and X category under XYZ analysis are included in AX category and maximum control is exercised on these items.

The combination of ABC analysis and XYZ analysis will give the following alternatives. X

Y

Z

A

AX

AY

AZ

B

BX

BY

BZ

C

CX

CY

CZ

AX category the most important items of materials and CZ category the least important category.

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Summary •

The object of inventory control is to reduce the investment in the inventory without affecting the efficiency in the area of production and sales.

•

It is essential to maintain the inventories in order to enhance stability of production and employment levels.

•

Cost of increasing production and employment level, involves: employment and training, additional staff and service activities, added shifts, and overtime costs.

•

Cost of decreasing production and employment level, involves: employee compensation, other employee costs, staff, clerical and service activities, and total time costs.

•

Material Cost is the “cost of commodities and materials used by the organization”. It can be direct or indirect.

•

Direct Material indicates that material which can be identified with the individual product and which becomes an integral part of the finished goods.

•

Indirect Material indicates that material which cannot be identified with the individual product.

•

Ordering or set up costs: These are the costs associated with ordering or manufacturing goods through purchasing or manufacturing.

•

Purchase cost or production cost (Material Cost): When large production runs are in process, these results in reduction of production cost per unit.

•

The cost associated with carrying or holding the goods in stock are known as carrying or holding costs.

•

The costs that are incurred as a result of running out of stock are known as stock out or shortage costs.

•

Economic Order Quantity (EOQ) models are the most basic models of inventory management. EOQ model is essentially a trade-off between various relevant costs and derive an order quantity and time for placing an order in such a way that the total costs are minimized.

•

Formula for calculating Economic Order Quantity can be given as - EOQ = √ (2 A O)/C

•

Various inventory levels are: maximum, minimum, re-order and danger level.

•

The ABC classification process is “an analysis of a range of objects such as, finished products, items lying in inventory or customers into three categories”.

•

XYZ analysis is one of the basic supply chain techniques, often used to determine the inventory valuation inside a store.

References •

Deepak, 2008. ABC analysis [Online] (Updated 18th March, 2011) Available at . [Accessed on 18th March 2011]

•

Inventory Management [Online] (Updated on 16th March, 2011). Available at [Last accessed on 16th March 2011]

•

Inventory Control Models [Online] (Updated 18th March, 2011). Available at . [Accessed on 18th March 2011]

Recommended Reading •

Frazelle, E., 2001. World-Class Warehousing and Material Handling. 1st ed., McGraw-Hill.

•

Richards, G., 2011. Warehouse Management: A Complete Guide to Improving Efficiency and Minimizing Costs in the Modern Warehouse. Kogan Page

•

Emmett, S., 2005. Excellence in Warehouse Management: How to Minimise Costs and Maximise Value. Wiley

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Self Assessment 1. _________material indicates that material which cannot be identified with the individual product. a. Inventory b. Direct c. Indirect d. Costly 2. The heart of _________analysis resides in the identification of relevant costs. a. product b. finished goods c. raw material d. inventory 3. The ABC concept is derived from which of the following? a. Pareto’s 20/80 rule curve b. Pareto’s 40/20 rule curve c. Pareto’s 40/80 rule curve d. Pareto’s 80/20 rule curve 4. What is material cost categorized into? a. Variable Cost b. Fixed cost c. Explicit cost d. Implicit cost 5. Which of the following statements is false? a. Inventory plays an important role for any organisation as it blocks the working capital which otherwise would have earned the organisation some money. b. All the stock is equally valuable and therefore doesn’t require the same management focus. c. Safety stock is that level of stock below which the actual should not be allowed to fall. d. The cost increases with the increase in the level of production activity and vice versa. 6. Which of the following statements is true? a. Inventory is an profitable resource, it is almost essential to keep some inventory in order to promote smooth and efficient running of business. b. The objective of inventory control is to avoid the situation of over stocking as well as under stocking. c. It is not essential maintain the inventories in order to enhance stability of production and employment levels. d. The level of inventories should be maintained at the minimum level.

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7. _______Analysis is the basis for material management processes and helps define how stock is managed a. Profit b. ABC c. XYZ d. Inventory 8. _______costs are generally assumed to be independent of the quantity ordered or produced a. Ordering b. Purchasing c. Carrying d. Set-up 9. Which of the following is that level of stock below which the actual should not be allowed to fall? a. Safety b. Optimum c. Required d. Purchase 10. Which of the following is the correct formula for calculating economic order quantity? a. EOQ = √ (3 A O)/C b. EOQ = √ (4 A O)/C c. EOQ = √ (2 C O)/A d. EOQ = √ (2 A O)/C

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Material and Store Management

Chapter III Inventory Models Aim The aim of this chapter is to: •

introduce to the concept inventory models

•

explain the model of accepting and rejecting discounts on purchases

•

elucidate the advantages and disadvantages of the inventory models

Objectives The objectives of this chapter are to: •

discuss concept of material requirement planning (MRP)

•

recognise the inputs and outputs of material requirement planning (MRP)

•

understand the fixed order and fixed interval system

Learning outcome At the end of this chapter, the students will be able to: •

understand the concept of inventory turnover

•

enlist the benefits of material requirement planning (MRP)

•

know the applicability of material requirement planning system

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3.1 Introduction to Inventory Models Material management is a day to day function. Various decisions regarding right size of the order, right price have to be taken on an on going basis. These decisions are repetitive in nature. They involve a lot of calculations. Therefore, it is advisable for the industries to develop certain models especially using information technology. These models can take care of calculation part and give enough time to the material managers to take the decision. The models will act as an aid to the managers to compare various offers, discounts prices etc. Inventory model is “a mathematical equation or formula that helps a firm in determining the economic order quantity, and the frequency of ordering, to keep goods or services flowing to the customer without interruption or delay”.

3.2 Models for Accepting/Rejecting Discounts on Purchases Many a times the suppliers of raw material come with an offer of discount on the catalogue price if a certain minimum quantity is ordered. The manufacturers may be tempted to accept the order thinking that they will make profit by availing the discount. Accepting or rejecting such decisions should not be impulsive decisions of the purchase department. They should be conscious decisions based on calculations and quantification of benefits. If a manufacturer orders a quantity which is more than the economic order quantity (EOQ) the following two things will happen: •

Reduction in cost due to: ‚‚ discount on the price of the raw material ‚‚ reduction in ordering cost, because the number of orders goes down

•

Increase in Carrying cost: ‚‚ If the reduction in cost is more than the increase in carrying cost then only a manufacturer should accept the discount offer. Other wise he should reject the offer.

If A > B, accept the discount offer. If A < B, reject the discount offer. We can develop a model using excel spread sheet which will help us in taking a decision. We have to just feed the original data. Rest of the calculations and comparisons are done by the computer. The following is the model developed in excel spread sheet. Those have working knowledge of Excel can easily understand this format and formulae used.

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Row No.\Column Name 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

A 1 2 3 4

B Accept/reject a discount model A) Basic information Annual requirement units Ordering cost per order Carrying cost Price per unit

C 20,000 2,000 20% 100

5 6

Discount quantity units Discount rate

5,000 1%

1 2 3 4 5 6 7

B) If EOQ model followed EOQ units No. of orders No. of orders rounded off Ordering cost Carrying cost Material cost Total Cost in Rupees

-SQRT((2*C3*C4)/(C5*C6)) -C3/C12 -CEILING(C13,1) -C4*C14 -C12/2*C5*C6 -C3*C6 -C15+C16+C17

1 2 3 4 5 6 7

C) If discount offer is accepted Discount quantity No. of orders No. of orders rounded off Ordering cost Carrying cost Material cost Total cost rupees

-C8 -C3/C21 -CEILING(C22,1) -C4*C23 -C21/2*C5*C6 -C3*C6*(1-C9) -C24+C25+C26

D) Benefit of discount offer E) Decision

=C18-C27 =IF(C29>0, “Accept”,” Reject”)

Table 3.1 Model developed for accepting/rejecting discounts on purchases in excel spread sheet Illustration 1 A

B

C

Accept/reject a discount model A) Basic information

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1

Annual requirement units

20,000

2

Ordering cost per order

2,000

3

Carrying cost

20%

4

Price per unit

100

5

Discount quantity units

5,000

6

Discount rate

1%

B) If EOQ model followed 1

EOQ units

2,000

2

No. of orders

10

3

No. of orders rounded off

10

4

Ordering cost

20,000

5

Carrying cost

20,000

6

Material cost

2,000,000

7

Total Cost Rupee

2,040,000

C) If discount offer is accepted

Illustration 2

A

1

Discount quantity

5000

2

No. of orders

4

3

No. of orders rounded off

4

4

Ordering cost

8,000

5

Carrying cost

50,000

6

Material cost

1,980,000

7

Total cost rupees

2,038,000

D) Benefit of discount offer

2000

E) Decision

Accept

1 2 3 4

B Accept/reject a discount model A) Basic information Annual requirement units Ordering cost per order Carrying cost Price per unit

C 10,000 1,000 10% 200

5 6

Discount quantity units Discount rate

4,000 1%

1 2 3 4 5 6

B) If EOQ model followed EOQ units No. of orders No. of orders rounded off Ordering cost Carrying cost Material cost

1,000 10 10 10,000 10,000 2,000,000 33/MITSDE

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7

Total Cost Rupee

2,020,000

1 2 3 4 5 6 7

C) If discount offer is accepted Discount quantity No. of orders No. of orders rounded off Ordering cost Carrying cost Material cost Total cost rupees

4000 3 3 3,000 40,000 1,980,000 2,023,000

D) Benefit of discount offer E) Decision

-3000 Reject

Illustration 3 The Purchase Department of the organisation has received an offer of quantity discounts on its orders of materials as under:

Price Per Ton 1,200

Order Size in Tons Less than 500

1,180

500 and less than 1000

1,160

1000 and less than 2000

1,140 1,120

2000 and less than 3000 3000 and above

The annual requirement for the material is 5000 tons. The delivery cost per order is Rs.1, 200 and the stock holding cost is estimated at 20% of material cost per annum. You are required to advice the Purchase department the most economic purchase level. Solution : Lot Price per Size ton 1 2

Purchase price 3 3- 5000Xcol.2

100 250 500 625 1000 1250 2500 5000

1,200 1,200 1,180 1,160 1,160 1,160 1,120 1,100

6,000,000 6,000,000 5,900,000 5,900,000 5,800,000 5,800,000 5,600,000 5,500,000

No. of orders 4 4- 5000/ col.1 50 20 10 8 5 4 2 1

Ordering cost

Carrying cost

Total cost

5

6

7

5-1200Xcol.4

6-col.3X20/2

7-col.3+col.5+col.6

60,000 24,000 12,000 9,600 6,000 4,800 2,400 1,200

12,000 30,000 59,000 73,750 116,000 145,000 280,000 550,000

6,072,000 6,054,000 5,971,000 5,983,350 5,922,000 5,949,800 5,882,400 6,051,200

Observations from the above table: •

As the lot size increases the number of order decreases, hence the ordering cost also decreases.

•

As the lot size increases the carrying cost increases.

•

As the lot size increases the material cost decreases due to discount for higher quantity.

•

A lot of size of 500 units is the economic order quantity (EOQ) since the total cost is lowest at this level.

•

Even though the discount is highest for an order of 2500 units, this is not economical because, the benefit of discount plus reduction in ordering cost is less than increase in carrying cost.

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3.3 Fixed Order vs. Fixed Interval System There are two basic systems of managing or controlling inventory under the independent demand pattern: •

Cyclical ordering or Fixed period system (Time based)

•

Order point or Fixed order quantity system (Quantity based)

3.3.1 Cyclical Ordering or Fixed Period System (Time Based) •

Fixed period based systems (also called cyclical systems), are designed so that each inventory item is reviewed and reorders are placed after a predetermined time interval (i.e. every two weeks, every thirty days, etc.).

•

Orders are placed for each item equal to the difference between current inventory level and a predetermined maximum. In cyclical systems, time between reorders is constant, but reorder quantity is variable.

•

Predetermined maximums are set with a consideration of order lead time.

•

It involves scheduled periodic reviews of the stock level of all inventory items. This is given below in detail.

Fixed schedule (calendar) for reviewing a group of items is drawn, fixed Desired Inventory Level (DIL) of each item or group of items is calculated. In case where stock level of an item is insufficient to sustain the production operation until the next scheduled review, order is placed to replenish the stock to DIL, maintenance of perpetual inventory records. Procedure •

First, all the inventory items are grouped in certain feasible categories or classes of items such as pipes & pipe fittings, raw materials, chemicals and reagents, oil and lubricants etc.

•

Now, a calendar is drawn for all the classes so that depending upon the number of classes each class is reviewed for replenishment during certain specified time frame.

•

The DIL for each group or individual item is fixed.

•

DIL = (Review Period + Lead Time + Safety Stock) x Periodical Demand

Illustration Review Period = 30 days Lead Time = 15 days Safety Stock = 10 days Daily Demand = 100 units Desired inventory level (DIL) = (30 +15 +10) x 100 = 5,500 If the actual quantity on hand is 1,400 on the date of reorder, the reorder quantity will be 5,500- 1,400 = 4,100. Depending upon the review period, a class of items is reviewed with reference to its stock position, production plan, any dues in quantity against any previous order. During review and based on the lead time, if the present stock of an item or group of items is not expected to last the next production plan then action for replenishment is taken by raising the material procurement requisition. The order quantity = (DIL- (Present stock + dues in) This system is suitable for the following: •

for materials whose purchases can be planned months in advance

•

for materials which exhibit an irregular or seasonal usage pattern

•

for items with volatile prices

•

for group of items purchased from and shipped together by one supplier

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Disadvantages of the system are as under: •

compels periodic reviews of all items

•

not effective to combat stock out situations

•

actual ordering quantities may deviate from optimum quantity

•

tends to peak the purchasing work load around the review dates

•

there is no automatic trigger for reorder before the review time in the event of increased usage, which generally leads to increased inventory levels as a means of stock out prevention

•

system does not permit effective use of economic order quantities

Illustration of disadvantages of fixed period

20,000 2,000 20% 100

Change in annual quantity 12,000 2,000 20% 100

Change in unit price 20,000 2,000 20% 200

Change in ordering cost 20,000 1,000 20% 100

Change in carrying cost 20,000 2,000 10% 100

A) Basic information 1 2 3 4

Annual requirement units Ordering cost per order Carrying cost Price per unit

1 2 3 4 5 6 7

B) If EOQ model followed EOQ units No. of orders No. of orders rounded off Ordering cost Carrying cost Material cost Total cost rupees

2,000 10 10 20,000 20,000 2,000,000 2,040,000

1,549 8 8 16,000 15,492 1,200,000 1,231,492

1,414 14 15 30,000 28,284 4,000,000 4,058,284

1,414 14 15 15,000 14,142 2,000,000 2,029,142

2,828 7 8 16,000 14,142 2,000,000 2,030,142

1 2 3 4 5 8 9 10 11 12

C) If fixed period is followed Review period days Lead period days Safety stock days Daily demand DIL No. of orders rounded off Ordering cost Carrying cost Material cost Total cost rupees

30 15 10 67 3,667 12 24,000 36,667 2,000,000 2,060,667

30 15 10 40 2,200 12 24,000 22,000 1,200,000 1,246,000

30 15 10 67 3,667 12 24,000 73,333 4,000,000 4,097,333

30 15 10 67 3,667 12 12,000 36,667 2,000,000 2,048,667

30 15 10 67 3,667 12 24,000 18,333 2,000,000 2,042,333

-20,667

-14,508

-39,049

-19,525

-12,191

D) Benefit/loss due to fixed period

The above illustration shows that if a fixed period system is followed, there will be loss compared to EOQ model. Order point or Fixed order quantity system (Quantity based) Order point system / fixed order quantity system of inventory control is based on the order point and order quantity factors rather than on the time factor. The inventory policy is drawn after defining the following: •

fixed order point / re-order level (ROL) for each item

•

fixed maximum, minimum levels for each item

•

fixed quantity to be ordered often called Min-Max systems; these involve both a maximum inventory level and

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a minimum at which reorders are generated Basically, units of an item are issued until the level of that inventory reaches the predefined reorder point. An order is then triggered for a predetermined quantity (usually a calculated economic order quantity). In this system, the order quantity is constant and the time between orders is variable. The different inventory points (Levels) of stock for an item are: •

Maximum level (Max.), predetermined

•

Minimum Level (Safety Stock, SS), predetermined

•

Lead time (LT), predetermined

•

Monthly demand = D (often based on Moving average method)

•

MaxL= (Review period + LT + SS) x D

•

Reorder level (ROL) = (LT + SS) x D

•

Order Quantity (OQ) = Max – (Present stock + Pipeline dues)

Process: In course of consumption of an inventory item in the form of issue from stores to the users, the stock level of the item starts depleting through its usage rate D. As per the above definition, the stock goes up to the maximum level in the first replenishment and then, because of steady consumption, comes gradually down. In that process, again it touches the Reorder Level (ROL). As soon as the stock level touches the ROL, fresh replenishment action is initiated. It is presumed that the next lot shall arrive by the time the present depleting stock touches the safety stock, keeping a stable lead time and a stable usage rate, D. Advantages of Fixed order quantity system: •

Each item is procured in the most economical quantity

•

An item is attended to only when it needs attention i.e. when its stock has reached the ROL

•

Control can be exercised on inventory with reference to maximum & minimum levels.

•

Applicability of Order Point system: Item must have a reasonable stable usage

•

Lead time should not have radical variation

•

Supplier should be able to accept irregularly timed and unscheduled orders

Limitations of the Fixed order quantity system: •

needs continuous monitoring of stock level of each item

•

cumbersome to operate for items with unstable usage and lead time

•

perpetual inventory records are required

Illustration to highlight disadvantages of the fixed order system

1 2 3 4

Annual requirement units Ordering cost per order Carrying cost Price per unit

20,000 2,000 20% 100

Change in annual quantity 12,000 2,000 20% 100

1 2 3

B) If EOQ model followed EOQ units No. of orders No. of orders rounded off

2,000 10 10

1,549 8 8

A) Basic information

Change in unit price

Change in ordering cost

Change in carrying cost

20,000 2,000 20% 200

20,000 1,000 20% 100

20,000 2,000 10% 100

1,414 14 15

1,414 14 15

2,828 7 8 37/MITSDE

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4 5 6 7

Ordering cost Carrying cost Material cost Total cost rupees

20,000 20,000 2,000,000 2,040,000

16,000 15,492 1,200,000 1,231,492

30,000 28,284 4,000,000 4,058,284

15,000 14,142 2,000,000 2,029,142

16,000 14,142 2,000,000 2,030,142

1 2 3 4 5 6 7

C) If fixed order is followed Fixed order quantity No. of orders No of orders rounded off Ordering cost Carrying cost Material cost Total cost rupees D) Benefit/loss due to fixed order

1,000 20 20 40,000 10,000 2,00,000 2,050,000

1,000 12 12 24,000 10,000 1,200,000 1,234,000

1,000 20 20 40,000 20,000 4,000,000 4,060,000

1,000 20 20 20,000 10,000 2,000,000 2,030,000

1,000 20 20 40,000 5,000 2,000,000 2,045,000

-10,000

-2,508

-1716

-858

-14,858

3.4 Material Requirement Planning (MRP) Dependent demand occurs when the need for parts, supplies, or materials is dependent upon a predetermined usage or production schedule. In such cases, a description and quantity of components needed and the exact date of each need is defined by a production schedule. Required delivery dates for each component will then be offset by lead time, and orders will be placed accordingly. Example: If a pen manufacturing company plans to produce 1000 pens in a period, it will need 1000 nibs, 1000 caps, etc., and will need them at the rate they will be installed in the finished pens. Such needs, with consideration for lead time, are considered in a dependent demand planned order schedule. Material Requirement Planning is one example of a system specifically designed to manage dependent demand reorders. Material Requirement Planning (MRP) happens to be the best model of dependent demand pattern of Inventory. Under it, the requirement of an item is predetermined as it depends upon the actual need of it, triggered by certain production schedule. Obviously, MRP has two main characteristics, the known requirement and the known period of requirement (time). Materials Requirements Planning (MRP) is a set of techniques that takes the master production schedule and other information from inventory records and product structure records as inputs to determine the requirements and schedule of timing for each item.

Based on a master production schedule, a material requirements planning system performs the following functions: •

creates schedules identifying the specific parts and materials required to produce end items

•

determines exact numbers needed

•

determines the dates when orders for those materials should be released, based on lead times

MRP does not need carrying of any inventory ahead of requirement. It starts with the finalisation of the production plan in a firm. The production plan then is used by the materials management professionals to explode the 'Bill of Material' which is a complete detailing of the materials needed including their various components. It is exploded for the number of units to be produced, to obtain that product’s exact requirement. Since a given common part is used in many items, sub-assemblies etc, total requirement of that part is summed up to draw a consolidated requirement. Since this exercise is done for a great number of materials, computers become very useful for the purpose. After the bill of material is finalised, its taken over by the materials professionals of the firm who check the availability of any item. A detailed action plan indicating the materials, quantity to be procured and most importantly the time all of these are required at is prepared. Accordingly, the orders are placed and the suppliers are asked to match the given delivery period. In practice, under this system, the production material requirements are calculated on weekly basis. It then generates 38/MITSDE

requisitions for each material to be delivered in the required quantity a given number of days prior to the start of manufacturing operation. Obviously, it puts more pressure on purchasing and production planning rather than on maintenance of inventory. In MRP system, master production schedule which is updated periodically is the force that directly initiates and drives subsequent activities of the purchasing and manufacturing functions. 3.4.1 Applicability of the MRP System •

It is best suited where production is not done on a continuous basis.

•

It is ideally suited for the job shop operations environment.

•

It is ideally suited where the demand is directly dependent on the production of other specific inventory items or finished products.

•

It is used where the demand of the individual components are dependent on the requirement of the main product.

•

It can be used where the flexibility is possible in placement of orders or delivery releases is to be done on short term basis.

3.4.2 Inputs for MRP MRP process is triggered by the Master Production Schedule (MPS) which indicates the production volume of finished products on weekly basis. MPS is the primary input. Therefore, for a successful run of the MRP, MPS must have a time schedule that is greater than the total lead time of the finished product. Bill of Materials (BOM) which is a detailed item wise requirement document is the second input for MPR. It may contain multistage type of products that may require several stages of a number of components to be fitted or converted into leading to the making of the final or finished product. Inventory Record File (IRF) is the third input for MRP. It contains the status of an inventory item. It indicates the current stock position, the past timing and sizes of all orders, including the open orders for the item, the lead time for each item. IRF basically happens to be the past experience and serves as a good reference point for planning for the future MRP. 3.4.3 MRP Process The MRP process involves the following steps: •

Determine the gross requirements for a particular item.

•

Determine the net requirements and when orders will be released for fabrication or subassembly.

•

Net Requirements = Total Requirements – Available Inventory.

•

Net Requirements = (Gross Requirements + Allocations) – (On Hand) + Scheduled Receipts.

•

Develop a master production schedule for the end item (this is the output of the aggregate / production planning).

•

MPS is adjusted accordingly .

•

Create schedules identifying the specific parts and materials required to produce the end items. The bill of materials will be useful here.

•

Determine the exact numbers needed.

•

Determine the dates when orders for those materials should be released, based on lead times.

3.4.4 Outputs of MRP The basic outputs of the MRP system are the planned orders from the planned order release row of the MRP matrix which details the timing and the quantity of subassemblies, parts and raw materials used to plan purchasing and manufacturing actions. Specifically, these outputs include: •

purchase orders - sent to outside suppliers

•

work orders - to be released to the shop floor for in-house production 39/MITSDE

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•

action notices or rescheduling notices - issued for items that are no longer needed as soon as planned or for quantities that may have changed

3.4.5 Benefits of MRP The MRP is a framework for providing useful information for decision makers. The key to realizing the benefits from any MRP system is the ability of the inventory planner to use the information well. The specific benefits of MRP include the following: •

increased customer service and satisfaction

•

improved utilization of facilities and personnel

•

better inventory planning and scheduling

•

fast response to market changes and shifts

•

reduced inventory levels without reduced customer service

The MRP is also a very powerful tool since it takes into consideration changes in certain assumptions especially under uncertain conditions, especially when the inputs to the MRP system change because of the following realities in the production area: •

delays in scheduled receipts

•

changes in planned order sizes because of capacity constraints

•

changes in gross requirements which dictate changes in lot sizes at subcomponent levels

Unavailability of raw materials for one sub-component which negates the need for a fellow sub-component as both must be ready for the parent production. Utilization of same parts at different levels indicating the need to restructure the bill of materials and presence of price discounts or some other features which makes it advisable to purchase more than the anticipated need. Thus MRP can be summarised as being a system which is solely dependent upon three concepts: •

dependent demand

•

inventory / open order netting, and

•

time phasing on the basis of requirement period and the lead time for each item

MRP system, thus, generates a complete set of planned orders for all manufactured parts and purchased materials based on information inputs. Accurate forecast and a timely lead time happen to be the main determinant of its success in a run.

3.5 Inventory Turnover Inventory turnover indicates the ratio of materials consumed to the average inventory held. It is calculated as below: Inventory turnover = Value of material consumed/Average inventory held where, Value of material consumed can be calculated as; Opening Stock + Purchases - Closing Stock Average inventory held can be calculated as; (Opening Stock + Closing Stock)/2 Inventory turnover can be indicated in terms of number of days in which average inventory is consumed. It can be done by dividing 365 days (a year) by inventory turnover ratio. Illustration 1 From the following data for the year ended 31st March, 2010, calculate the inventory turnover ratio. Opening Stock 10,000 40/MITSDE

Purchases during the year Closing Stock

50,000 12,000

Value of material consumed = Opening Stock + Purchases - Closing Stock. = 10,000 + 50,000 – 12,000 = 48,000 Average inventory = (Opening Stock + Closing Stock)/2 = (10,000+ 12,000)/2 = 11,000 Inventory turnover ratio = Value of material consumed /Average Inventory held = 48,000/11,000 = 4.36 times Inventory Turnover Period = 365/ Inventory turnover ratio = 365/4.36 = 84 days Illustration 2 Opening Stock: Closing Stock: Sales:

100 120 1,100

Inventory turnover = Sales / Average Stock = 1,100/110 = 10 times Inventory turnover (Average Stock Holding period) = Average Stock x 365 / Sales = 110 x 365/1,100 = 37 days Inventory turnover (Average Stock Holding %) = Average Stock x 100 / Sales = 110 X 100/1,100 = 10% 3.5.1 Interpretation of Inventory Turnover Inventory turnover of 4 times is concerned as normal. Any turnover more than 4 times is desirable. Average stock holding period of 90 days is concerned as normal. Any stock holding period less than 90 days is desirable. Average stock holding percentage of 25% is concerned as normal. Any Stock Holding percentage less than 25% is desirable. Any turnover more than 4 times also means Stock Holding period less than 90 days which in turn means Stock Holding percentage less than 25%. From the above illustration it can be seen that the Inventory Turnover can be expressed in three ways. The meaning of all the three is same. Inventory turnover of 10 times indicates a very high rate of turnover, which in turn means more profit. 'More turnover, more profit' is the general interpretation.

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Summary •

Inventory models is a mathematical equation or formula that helps a firm in determining the economic order quantity, and the frequency of ordering, to keep goods or services flowing to the customer without interruption or delay.

•

If a manufacturer orders a quantity which is more than the economic order quantity (EOQ) two things will happen: reduction in cost and increase in carrying cost.

•

There are two basic systems of managing or controlling inventory under the independent demand pattern: cyclical ordering or fixed period system (Time based), and order point or fixed order quantity system (Quantity based).

•

Fixed period based systems (also called 'cyclical systems') are designed so that each inventory item is reviewed and reorders are placed after a predetermined time interval

•

Order point system / fixed order quantity system of inventory control is based on the order point and order quantity factors rather than on the time factor.

•

Dependent demand occurs when the need for parts, supplies, or materials is dependent upon a predetermined usage or production schedule. In such cases, a description and quantity of components needed and the exact date of each need is defined by a production schedule.

•

Material requirement planning (MRP) happens to be the best model of dependent demand pattern of inventory. Under it, the requirement of an item is predetermined as it depends upon the actual need of it, triggered by certain production schedule.

•

MRP has two main characteristics: the known requirement and the known period of requirement (time).

•

Materials requirements planning (MRP) is a set of techniques that takes the master production schedule and other information from inventory records and product structure records as inputs to determine the requirements and schedule of timing for each item

•

Inputs of MRP are: master production schedule (MPS), bill of materials (BOM), and inventory record file (IRF).

•

Outputs of MRP are: purchase order, work orders, and action notices.

•

Inventory turnover indicates the ratio of materials consumed to the average inventory held.

References •

2011. Managing Facilitating Goods [Online] (Updated 21st March, 2011) Available at . [Accessed on 21st March 2011]

•

Joshi, Amit, Juyal Ankur, Pasbola Prabhat Inventory Models [Online] (Updated 21st March, 2011) Available at [Accessed on 21st March, 2011]

•

Statistical Inventory Control Models [Online] (Updated 18th March, 2011). Available at .[Accessedon18thMarch2011]

Recommended Reading •

Tijms, H. C., 1972. Analysis of (s S) Inventory Models. 1st ed., Mathematical Centre Tracts;

•

Beyer, D., 2009. Markovian Demand Inventory Models (International Series in Operations Research & Management Science). 1st ed., Springer.

•

Bartmann, D., 1992. Inventory Control: Models and Methods (Lecture Notes in Economics and Mathematical Systems). Springer

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Self Assessment 1. Inventory turnover indicates the ratio of materials consumed to the ____________. a. average inventory held b. opening stock c. closing stock d. purchases 2. The two main characteristics of material requirement planning are the known requirement and _____________. a. known period of manufacturing b. known period of stock c. known period of planning d. known period of requirement 3. Which of the following statements is false? a. MRP is a framework for providing useful information for decision makers. b. MRP does need carrying of any inventory ahead of requirement. c. Material Requirement Planning (MRP) happens to be the best model of dependent demand pattern of Inventory. d. Orders are placed for each item equal to the difference between current inventory level and a predetermined maximum. 4. Which of the following statements is true? a. Many a times the suppliers of raw material come with an offer of discount on the catalogue price if a certain minimum quantity is ordered. b. In cyclical systems, time between reorders is variable, but reorder quantity is constant. c. Predetermined minimums are set with a consideration of order lead time. d. Units of an item are issued until the level of that inventory is low than the predefined reorder point. 5. Average inventory held can be calculated as: a. (Opening Stock + Closing Stock)/3 b. (Opening Stock + Current Stock)/2 c. (Optimum Stock + Closing Stock)/2 d. (Opening Stock + Closing Stock)/2 6. What does DIL stands for? a. Desired Inventory Level b. Determined Inventory Level c. Desired Inventory Lead d. Demand inventory Level

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7. ___________turnover can be indicated in terms of number of days in which average inventory is consumed. a. Stock b. Inventory c. Goods d. Services 8. ___________and a timely lead time happen to be the main determinant of its success in a run. a. Accurate forecast b. Inventory planning c. Fixed order d. Inventory control 9. Order point system / fixed order quantity system of inventory control is based on the: a. order point and order planning b. order time and order quantity c. order point and order quantity d. order point and order turnover 10. The key to realizing the benefits from any MRP system is the: a. ability of the inventory planner to use the information well b. other information from inventory records c. requirement of an item d. demand pattern of inventory

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Chapter IV Purchase Management Aim The aim of this chapter is to: •

explain the concept of purchase management

•

elucidate the objectives of purchasing

•

introduce the students to the concept of vendor management

Objectives The objectives of this chapter are to: •

recognise the functions of purchase management

•

understand the concept of purchase requisition

•

discuss purchase procedure

•

understand different types of requisitions

Learning outcome At the end of this chapter, students will be able to: •

understand the types of tenders

•

know about inspection of materials

•

identify the discrepancies in material receipts

•

know the several ways of carrying out inspection

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4.1 Introduction to Purchase Management Corporate purchasing dates back to its history sometimes to the late 1890s. Purchasing was mainly seen then as a different department except some railroad organizations. Even during the early 1900s, purchasing was considered to be a clerical work. During World War I and II, purchasing function increased due to the importance of obtaining raw materials, supplies and services needed to keep the factories and mines operating. During 1950s and 60s, purchasing continued to gain stature as the techniques for performing the function became more refined and as the number of trained professionals increased but still purchasing agents were basically orderplacing clerical personnel serving in a staff-support position. In the late 1960s and early 70s, purchasing personnel became more integrated with a materials system. As materials became a part of strategic planning, the importance of the purchasing department increased. In the 1970s the oil embargo and the shortage of almost all basic raw materials brought much of business world’s focus to the purchasing arena. The advent of just-in-time purchasing techniques in the 1980s, with its emphasis on inventory control and supplier quality, quantity, timing and dependability, made purchasing a cornerstone of competitive strategy. During early 1990s, value proposition in purchasing is increased. People realized that by letting purchaser negotiate and ask for discount bring lots of cost reduction. Cost savings become a buzz word and of course control over the buying process remains one important function of purchasing. During late 1990s, the purchasing evolved into strategic sourcing. Enterprise wide process that continuously improves and re-evaluates the purchasing activities of a company had started. More emphasis on supplier data base begun. Contracts were sourced for long term basis to have better cost. Supplier relationship building and supplier management started. Purchasing function in a business environment is one of the most critical functions as it provides the input for the organisation to convert into output. Materials today are lifeblood of industry. They must be available at the proper time, in the proper quantity, at the proper place and the proper price. Company costs and company profits are greatly affected by them as normally, a manufacturing organisation spends nearly 50% of its revenue in purchasing. 4.1.1 Objectives of Material Management The key objectives of material management are given below: •

to buy the materials at the lowest price

•

consistent with desired quality and service

•

to maintain continuity of supply of materials and ser vices to users

Purchasing administration plays an important role in this regard. Every organisation establishes a purchase department to carry out different functions. Purchasing is responsible for spending nearly half of a company’s income for buying the input materials. Obviously, any saving achieved by it results into direct saving for the company and all such savings are a company’s profit. One percent saving achieved in purchasing results in 5% profit for any organization.

4.2 Functions of Purchase Department The job of a materials manager is to provide, to the user departments, the right material at the right time in right quantity of right quality at right price from the right source. To meet these objectives, the activities undertaken include selection of sources of supply, finalisation of terms of purchase, placement of purchase orders, follow up, maintenance of relations with vendors, approval of payments to vendors, evaluating, rating and developing vendors. The functions of purchase department are to: •

support company operations with an uninterrupted flow of materials and services

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•

buy competitively and wisely

•

help keep a minimum inventory

•

develop reliable alternate sources of supply

•

develop good vendor relationship and a good continuing supplier relationship

•

achieve maximum integration with the other departments of the firm

•

train and develop highly competent personnel who are motivated to make the firm as well as their department succeed

•

develop policies and procedures which permit accomplishment of the preceding objectives at the lowest reasonable operating cost

Before deciding the quantity to be purchased, the following factors should be taken into consideration: •

Quantity already ordered

•

Quantity reserved: It may happen that a particular quantity, though in hand, might have been reserved for a particular job which is not available for other purposes. In such cases, this quantity is treated as if it is not in stock.

•

Funds availability: Amounts which are kept aside for drawing up purchase budget should be considered are used.

For any organization, purchasing function assumes importance for the reason that it fulfils, to a great extent, the input needs of the organization. An organization needs input of right quality at right price from the right source in right quantity at the right time. Called 5 R’s (right things to do), these determine the broad parameters within which the purchasing functions in any organization. Depending upon the size and nature of operation, the quantum of purchase of product and services vary. Purchase Department carries out all the tasks associated with the development of policies, procedures, controls and the mechanics for coordinating purchasing operations with those of other departments. The following are the important activities of a purchase department: •

Buying activity: It addresses to a wide gamut of activities such as, reviewing requisitions, analyzing specifications, investigating vendors, interviewing sales people studying costs and prices and negotiating.

•

Expediting: This is basically the order follow up activity involving various types of vendor relationship work. It involves reviewing order status, providing clarifications on transportation, writing and emailing vendors etc.

•

Special projects (Non routine): In order to facilitate smooth purchasing in a highly competitive business environment, purchasing authorities have to keep building the capacity to do better by taking up as special projects activities such as vendor development, vendor registration, value analysis, market studies, system studies etc.

•

Routine: Purchasing process or procedure involving routine or every day activities such as dealing specific purchase file, placing orders, maintaining records of commodities, vendors etc.

4.2.1 Purchasing Function vs. Purchase Department Purchasing functions

Purchase department

• This function is commonly seen in all those • It is a unit of an organisation that performs organisations that undertake purchasing activipurchasing function. ties. • It is directed by an efficient manager to • It is usually performed by a specialised and achieve the performance in an economical centralised purchasing department. manner. Table 4.1 Purchasing function vs. purchase department

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4.2.2 Procurement vs. Purchasing Procurement is one of several supply functions involved in logistics activities. In the broadest sense procurement includes the entire process by which all classes of resources (people, materials, facilities and services) for a particular project are obtained. Where as, Purchasing is a unique function, it differs a bit from procurement in the sense that while procurement, with the same objective has a wider domain, purchasing with the same objective is included in it. 4.2.3 Objectives of Purchasing The basic objective of purchasing is to derive the maximum value for each unit of money spent in buying. A purchaser has to find answers to the following questions: •

Are we buying at right cost?

•

Supplier is producing it at right quantity or not?

•

Whether supplier is producing the right product or not?

•

Whether material will come at right time or not?

•

Whether buyer is buying for the company or for personnel gain?

Formalized systems and procedures are required to run its purchasing function, to ease in operation and accountability. Formal procedures are required to be laid down for initiating purchase, selecting suppliers, placing purchase orders, follow-up, receiving materials and so on.

4.3 Purchase Requisition Purchase Requisition is an indication given to the purchases department to purchase certain material. It is issued either by the storekeeper (in respect of material required for regular production purposes) or by production department (in respect of special materials required). Following particulars must appear in purchase requisition: •

Material to be purchased: It should be clearly specified. To make it more specific, in addition to the description of the material required, the code number should also be specified.

•

When it is required: Unless the material is required for regular production purposes (when the storekeeper himself will place the purchase requisition as soon as it reaches the ordering level), purchase requisition should mention the last date by which the material is required. Ideally, the material should be purchased whenever the market for the same is favourable.

•

How much to be purchased: Purchase requisition should state the quantity of the material required.

4.3.1 Types of Purchase Requisitions Different kinds of requisitions used are as follows: Standard requisition Also called as indent for material (or service), materials requisition plan etc., a requisition is made by an authorized person in the concerned department. However, it has to be countersigned by a senior officer who checks the entries made in. Normally, a requisition, in a pre-printed format, contains particulars such as, the detailed description of materials or services to be purchased, desired quantity, schedule for receipt of such material/service, the estimated price, possible sources and the account head, requisitioner’s identity. In any organisation, only a limited number of personnel are empowered to countersign the requisition as it amounts to authorisation of the expenditure. Purchase department usually maintains a list of such officers so as to check the validity of the purchase requisitions. Normally, there is a delegation of power of authority for authorising a requisition. This is expressed in terms of the financial limits up to which an officer can authorise a requisition for a capital or revenue item. These details must also be available with the purchase department. 48/MITSDE

Travelling requisition As the name suggests, this requisition form travels from the requisitioning department to the purchaser directly who then only authorizes the supplier through a purchase order to deliver the required material. This document is generally used for requisitioning items that are required frequently in bulk quantities over a long period of time. Usually, for repeat items such as, in inventory, a card containing the details of previous supply containing material specifications, suppliers details, last purchased price , reorder point, usage details are written permanently and provisions for entering date, quantity required, names of requisitioned and authoriser are available. On getting it, the purchaser only has to take these details for placement of order. The travelling requisition which is a permanent document of the originating department is returned to it. It reduces the paper work and eases the operation. Bills of materials Bill of material is a comprehensive list of materials needed to produce a product or service. It is basically the details of materials needed, their specification, quantity, required delivery schedule etc. It is often used as a sequel to firming of a production plan, a stage where the exact material/service needs are known.

4.4 Purchase Procedure A purchase department is usually engaged in purchasing a number of materials and services falling in different categories. The activities are performed regularly by purchase professionals with the objective of fulfilling organisation’s materials and services needs. Therefore, depending upon the nature of procurement, environmental practices etc the purchasing systems and procedures may also vary substantially. However, purchase procedure can be seen to have a bit of standardisation across the globe. A professional purchasing system does show following steps that eventually constitute a purchasing cycle: •

recognition and description of need

•

transmission of need

•

selection of source to satisfy the need

•

contracting with the accepted source

•

following up with the source

•

receiving and inspecting material

•

payment and closure of the case

4.5 Types of Purchasing The following are the different types of purchasing: •

Forward buying

•

Tender buying

•

Systems contract

•

Speculative buying

•

Rate contracts

•

Reciprocity in buying

•

Zero stock buying

•

Blanket orders

4.5.1 Forward Buying Forward buying, as the name suggests, is the system under which buying is done with longer term in perspective. It is not meant for meeting the present consumption requirement. It is rather a commitment on part of both the buyer and the seller, normally for a period of one year. Depending upon the availability of the item, the financial policies, the economic order quantity, the quantitative discounts and the staggered delivery, the future commitment is decided. A few organisations do hedge, particularly in the commodity market by selling or buying contracts. 49/MITSDE

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Forward buying helps a firm in booking capacity of a supplier and thus often results into a safeguard against a competitor acquiring his capacity. It is usually done for raw materials but is not limited to it. Such an arrangement is a win-win situation for both, the buyer and the supplier 4.5.2 Tender Buying Tender buying has always been considered the only way of buying materials / services in the government and quasi government procurements. Selecting a supply source (supplier) out of many sources available is called tender buying. Many applicants are invited to participate in the tendering process and then one or more than one tender is selected for order placement. Such tenders are also called the accepted tender/s (A/Ts). The main focus through tender buying is on competition of price and quality. Usually, the best quality (T1 or Q1) is selected after assessment of the technical offers and then the lowest offered price (L1) tender is selected for order placement. Process of tender buying •

A purchase function starts with the raising of a requisition (indent/material procurement requisition) for an item which is required for a stated purpose.

•

This requisition is then converted into an enquiry form which is issued to the probable vendors who are asked to respond within a given date and time (called tender opening date) as mentioned in the enquiry issued to them.

•

The interested vendors respond to the tender enquiry by giving their tenders.

•

Tenders thus, received are opened on the tender opening date at the fixed time.

•

The tenders are then subjected to evaluation with respect to a tenderer’s capability, financial as well as technical, and other criteria as laid down in the tender enquiry.

•

This step also witnesses series of discussions, clarifications and negotiation with the tenderers.

•

Some tenders can be rejected at this stage as they might not meet the requirement of the purchaser.

•

Finally, the tenders that are found suitable are subjected to price comparison and usually the tenderer offering the lowest price (L1) is selected for placement of order.

•

The process explained above shows a great deal of variations depending upon a company’s procurement policy.

•

In some places, the best quality offering tenders are accepted for subsequent price comparison whereas in some other place all the tenderer’s who meet the minimum requirement are considered accepted for price comparison and order placement.

•

Similarly, in some places the order is placed only on L1 (lowest offered price) whereas in some other places it may not be rigidly followed so. Price/Quantity

High

Medium

Low

Low

Q1L1

Q2L1

Q3L1

Medium

Q1L2

Q2L2

Q3L2

High

Q1L3

Q2L3

Q3L3

Table 4.2 Matrix of price and quality of the tenders Q1L1, Q1L2 and Q1L3 are short listed. After negotiations Q1L1 is selected normally. Q3L1, Q3L2 and Q3L3 are normally rejected at the initial stage. Types of tenders Since the tenders are sent to the probable vendors, knowledge of vendors for the item in question is a necessity. It’s based on this concept that the types or mode of tendering is decided against a particular purchase requisition. Most 50/MITSDE

commonly used types of tendering / tender buying are mentioned below: •

Global tender ‚‚ A global tender is floated with a view to elicit offers/response from any vendor situated anywhere in the world. ‚‚ The need for a global tender arises when the purchaser either does not know about the vendors for a particular item in question or when he thinks that a wider choice of vendor is possible through it, irrespective of his nation’s boundaries.

•

Open tender ‚‚ An open tender too like a global tender tends to invite tender from any interested vendor. ‚‚ The basic difference assumed between an open tender and a global tender enquiry is essentially the range of its applicability. While a global tender gets the worldwide publicity, an open tender is limited only within a country. Otherwise, the concept remains the same as it also seeks to elicit better or wider response. ‚‚ Since the open tender enquiry is limited within the country itself, besides the internet mode, the enquiry is also printed in the national dailies, internal trade bulletins etc. for ensuring its wide publicity, within the country. Any vendor who meets the tender requirements can make an offer.

•

Limited tender ‚‚ When the issue of tender enquiry is limited only to a selected few vendors, it is called limited tender enquiry (LTE). ‚‚ LTE is issued when the capabilities of the vendors is well known to the purchaser. ‚‚ It is considered better than global and open tender modes as there is always an element of uncertainty in those two modes with respect to the capabilities of the vendors. ‚‚ For issuing LTE, a purchaser maintains a list of approved /registered vendors whose capabilities are checked periodically.

•

Single tender enquiry ‚‚ An STE is issued only when either the item is proprietary in nature, that is only one supplier produces that item or where there may be more vendors but due to certain exigencies it is not possible to devote time on evaluating the vendors’ offers/one supplier can fulfil the needs. ‚‚ The mode to tender depends on many factors as well a company’s procurement policy. For example, for a small value purchase, if the policy does not prohibit, single tender enquiry or limited tender enquiry is considered ideal. ‚‚ These are also ideal for high value and frequently bought items. On the other hand, for high value and nonfrequently bought items/systems, open/global tenders are suited. ‚‚ In many government organisations, whose procurements are also called public procurements for the reason that they spend public money for the public cause, all the tenders are to be invited only through open/global tenders.

4.5.3 Systems Contract Systems contract is a contract of system of buyer with that of the seller. It is a release system in which items, usually, commonly available off-the-shelf, are identified and pre-priced in anticipation of certain usage. Delivery releases are made against existing orders placed by purchase. This is a procedure intended to help the buyer and the seller to reduce administrative expenses and at the same time to ensure proper controls. The system authorises the designated persons of the buyer to place orders directly to the supplier with the specific materials during a given contract period. The contract is thus finalised only after it is ensured that an attempt has been made to integrate as many buyer-seller materials management functions as possible. In this system the original indent, duly approved by competent authorities, is shipped back with the items and avoiding the usual documents like purchase orders, materials requisitions, expediting letters and acknowledgements, goods in transit report, etc. The contract is simple, covering only delivery period, price and invoicing procedure. System contracting is particularly useful for items with low unit price and high consumption profile and thus, relieves the 51/MITSDE

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buyers of the routine work. While systems contract has certain features in common with other purchasing agreements, it is this integration of buyer-seller operations that clearly distinguishes it from other types of contracts. Obviously, the systems contracts are an excellent way of simultaneously cutting costs while building efficiencies through simplifications. 4.5.4 Speculative Buying When purchasing is done purely from the point of view of taking advantage of a speculated rise in price of the commodity it is called speculative buying. The intent is not to buy for the internal consumption but to resell the commodity at a later date when the prices have gone up and to make a profit by selling. The items may be those that are needed for internal consumption but the quantity shall be much more than the requirement so as to take advantage of the coming price rise. 4.5.5 Rate Contracts Rate contracts are mutual agreements between the buyer and the seller to operate a set of chosen items, during a given period of time, for a fixed price or price variation. Under this system the rates are fixed and at times even the quantity of the selected items. As and when the need arises the buyer issues a purchase order directly on the basis of the rate chart available on the supplier who in turn supplies the items. The system of rate contract is prevalent in public sector organisations and government departments. It is common for the suppliers to advertise that they are on rate contract with the DGS & D (Directorate General of Supply & Disposal), for the specific period for the given items. After negotiation, the seller and the buyer agree to the rates of items. Application of rate contract helps organisations cut down the internal administrative lead time as individual firms need not go through the central purchasing departments and can place orders directly with the suppliers. However, suppliers always demand higher prices for prompt delivery, as rate contracts normally stipulate only the rate and not the schedule on which the item is needed. This difficulty has been avoided by ensuring the delivery of a minimum quantity at the agreed rates. This procedure of fixing a minimum quantity is called the running contract and is being practiced by the railways and the DGS&D. As mentioned above, this system of buying helps an organisation reduce its internal as well as the external lead time, reduces administrative work load as the files don’t need to go up and down, helps in building buyer-supplier relationship as the contract period is usually one year and then there is always a chance of the same players doing the next contract.

The system works well normally in a situation where the selected items are routinely consumed. However, there is no compulsion that the demand be uniform over the period of time. 4.5.6 Reciprocity in Buying In certain business situations a buyer may give preference to a supplier who also happens to be his customer. This relationship is known as reciprocity. It is something like 'I buy from you if you buy from me'. One of the main questions for which this, otherwise simple way of buying, is always under the scanner of purchasing ethics is its undue ability to restrict competition and fair play. One of the major roles that any purchaser plays for his firm is in cost reduction arena which is attempted by generating competition among the suppliers. This principle gets a jolt through reciprocity in buying. However, when factors such as quality, after sales service, price etc, are equal normally a buyer would like to buy from his customer, if for nothing then at least for having a good working relationship. However, the distinct disadvantages of reciprocal buying outweigh the limited and narrow advantage that a firm may derive out of it.

Some of the main disadvantages of reciprocity are not being able to follow the well laid criteria of quality, price and service. 52/MITSDE

A purchasing executive should not indulge in reciprocity on his initiative when the terms and conditions are not equal with other suppliers. It is often found that less efficient manufacturers and distributors gain by reciprocity what they are unable to gain by price and quality. Since this tends to discourage competition and might lead to higher prices and fewer suppliers, reciprocity should be practiced on a selective basis. 4.5.7 Zero Stock Buying Zero stock buying refers to buying in a manner that the system ensures that the material is delivered by the seller only when it is required and that no prior inventory of the item is maintained by the buyer. As the competition becomes more intense the need for a lean manufacturing system becomes more focussed. Keeping inventory thus is blocking huge money that is idle for the firm. Thus, zero stock buying is more of an inventory safeguard rather than the normal buying. Normally, under this system the firms try to operate on the basis of zero stock and the supplier holds the stock for these firms. Usually, the firms of the buyer and seller are close to each other so that the raw material of one is the finished product of another. Alternatively, the system could work well if the seller holds the inventory and if the two parties work in close coordination. However, the price per item in this system is slightly higher as the supplier may include the inventory carrying cost in the price. In this system, the buyer need not lock up the capital and so the purchasing routine is reduced. This also significantly reduces obsolescence of inventory, lead time and clerical efforts in paper work. Thus, the seller can devote his marketing efforts to other customers and production scheduling becomes easy. In practice, the buyer is called upon to pay to the supplier only when the material is delivered as per the need. For example, in India, say the Indian Oil Limited maintains its petrol and diesel refilling stations inside the manufacturing premises of many companies. As and when petrol or diesel is required, say in a lorry, IOL fills that and a coupon is signed by the driver of the lorry. Buyer makes the payment to IOL against that coupon. Zero stock is becoming popular with the concepts such as Just-in-time approach that is similar to it. However, in situations where the supplier has to transport material from one place to the other with a fair distance in between, this system needs careful handling as one never knows the road or weather conditions. Normally, the system caters to those items that are not very critical to manufacturing. It best suits the situations where the output of one firm is the input of the other firm with both the firms located nearby. 4.5.8 Blanket Orders Under this system, an agreement is done between the buyer and the supplier to provide a required quantity of specified items, over a period of time, usually for one year, at an agreed price. This system minimises the administrative expenses and is useful for ‘C’ class items for which rigid controls are not required. Deliveries are made depending upon the buyer’s needs. The system relieves the buyer from routine work, giving him more time for focusing attention on high value items such as ‘A’ and part of ‘B’ class. It requires fewer purchase orders and thus reduces clerical work. It often achieves lower prices through quantity discounts by grouping the requirements. The supplier, under the system, maintains adequate inventory to meet the blanket orders, but he does not incur selling costs, once the negotiations are finalised.

4.6 Vendor Management Prerequisite to a successful materials management is the availability of a sound vendor base which is now rightly acknowledged as an extended arm of the business. One of main reasons of failure of many supply chains has been the inability to hold trusted vendors together. Vendor management, therefore, requires careful planning and execution, over a fairly long period of time. Management of vendors is attempted through the following ways: •

Vendor Registration

•

Vendor Development

•

Vendor Rating 53/MITSDE

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•

Vendor Exploration

For ensuring continuous supply of right quality materials required, at the optimum cost, it is essential to have a dependable, competent & competitive vendor base. The Limited Tender Enquiry (LTE) is issued only when reliable manufacturers/suppliers/traders/contractors are known and for this purpose, there is a need to maintain a list of registered vendors. So, vendors are empanelled for the supply of various categories/subcategories of items. Vendor registration For this purpose, the vendors interested to supply the specific category/subcategory of items are asked to submit the application along with all the documents required to establish their financial & technical capability. The application forms so received are scrutinized and the vendor capacity assessment is carried out through inspection department / technical experts to establish the technical capability of the vendors. These vendors are listed as ‘registered’ after following up certain processes. Vendor development Many process industries like to search the alternative and less costly material as substitution of the currently used costlier materials. The less the procurement cost the more is the profit. Also, there may be situations where the existing suppliers may not be willing to supply the items on various grounds, thus, necessitating, looking into different alternatives. An efficient materials manager would devote enough time to develop substitutes & sources of supply with a view to reduce cost of input materials and also to have reliable alternative source for foreign sources. Normally, in large manufacturing organisations, a Vendor Development Cell (VDC) remains engaged all through for the purpose. When the need to develop a vendor for an item is felt the requisition for such items is made by concerned department indicating the trial quantity and the potential vendors. Trial orders are placed on potential vendors and also necessary help is rendered to them to come up to the desired level. Vendor rating The vendors also like to be given priority to be the purchaser if it constantly improves its selling performance which from a purchaser point of view is mainly its offered price, quality and punctuality in delivery. For purchaser, there shall always be a need to continuously monitor and update its registered vendor base so that the organisation continues to have the most competent & competitive vendors in its list of vendors. For this purpose the efforts are made to monitor supply performance of the vendors and rate them objectively. The major factors usually considered for such vendor rating are competitiveness of vendor (price), quality of supply and delivery adherence. Vendor rating may also be used for removing a vendor from registered vendor list and also in the selection of vendors while issuing Limited Tender Enquiry. Vendor exploration To have competitive & competent sources of supply, efforts are made to explore suitable vendors from various sources like, internet websites, international bulletins, vendors list of other similar manufacturing organisations etc. This is known as vendor exploration and in the competitive environment it is taken as a serious activity.

4.7 Inspection of Materials Any organization, big or small, shall look for quality input (materials) from suppliers to have the desired output or use. For this reason, it devises ways to control the incoming materials by having a check system on quantity, quality and readiness for use. Control on incoming materials is exercised through inspection by the purchaser. Inspection is an important aspect of integrated materials management. It is an accessory to the purchase function to ensure that the incoming materials of right quality are procured for use. The word quality has numerous meanings. The most appropriate meaning of quality in the present context is “Conformance to Ordered Specification & Fitness for Use”, whether for products or services. Depending upon the nature, criticality & value of items, inspection is conducted either at supplier’s premises or at plant 54/MITSDE

stores after receipt. There are several ways of carrying out inspection. A few of these are mentioned below: 4.7.1 Pre Dispatch Inspection This is inspection before dispatch of material. Usually specified in the Purchase Order (PO), the inspection is carried out at supplier’s premises (works). Supplier gives an Inspection Request (IR) to the inspection agency mentioned in the PO. On receipt of IR, the inspecting officer visits the supplier’s premises along with documents necessary for inspecting such as copy of PO, drawing, specification etc. The following checks are conducted depending on the nature of item: •

Visual check

•

Dimensional check

•

Functional check

•

Physical testing such as hardness, pressure test, load test etc

•

Electrical and other on-bed testing such as high voltage test, insulation resistance test etc.

The accepted materials are marked by stamping/punching/stickers/ seal/ tag etc as a mark of acceptance. The supplier is asked to deliver the same to the consignee as mentioned in the PO. 4.7.2 Stage Inspection / Final Inspection For critical items, it is required to conduct stage inspection of semi-finished items (such as, castings, forgings etc.) at suppliers premises. In such cases, the supplier gives an interim Inspection Request (IR) to the inspection agency. During stage inspection, sample is collected by the inspecting officer for chemical analysis / physical testing at either their own facility or at 3rd party locations. On receipt of test results, conformance to specification is verified & clearance is given to the supplier for further processing of the item. After readiness of the material in all respect & internal checking, the supplier gives the final inspection request to the inspection agency. In some critical cases, joint inspection by indenter & inspection is carried out at supplier’s premises. 4.7.3 Document Inspection Sometimes and usually for every standard ,off the shelf items, inspection can be carried out through the verification of supplier given certificates such as, Material Test Certificate (MTC), Manufacturing Certificate (Mfg. TC), Guarantee Certificate (GC) etc. After ensuring conformance of materials to the ordered specification in all respect, Inspection Certificate (IC) is issued by the inspecting officer to the supplier. 4.7.4 Stores/Receipt Inspection Majority of items are inspected through this route. Materials are received in the receiving bays of stores. Such items are usually accepted based on visual examination & verification of documents. Materials in the receiving bay are segregated into several categories, based on their quality control status and destination. Procedures in receiving provide for storage and transport of material in each category.

The major categories include: •

Awaiting inspection - This category consists of material that has been received and is awaiting inspection before being moved into stock.

•

Acceptance upon certification - This category consists of material that may be accepted pending certification.

•

Rework - This category contains the materials that are defective and must be reworked.

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•

Return - This category contains materials that are defective and will be returned to the supplier for credit or replacement.

•

Materials to be tested - This category consists of materials which have been received and are awaiting delivery to the using/testing department.

4.7.5 Third Party Inspection In case of specialized items, which require special proficiency for inspection, help of third party inspection agencies is taken. After material is received from the supplier, the quantity received actually, is compared with quantity ordered. Variations, if any, are taken up with the supplier again.

Excess material received may be dealt with using any of the following ways: •

accepting all the material received

•

accepting the material ordered and return the excess to the supplier

Before accepting, material may be subjected to inspection. The extent of inspection may vary from material to material. The supplier’s invoice received for the supply of material is subjected to scrutiny before a voucher is passed for the same for making the entry in the books of accounts. For this purpose, the supplier’s invoice may be compared along with the following documents. •

Purchase Order

•

Goods Received Note

•

Inspection Report

If the quantity and/or rate as per purchase order and invoice match with each other, the invoice of the supplier is passed for making the entry in the books of accounts. If the quantity and/or rate as per purchase order and invoice differ from each other, the difference is adjusted by raising a debit or credit note in favour of the supplier. Discrepancies in material receipts The material physically received when compared with material ordered as per the purchase order may reveal certain discrepancies which may take any of the following forms. •

Quantity received in excess

•

Quantity received in short

• Quantity received of different quality Excess quantity received may be retained and accepted, if required, with the approval of the purchase department. Alternatively, if it is not accepted, it may be returned to the supplier with Goods Returned Note (GRN). The usual form in which Goods Returned Note is prepared in the following format: GOODS RETURNED NOTE To: No. Date: Following material supplied by you vide your D.C. No.____________ and Invoice No.____________ against our Purchase Order No. ______________is being returned to you for the reasons stated below: Description

Quantity

Reasons

Signature Usually, three copies of Goods Returned Note (GRN) are prepared to be distributed as below: •

one copy to the supplier

•

one copy to the purchase department

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•

one copy to be retained by the stores department

Excess quantity accepted If excess quantity is already billed in the invoice, it will be approved and paid. If not, either the supplier may be asked to give a supplementary invoice or credit note may be issued to the supplier for amending the amount. Excess quantity returned If excess quantity is already billed in the invoice, debit note may be issued to the supplier for amending the amount. In case the quantity received is short, purchase department may take up the case with the supplier or carrier or insurer as per the terms of purchases. If quantity short supplied is billed in the invoice, invoice is suitably amended and debit note is issued to the supplier. If quantity received is of different quality and is rejected in inspection, it can either be retained or returned. It may be retained by accepting some mutually decided concessional price. The variation in prices may be adjusted by issuing either the credit note or debit note in favour of the supplier.

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Summary •

Purchasing function in a business environment is one of the most critical functions as it provides the input for the organisation to convert into output.

•

Purchasing is responsible for spending nearly half of a company’s income for buying the input materials.

•

The job of a materials manager is to provide, to the user departments right material at the right time in right quantity of right quality at right price from the right source.

•

Factors to be kept in mind before deciding the quantity to be purchased are: quantity already ordered, quantity reserved and funds availability.

•

The important activities of purchase department are: buying activity, expediting, special projects, and routine.

•

Purchase Requisition is an indication given to the purchases department to purchase certain material. It is issued either by the storekeeper or by production department.

•

Standard requisition is also called as indent for material; it is a requisition is made by an authorized person in the concerned department, which has to be countersigned by a senior officer who checks the entries made in.

•

Travelling requisition form travels from the requisitioning department to the purchaser directly who then only authorizes the supplier through a purchase order to deliver the required material.

•

Bill of material is a comprehensive list of materials needed to produce a product or service. It is often used as a sequel to firming of a production plan, a stage where the exact material/service needs are known.

•

The steps in a purchasing cycle are: recognition and description of need, transmission of need, selection of source to satisfy the need, contracting with the accepted source, following up with the source, receiving and inspecting material, and payment and closure of the case.

•

Different types of purchasing are: forward buying, tender buying, systems contract, speculative buying, rate contracts, reciprocity in buying, zero stock buying and blank orders.

•

A global tender is floated with a view to elicit offers/response from any vendor situated anywhere in the world.

•

An open tender too like a global tender tends to invite tender from any interested vendor. The basic difference assumed between an open tender and a global tender enquiry is essentially the range of its applicability. While a global tender gets the worldwide publicity, an open tender is limited only within a country.

•

When the issue of tender enquiry is limited only to a selected few vendors, it is called Limited Tender Enquiry (LTE). LTE is issued when the capabilities of the vendors is well known to the purchaser.

•

A Single Tender Enquiry (STE) is issued only when either the item is proprietary in nature, that is only one supplier produces that item or where there may be more vendors but due to certain exigencies it is not possible to devote time on evaluating the vendors’ offers / one supplier can fulfil the needs.

•

Management of vendors is attempted through; vendor Registration, vendor Development, vendor rating, and vendor Exploration.

•

Control on incoming materials is exercised through inspection by the purchaser. Inspection is an important aspect of integrated materials management.

References •

Aher, Kiran, 22nd March,. 2011, Purchasing Management [Online] (Updated 22nd March, 2011) Available at < http://www.authorstream.com/Presentation/kiranaher1989-387753-purchase-management-mgmt-entertainmentppt-powerpoint/>. [Accessed on 22nd March 2011]

•

22nd March, 2011, Purchasing Management [Online] (Updated 22nd March, 2011) Available at . [Accessed on 22nd March 2011]

•

22nd March, 2011, Purchase Management [Online] (Updated 22nd March, 2011) Available at . [Accessed on 22nd March 2011]

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Recommended Reading •

Anderson, Ernest L. & Morgan, James P., 1998. The Systems Purchasing Breakthrough. 1st ed., Cahners Pub. Co.

•

Farrington, B., 2001. Creative Control of Purchase Prices. Spiro Press.

•

Sabri, Ehap H. & Gupta A., 2006. Purchase Order Management Best Practices: Process, Technology, and Change Management. J. Ross Publishing.

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Self Assessment 1. Standard requisition is also known as: a. Bill of materials b. Indent of material c. Open requisition d. Global requisition 2. __________is basically the order follow up activity involving various types of vendor relationship work a. Expediting b. Purchasing c. Selling d. Inspection 3. Which of the following statements is false? a. Purchasing is responsible for spending nearly half of a company’s income for buying the input materials. b. For any organization, purchasing function assumes importance for the reason that it fulfils, to a great extent, the input needs of the organization. c. An organization needs input of right quality, at right price, from the right source in right quantity at the right time. d. Formalized systems and procedures are required to run its manufacturing function, to ease in operation and accountability. 4. __________ is one of several supply functions involved in logistics activities a. Procurement b. Inspection c. Tender buying d. Purchasing 5. The basic difference assumed between an open tender and a global tender enquiry is: a. order follow up activity b. capabilities of the vendors c. receiving and inspecting material d. essentially the range of its applicability 6. Which of the following is issued only when either the item is proprietary in nature, that is only one supplier produces that item or where there may be more vendors? a. Open tender b. Single tender enquiry c. Global tender d. Limited tender enquiry

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7. Which of the following statements is true? a. A purchase department is usually engaged in purchasing a number of materials and services falling in one category. b. Forward buying helps a firm in booking capacity of a supplier and thus often results into a safeguard against a competitor acquiring his capacity. c. Tender buying is selecting five supply sources or suppliers out of many sources available. d. A global tender is floated with a view to elicit offers/response from any vendor situated anywhere with in the country. 8. In certain business situations a buyer may give preference to a supplier who also happens to be his customer, this relationship is known as ________. a. reciprocity b. indentation c. expediting d. procurement 9. _____________is a comprehensive list of materials needed to produce a product or service. a. Purchase requisition b. Inventory list c. Bill of material d. Open tender

10. Materials in the receiving bay are segregated into several categories, based on their quality control status and________. a. destination b. industry type c. cost d. usage

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Chapter V Stores Management Aim The aim of this chapter is to: •

introduce the students to the concept of store management

•

explain the functions of stores department

•

elucidate the company motives to hold the inventory

Objectives The objectives of this chapter are to: •

recognise the four types of movements of material from the stores department

•

understand the concept of bin card and stores ledger

•

discuss proper storage function

Learning outcome At the end of this chapter, students will be able to: •

understand the methods for valuation of issues

•

know about valuation of material in three ways

•

understand the comparison of value of stock under different methods

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5.1 Introduction to Stores Management Management of inventory assumes importance due to the fact that investment in inventory constitutes one of the major investments in current assets. The various forms in which a manufacturing concern may carry inventory are: •

Raw Material: These represent inputs purchased and stored to be converted into finished products in future by making certain manufacturing process on the same.

•

Work in Progress: These represent semi-manufactured products which need further processing before they can be treated as finished products.

•

Finished Goods: These represent the finished products ready for sale in the market.

•

Stores and Supplies: These represent that part of the inventory which does not become a part of final product but are required for production process. They may be in the form of cotton waste, oil and lubricants, soaps, brooms, light bulbs etc. Normally, they form a very minor part of total inventory and do not involve significant investment.

5.1.1 Motive to Hold Inventory A company may hold the inventory with the following motives: •

Transaction motive: A company may be required to hold the inventories in order to facilitate the smooth and uninterrupted production and sales operations. It may not be possible for the company to procure raw material whenever necessary. There may be a time lag between the demand for the material and its supply. Hence it is needed to hold the raw material inventory. Similarly, it may not be possible to produce the goods immediately after they are demanded by the customers. Hence it is needed to hold the finished goods inventory. The need to hold work in progress may arise due to production cycle.

•

Precautionary motive: In addition to the requirement to hold the inventories for routine transactions, the company may like to hold them to guard against the risk of unpredictable changes in demand and supply forces. For example- the supply of raw material may get delayed due to the factors like, strike, transport, disruption, short supply, lengthy processes involved in import of the raw materials etc. Hence the company should maintain sufficient level of inventories to take care of such situations. Similarly, the demand for finished goods may suddenly increase (especially in case of seasonal types of products) and if the company is unable to supply them, it may mean gain of the competitions. Hence, the company will like to maintain sufficient stock of finished goods.

•

Speculative motive: A company may like to purchase and stock the inventory in the quantity which is more than needed for production and sales purpose. This may be with the intention to get the advantages in terms of quantity discounts connected with bulk purchasing or anticipated price rise.

After the material is received, inspected and approved, the process of storing comes into operation which deals with storing the material in good condition till it is required for use by production departments and issuing the same whenever required. Stores department plays an important role in this respect.

5.2 Functions of Stores Department The following are the types of movement of the material from the stores department: •

Receipt of material

•

Issue of material

•

Return of material from Production Department to Stores Department.

•

Transfer of material

5.2.1 Receipt of Material Usually the receipt of material is accompanied by delivery challan given by the supplier. On receipt of the material, quantity received is checked with the quantity ordered by the stores department. The received material may be inspected, before acceptance either by separate inspection department or by stores department itself. A document known as Goods Received Note or Goods Received Report (GRN or GRR) is prepared to record the details of the 63/MITSDE

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material received. The usual form in which GRN or GRR is prepared is as below: GOODS RECEIVED NOTE No. Date: S. No. Description

Code Qty. Recd.

Qty. Accepted Qty. Rejected Remarks

Prepared by

Received by

Inspected by



Store Keeper

It may be prepared in quadruplicate to be distributed as follows: •

one copy to purchases department for comparing with purchases order and approving the invoice of the supplier

•

one copy to accounts department for making the payment of supplier’s invoice

•

one copy to costing department for pricing and entering in stores record

•

one copy to be retained by stores department

GRN/GRR should be serially numbered in order to locate the material which is physically received but for which invoice is not received. 5.2.2 Issue of Material Here, the issue of material refers to issue of material from stores department to production department. The material should not be issued from the stores unless a proper authority in writing is produced before the stores department. Usually, this authority is in the form of material requisition note or material requisition slip. The normal contents of this note/slip are as follows: •

number and date (ideally, they should be serially numbered)

•

department demanding the material

•

description and code of material demanded

•

quantity of material demanded

•

signature of authority approving the demand

•

signature of the person receiving the material

Normally one note/slip is prepared for requisitioning a single item of material. The usual form in which it is prepared is as below:

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MATERIAL REQUISITION NOTE Production/Job Order No. No. Bill of Materials No. Date : Department :

Description Code Qty. Unit Cost (for costing Dept. only)

Rate per unit Authorised by

Issued by

Received by

Amount Rs. Entered by

Valued by

Normally, it is prepared in three copies. Two copies to stores department which in turn passes one copy to costing department for pricing while second copy is retained by the stores department. One copy is for demanding department. 5.2.3 Return of Material There can be some situations, when material once issued to production department is returned back to the stores. It can happen in the following circumstances. •

material issued in excess than the requirement

• scrap or defective work arising out of the production processes Under these circumstances, a document in the form of materials returned note is prepared, which is to record return of unused materials. The usual form in which this document is prepared is as below:

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MATERIALS RETURNED NOTE Production/Job Order No.

No.

Bill of Materials No.

Date :

Department : Description

Code

Qty.

Unit Cost (for costing Dept. only)

Rate per unit Amount Rs. Authorised by



Received by

Posted by

As far as the valuation of the returned material is concerned, it may be treated as the fresh receipt of the material or alternatively, it may be treated as the negative (minus) issues. 5.2.4 Transfer of Materials In some situations, considering the urgency for the requirement of the material, it may be necessary to transfer the material from one production/job order to another. Such transfer of material is usually accompanied by preparing a document in the form of material transfer note. The usual form in which this document is prepared is as below: MATERIAL TRANSFER NOTE No. Date : From…………Dept. To…………..Dept. Production/Job

Production/Job

Order No.

Order No.

Description

Qty. Cost (for costing Dept. only)

Code No.

Rate per unit Authorised by

Amount Rs.

Received by

Posted by

Transfer of materials does not result into any fresh issue of material. However, material transfer notes will have to be valued and considered in order to compute the material cost as per the job orders and production orders. 5.2.5 Proper Storage Function The proper conduct of storage function requires that material should be properly stored in a good condition till it is required for use by production departments and should be issued whenever required. This proper conduct is ensured by what is known as 'Perpetual Inventory System'. The aims of the perpetual inventory system are two fold: •

Recording receipts and issues in such a way so as to know at any time, the stock in hand, in quantity and/or value, without the need of physical counting. This aim is achieved by maintaining what is called as bin card and stores ledger.

•

Continuous verification of physical stock at regular intervals.

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Bin Card It is only a quantitative record of receipts, issues and closing balance of an item of material. Separate bin card is maintained for each item of material. The usual form in which a bin card is maintained is as below. BIN CARD Description

Maximum level

Code No.

Minimum level

Location/Unit

Reorder level

Date Document No.

Receipt Issue

Balance

Remarks

Entries in receipts column are made on the basis of goods received note or material returned note. Entries in issues column are made on the basis of material requisition note. After every entry of either receipts or issues, the balance quantity is calculated and recorded so that the balance can be known at any point of time. The levels indicated on bin card enable the stores department to keep a watch on balance and replace the material as soon as it reaches the reorder level. Ideally, the bin card should be placed along with the material. But it may not be possible in all the cases, so the bin cards are placed at a centrally located place but within stores department only. Stores Ledger Like the Bin Card, it is maintained for the recording of all receipts and issue transactions of material, but with the exception that it records not only the quantities received or issued or in stock but also the financial expressions of the same. The usual form in which the stores ledger is maintained is as follow: STORES LEDGER Description

Maximum level

Code No.

Minimum level

Location/Unit Reorder level Date

Doc. No.

Receipts Quantity

Rate

Issues Rs.

Quantity

Rate

Balance Rs.

Quantity

Rate

Rs.

By summing up the amounts appearing in the ‘issues’ column of stores ledger, one can get the cost of material issued to production department which forms the ‘Material Cost’. As in case of bin card, separate store ledger sheets are maintained in case of each item of material. The stores ledger sheets are maintained either in loose form or in bound book form. Bin Card vs. Stores Ledger If the stores ledger is having all the information mentioned in a bin card plus some additional information is also available, the next question which arises is why is it necessary to maintain both bin card and stores ledger simultaneously as it will be only duplication of work. In the situations of computerized inventory accounting system, maintenance of bin card and stores ledger simultaneously can be avoided. However, in the situation of manual inventory accounting system, it will be ideal to maintain bin card and stores ledger simultaneously due to the following reasons: •

Bin card is maintained by stores department while stores ledger is maintained by costing department. 67/MITSDE

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•

Bin card is not an accounting record but only a quantity record and as such is not concerned with the financial implications of stores transactions.

•

Maintenance of stores ledger provides a second check on maintenance of bin cards.

Reconciliation of Bin Card and Stores Ledger As the source documents for the entries in Bin Card and Stores Ledger are the same, the closing balances disclosed by both of them should match with each other. But in practice, they may not match due to the following reasons. •

arithmetical error in calculating balance

•

non-posting of a certain document’ in either of these documents

•

posting on wrong bin card or stores ledger sheet

•

treating receipts transaction as issue transaction or vice versa

If the closing balance as per bin card and stores ledger is not matching, the very purpose of maintaining these two documents simultaneously will be defeated. As such, it is necessary to reconcile both balances at regular intervals by keeping all the entries up to date. If the balances as on a particular day are not matching, all the previous transactions should be checked to locate differences.

5.3 Valuation of Material The stores ledger considers not only the movement of material in terms of quantity but also in terms of its financial implications. As such, it is necessary that all the possible movements of material are valued properly and are expressed in terms of money. We will consider this problem under the following heads. •

Valuation of receipts

•

Valuation of issues

•

Valuation of returns from production department to stores department

5.4 Valuation of Receipts Valuation of receipts is a relatively easy task, as the invoice or bill received from the supplier of the material is available as a starting point. Following propositions should be considered for this purpose. •

The price as billed by the supplier will be the valuation of the receipts. The trade discount is deducted from the basic price and all other amounts as billed by the supplier are added, like excise duty, sales tax, octroi duty, transport/insurance charges, etc. There are different opinions in respect of the treatment of cash discount. One opinion says that cash discount should be ignored, being purely of a financial nature, while valuing the receipts, while another opinion says that it should be considered while valuing the receipt of the material.

•

In some cases, more than one item of material is included in one single bill and some costs are jointly incurred for all the items of material. Such joint costs may be distributed on the basis of the basic price of the material.

•

In case of the imported material, the cost of the material consists of a basic price (which may be stated in foreign currency and should be converted in Indian Rupees), customs duty, clearing charges, transport charges, octroi duty, etc. In some cases, the point of receipt of imported material and the point of making the payment of invoice amount may be different. As such, the rate of foreign currency may be different at the time of payment of the customs duty and at the time of payment of the invoice amount. In such cases, the rate of exchange existing at the time of making the payment of invoice amount should be considered for valuing basic cost of material imported.

Illustration 1 The particulars relating to 1,200 kilograms of a certain raw material purchased by a company during April, 2010 are as below: a. Lot prices quoted by suppliers and accepted by the company for placing the purchase order. Lot up to 1000 kgs.

@ Rs. 22 per kg. For

Between 1000 - 1500 kgs. @ Rs. 20 per kg. Supplies 68/MITSDE

Between 1500 - 2000 kgs @ Rs. 18 per kg. to Factory Trade Discount 20%. Additional charge for containers @ Rs. 10 per drum of 25 kg. Credit allowed on return of containers @ Rs. 8 per drum. Sales Tax at 10% on raw material and 5% on drums. Total freight paid by the purchaser Rs. 240. Insurance at 2.5% (on net invoice value) paid by the purchaser. Stores Overheads applied at 5% on total purchase cost of material. The entire quantity was received and issued to production: The containers are returned in due course. Draw up a suitable statement to show: •

total cost of material purchased

•

unit cost of material issued to production

Solution a. Statement showing cost of purchases Basic Cost (Rs.)

Rs.1,200 kg x Rs. 20/kg = 24,000

Less: Trade discount @ 20%

4,800

Total cost

24,000 – 4,800 = 19,200

Container Cost 48 Drums x Rs. 10/Drum

480

Total cost

19,200 + 480 = 19,680

Sales Tax 10% on Rs. 19,200

192

5% on Rs. 480

24

Total Tax

216

Total cost

19,680 + 216 = 19,896

Other charges Insurance 2.5% on Rs. 21,264.00

531.60

Freight

240.00



20.667

Less: Credit for drums returned Rs. 8 per Drum x 48 Drums

384.00

TOTAL COST

22,020.60

Add: Stores Overheads 5%

1,101.03

b. Unit cost for valuation of issues:

23,121. 63 Rs. 23,121/1,200 kg = Rs. 19.268/kg

5.5 Valuation of Issues This is a more complex process than the valuation of the receipts. It is because of this reason that the material may be issued out of the various lots which might have been purchased at various prices. As such, a problem may arise as to which of the receipt prices should be used to value the material requisition notes. 69/MITSDE

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Various methods used for this purpose are as below: •

First In First Out (FIFO)

•

Last In First Out (LIFO)

•

Highest In First Out (HIFO)

•

Simple Average Rate (SAR)

•

Weighted Average Rate (WAR)

•

Market rate

5.5.1 First In First Out (FIFO) Method Under this method, the price of the earliest available lot is considered first and if that lot is exhausted, the price of the next available lot is considered. It should be remembered that the physical issue of the material may not be made out of the said lots, though it is presumed that it is made out of these lots. Illustration Following transactions have taken place in respect of a material during March 2010.

Date: 1 3 7 10 15 22 28 30

Opening Balance 400 units @ Rs. 10 per unit Purchased 100 units @ Rs. 9.5 per unit Issued 300 units Purchased 600 units @ Rs. 9.75 per unit Issued 200 units Issued 50 units Purchased 300 units @ Rs. 10.25 per unit Issued 350 units

Prepare the Stores Ledger assuming that the issues are valued on FIFO basis. Solution Valuation of stock by FIFO method Date Receipts Quantity Rate Rs. 1 3 100 9.50 950 7 10 15 22 28 30

500

300

9.75

10.25

Issues Quantity Rate

Rs.

300

10

3,000

200 50

10 10

2,000 488

4,875

3,075

350

10

3,413

Balance Quantity Rate 400 10.00 400 10.00 100 9.50 100 10.00 100 9.50 100 10.00 100 9.50 500 9.75 500 9.75 450 9.75 450 9.75 300 10.25 100 9.75 300 10.25

Rs. 4,000 4,000 950 1,000 950 1,000 950 4875 4875 4,388 4,388 3,075 975 3,075

Total Value 4,000 4,950 1,950 6,825 4,875 4,388 7,463 4,050

The objections raised against this method are mentioned below: •

Calculations become complicated if the lots are received frequently and at varying prices

•

Costs may be wrongly presented if the price of different lots of material is being used for pricing issues to various batches of production

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•

In case of varying prices, the pricing of issues does not consider current market prices

5.5.2 Last In First out (LIFO) Method Under this method, the price of the latest available lot is considered first and if that lot is exhausted, the price of the lot prior to that is considered. Here also, it should be remembered, that the physical issue of the material may not be made out of the said lots, though it is presumed that it is made out of the lots. Illustration The same example given under 5.5.1 above is solved as per LIFO method. Valuation of stock by LIFO method Date Receipts Quantity Rate Rs. 1 3 100 9.50 950 7

Issues Quantity Rate

Rs.

100 200

9.50 10.00

950 2,000

15

200

9.75

1,950

22

50

9.75

488

10

28

500

300

9.75

10.25

30

4,875

3,075 300 50

10.25 9.75

3,075 488

Balance Quantity Rate 400 10.00 400 10.00 100 9.50

Rs. 4,000 4,000 950

200 200 500 200 300 200 250 200 250 300 200 200

2,000 2,000 4,875 2,000 2,925 2,000 2,438 2,000 2,438 3,075 2,000 1,950

10.00 10.00 9.75 10.00 9.75 10.00 9.75 10.00 9.75 10.25 10.00 9.75

Total Value 4,000 4,950 2,000 6,875 4,925 4,438 7,463 7,513 3,950

The advantages of this method are as below: •

It is simple to operate.

•

The cost of materials issued considers fairly recent and current prices. The prices quoted on this cost fairly represent the real cost.

•

It can be conveniently applied if transactions are not too many and prices of the material are fairly steady.

The objections raised against this method are as below: •

Calculations become complicated if the lots are received frequently and at varying prices.

•

Costs may be wrongly presented if the price of different lots of material is used for pricing issues to various batches of production.

•

In case of falling prices in the market, this method may give wrong results.

5.5.3 Highest In First Out (HIFO) Method This method assumes that the stock should always be shown at the minimum value and hence the issues should always be valued at the highest value of receipts. For example, assume a situation as follows: Mar. 1 Purchased 100 units @ Rs. 12 Mar. 5 Purchased 125 units @ Rs. 18 Mar. 10 Purchased 75 units @ Rs. 15 On March 20, 120 units are issued to production and they will be valued at Rs. 18 per unit being the highest price. This method is not very popular. It always overvalues the issues and undervalues the closing stock. This method 71/MITSDE

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may be useful in case of the organisations dealing with monopoly products which is a rare possibility. Illustration The same example given under 5.5.1 in this unit will be solved as per weighted average rate method. Valuation of stock by HIFO method Date Receipts Issues Balance Quantity Rate Rs. Quantity Rate Rs. Quantity Rate Rs. 1 400 10.00 4,000 3 100 9.50 950 400 10.00 4,000 100 9.50 950 7 300 10.00 3,000 100 10.00 1,000 100 9.50 950 10 500 9.75 4,875 100 10.00 1,000 500 9.75 4875 15 100 10.00 1,000 100 9.50 950 100 9.75 975 400 9.75 3900 22 50 9.75 488 100 9.50 950 350 9.75 3,413 28 300 10.25 3,075 100 9.50 950 350 9.75 3,413 300 10.25 3,075 30 300 10.25 3,075 100 9.50 950 50 9.75 488 300 9.75 2,925

Total Value 4,000 4,950 1,950 6,825 4,850 4,363 7,438 3,875

5.5.4 Average Rate Method Both the above methods i.e. FIFO and LIFO, consider the exact or actual cost for valuing the issue of material. However these methods may prove to be disadvantageous if the transactions are too many and are at varying prices. In such cases, instead of considering the exact or actual cost, average cost may be considered to lessen the effect of variation in prices, either upward or downward. For example: Assume a situation as below: Mar. 1 - Received - 1500 units @ Rs. 10 - Rs. 15,000 Mar. 15 - Received - 1600 units @ Rs. 30 - Rs. 48,000

On March 20, 1800 units were issued to production.

If FIFO method is followed to price the issues, the issues will be valued as below: 1500 units @ Rs. 10 per unit Rs. 15,000 300 units @ Rs. 30 per unit Rs. 9,000 Total Rs. 24,000 The issues will be considerably under-valued and closing stock will be considerably over valued, as compared to the current market prices. If LIFO method is followed to price the issues, the issues will be valued as below: 1600 units @ Rs. 30 per unit Rs. 48,000 200 units @ Rs. 10 per unit Rs. 2,000 Total Rs. 50,000

The closing stock will be considerably under valued as compared to the current prices.

To lessen the effect of such drastic price variation, both on the valuation of issues as well as of closing stock, instead of considering the actual/exact price of Rs. 10 per unit or Rs. 30 per unit, average price may be taken into consideration. There are mainly two ways in which average prices may be considered.

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•

Simple Average Rate Method

•

Weighted Average Rate Method

5.5.4.1 Simple Average (SAR) Method Under this method, the simple average of the prices of the lots available for making the issues is considered for pricing the issues. After the receipt of new lot, a new average price is worked out. It should be remembered in this connection that, for deciding the possible lots out of which the issues could have been made, the method of First in First Out (FIFO) is followed. This method is suitable if the material is received in uniform quantity. If the material quantity of each lot varies widely, this method may lead to wrong results. Illustration Date

Receipts Quantity

Rate

Issues Rs.

Quantity

Rate

Balance Rs.

1 3

100

9.50

950

7 10

300 500

9.75

9.75

2925

4875

Quantity

Rate

Rs.

400

10.00

4000.00

500

9.75

4875.00

200

9.75

1950.00

700

9.75

6825.00

15

200

9.75

1950

500

9.75

4875.00

22

50

9.75

487.5

450

9.75

4387.50

750

10.00

7500.00

400

10.00

4000.00

28 30

300

10.25

3075 350

10.00

3500

5.5.4.2 Weighted Average Rate (WAR) Method As stated above, the simple average method of valuation of issues may lead to wrong results, if the quantity of each lot of material received varies widely. For example: Assume the following situation. Mar. 1 - Received - 100 units @ Rs. 10 Rs. 1,000 Mar. 10 - Received – 5,000 units @ Rs. 30 Rs. 1, 50,000 Total Rs.1, 51,000 On March 20, 4800 units were issued to production. As both the lots are possible lots for making the issue, the average of prices of both the lots will be taken into account if simple average method is considered. Hence, per unit issue price will be. (Rs. 10 + Rs. 30)/2 = Rs. 20 As such, the issue quantity will be priced at : 4,800 units x Rs.20 i.e. Rs. 96,000, which will be incorrect, as considering the quantity of issue, the price of the material received on March 10 should get more weightage. To overcome this drawback of simple average method, weighted average method may be used which considers not only the price of each lot but also the quantity of the same. Though this method involves considerable amount of clerical work, in practice, this method proves to be very useful in the event of varying prices and quantities. In practice, the calculation of weighted average rate proves to be very simple. The products of quantity and price divided by the total quantity of all lots, just before the issue, gives the unit price in respect of the subsequent issues.

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Illustration The same example given under 5.5.1 in this unit will be solved as per weighted average rate method. Valuation of stock by weighted average method. Date

Receipts Quantity

Rate

Issues Rs.

Quantity

Balance

Rate

Rs.

1 3

100

9.50

950

7 10

300 500

9.75

9.90

2970

4875

Quantity

Rate

Rs.

400

10.00

4000.00

500

9.90

4950.00

200

9.90

1980.00

700

9.79

6855.00

15

200

9.79

1959

500

9.79

4896.43

22

50

9.79

489.6

450

9.79

4406.79

750

9.98

7481.79

400

9.98

3990.29

28

300

30

10.25

3075 350

9.98

3492

Q1R1 = 4000 Q2R2 = 950 Q1R1+ Q2R2 = 4950. Q1+Q2 = 500 Weighted Average Cost = (Q1R1+Q2R2)/( Q1+Q2) = 4950/500 = 9.9 Comparison of value of stock under different methods: Sl. No. Method of valuation 1 First in First Out 2 Last in First out 3 Highest in first Out 4 Simple Average 5 Weighted Average

Value of Inventory 4,050.00 3,950.00 3,875.00 4,000.00 3,990.29

From the above table it is clear that the value of stock will be different in different methods of valuation. It is expected that a company should follow the same method every year. This is called principle of consistency in accounting. If the method of valuation is changed, it may lead to change in profit. In such case, the effect of change in the method on profitability has to be shown separately. 5.5.5 Market Rate Explained below are three methods of valuation under market rate: Market Price Under this method, market price is considered to be the base for pricing the issues. In this case, market price may be treated as the latest purchase price, realisable price or replacement price. This method is used mainly in respect of obsolete stock items or non-moving stock items. The defect in respect of this method is that the price concessions obtained in respect of bulk purchases are not reflected in the cost of material. Specific Price If the material is purchased against a specific job or production order, the issue of material is priced at actual purchase price. This method can be adopted if the purchase prices are fairly stable. Standard Price This is the normal or ideal price which will be paid in the normal circumstances, based on the basis of estimated market conditions, transportation costs and normal quantity of purchases. Any issue of material will be priced at standard prices irrespective of actual prices. This enables the simplification of accounting system with reduced 74/MITSDE

clerical work and also enables to decide the efficiency of purchase department.

5.6 Valuation of Returns This indicates the material returned by the production department to stores department The way in which the returned material can be valued is shown below: •

At the same price as when issued ‚‚ The original price of issue will be a base for valuing the returns, for which original material requisition note will be the base.

•

At the current price of issues ‚‚ The method which is followed for valuing the issue on the same date is considered for valuing the returns. ‚‚ This will avoid the clerical efforts, but at the same time the track of original issue of material can’t be maintained.

Treatment of shortages In some cases, the physical verification of stock may reveal that the physical stock is less than the stock as per the stores ledger. The valuation of this shortage is done as if it is an issue of material. The treatment given to the valuation of shortages in cost accounts depends upon the nature of the shortage i.e. normal shortage or abnormal shortage. Bill of materials In order to ensure proper inventory control, the ‘basic principle to be kept in mind is that proper material is available for production purposes whenever it is required. This aim can be achieved by preparing what is normally called as 'Bill of Materials'. A bill of material is the list of all the materials required for a job, process or production order. It gives the details of the necessary materials as well as the quantity of each item. As soon as the order for the job is received, bill of materials is prepared by production department or production planning department.

The form in which the bill of material is usually prepared is as below: BILL OF MATERIALS No. Date of Issue

Production/Job Order No.

Department authorised S. No. Description Code Qty. For Department Use only Remarks of Material No. Material Date Quantity Requisition No. demanded The functions of bill of materials are as below: •

Bill of material gives an indication about the orders to be executed to all the people concerned.

•

Bill of material gives an indication about the materials to be purchased by the purchases department if the same is not available with the stores.

•

Bill of material may serve as a base for the production department for placing the material requisitions ships.

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Material and Store Management

•

Costing/Accounts Department may be able to compute the material cost in respect of a job or a production order. A bill of material prepared and valued in advance may serve as a base for quoting the price for the job or production order.

•

Perpetual Inventory System: In order to exercise proper inventory control, perpetual inventory system may be implemented. It aims at two facts, given below. ‚‚ maintenance of bin cards and stores ledger in order to know about the stock in quantity and value at any point of time ‚‚ continuous verification of physical stock to ensure that the physical balance and the book balance tallies

The continuous stock taking may be advantageous from the following angles: •

Physical balances and book balances can be compared and adjusted without waiting for the entire stocktaking to be done at the year-end. Further, it is not necessary to close down the factory for annual stocktaking.

•

The figures of stock can be readily available for the purpose of periodic profit and loss account.

•

Discrepancies can be located and adjusted in time.

•

Fixation of various levels and bin cards enables the action to be taken for the placing the order for acquisition of material.

•

A systematic maintenance of perpetual inventory system enable in locating the slow and non-moving items and to take remedial action for the same.

•

Stock details are correctly available for getting the insurance of stock.

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Summary •

Management of inventory assumes importance due to the fact that investment in inventory constitutes one of the major investments in current assets. The various forms in which a manufacturing concern may carry inventory are; raw material, work in progress, finished goods and stores and supplies.

•

A company may hold the inventory with the following motive: transaction motive, precautionary motive, and speculative motive.

•

The types of movement of the material from the stores department are: receipt of material, issue of material, return of material from production department to stores department, and transfer of material.

•

The proper conduct of storage function requires that material should be properly stored in a good condition till it is required for use by production departments and this is ensured by perpetual inventory system.

•

Valuation of material is done in valuation of receipts, valuation of issues and valuation of returns from production department to stores department.

•

Valuation of receipts is a relatively easy task, as the invoice or bill received from the supplier of the material is available as a starting point.

•

Valuation of the issues is done by First In First Out (FIFO), Last In First Out (LIFO), Highest In First Out (HIFO), Simple Average Rate (SAR), Weighted Average Rate (WAR) and Market rate.

•

First in First out (FIFO) method: the price of the earliest available lot is considered first and if that lot is exhausted, the price of the next available lot is considered.

•

Last in First out (LIFO) method: the price of the latest available lot is considered first and if that lot is exhausted, the price of the lot prior to that is considered.

•

Highest in first out method assumes that the stock should always be shown at the minimum value and hence the issues should always be valued at the highest value of receipts.

•

Simple average (SAR) method, the simple average of the prices of the lots available for making the issues is considered for pricing the issues.

•

Weighted average (WAR) method considers not only the price of each lot but also the quantity of the same.

•

Valuation of the returns is done on two bases: at the same price at which issued and at the current price if issues.

References •

Stores Management in Non government organizations, 24th March, 2011[Online] (Updated on 24th March, 2011) Available at [Accessed on 24th March 2011]

•

Stores systems and procedures, 24th March, 2011 [Online] (Updated on 24th March, 2011) Available at [Accessed on 24th March, 2011]

•

Stores Management and Stock control study guide, 24th March, 2011 [Online] (Updated on 24th March, 2011) Available at [Accessed on 24th March 2011]

Recommended Reading •

Carter, R. & Price, P., 2004. Stores and Distribution Management. Liverpool Academic Press

•

Carter, R.J., 1982. Stores Management and Related Operations (M & E Handbook Series). Trans-Atlantic Publications

•

Farrington, F., 2010. Store management-complete. Nabu Press

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Material and Store Management

Self Assessment 1. Which of the following document is used to record the details of the material received? a. Inspection receipt b. Goods received report c. Bin card d. Stores ledger 2. Which of the following methods assumes that the stock should always be shown at the minimum value and hence the issues should always be valued at the highest value of receipts? a. First in first out b. Last in first out c. Highest in first out d. Simple average rate 3. If the material is purchased against a specific job or production order, the issue of material is priced at _________ purchase price. a. actual b. cost c. selling d. inventory 4. Which of the following statement is false? a. A company may be required to hold the inventories in order to facilitate the smooth and uninterrupted production and sales operations b. Usually the receipt of material is accompanied by delivery challan given by the supplier c. On receipt of the material, quantity received is checked with the quantity ordered by the stores department d. The material can be issued from the stores without a proper authority in writing is produced before the stores department 5. Which of the following system ensures the proper conduct of storage?

e. f. g. h.

Perpetual inventory Bin card Stores ledger Valuation of receipts

6. Which of the following method may be useful in case of the organisations dealing with monopoly products which is a rare possibility? a. First in first out b. Last in first out c. Highest in first out d. Simple average rate

78/MITSDE

7. Which of the following statements is true? a. Bill of material gives an indication about the orders to be executed to all the people of the organisation b. Bill of material gives an indication about the materials to be purchased by the purchases department if the same is available with the stores c. Bill of material may serve as a base for the production department for placing the material requisitions ships d. Bill of material prepared and valued later on and may serve as a base for quoting the price for the job or production order 8. Bin card is maintained by stores department while stores ledger is maintained by ________department. a. manufacturing b. distribution c. packaging d. costing 9. The levels indicated on bin card enable the stores department to keep a watch on balance and replace the material as soon as it reaches the ___________level. a. minimum b. re-order c. actual d. valuation 10. The stores ledger considers not only the movement of material in terms of quantity but also in terms of its _________implications. a. distribution b. economical c. financial d. production

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Material and Store Management

Application I Material Cost Management Swarupa Industries manufactures a special product ‘Vick’. The following particulars are collected for the year 1986. •

Monthly demand of “Vick” - 1000 units

•

Cost of placing an Order - Rs. 100

•

Annual carrying cost per unit - Rs. 15

•

Normal Usage 50 units per week

•

Minimum Usage 25 units per week

•

Maximum Usage 75 units per week

•

Re-order period 4 to 6 weeks

Questions: Compute the following: 1. Re-order Quantity 2. Re-order Level 3. Minimum Level 4. Maximum Level 5. Average Stock Level Answers: 1. Reorder Quantity: EOQ = √(2 A O)/C = √(2 X 12,000 x 100) / 15 = √(24,00,000/15) = √1,60,000 = 400 units 2. Reorder Level = Maximum Lead Time x Maximum Usage = 6 weeks x 75 units = 450 units 3. Minimum Level = Reorder Level – (Normal Usage x Normal Lead time) = 450 units – (50 units X 5 weeks) = 200 units 4. Maximum Level = Reorder Level + Reorder Quantity – (Minimum Usage x Minimum Lead-time) = 450 units + 400 units – (25 units X 4 Weeks) = 750 units 5. Average Stock Level = (Minimum Level + Minimum Level) / 2 = (200 units + 750 units) / 2 = 475 units

80/MITSDE

Application II Material Cost Management Fill in the Blanks on the basis of the following information: Annual Requirement

10000

Ordering cost per order

300

Carrying cost

15%

Price per unit

200

Lot size 50 100 200 250 500 1000 2000

No. of orders 200 100 67 50 20 10 5

Ordering cost 30,000 20,000 15,000 12,000 6,000 3,000 1,500

Carrying cost 750 2,250 3,000 3,750 15,000 30,000

Total cost 60,750 31,500 22,250 15,750 13,500 18,000 31,500

The following information is given about M/s Shankar Industries. Normal usage : 40 units per week each Minimum usage : 30 units per week each Maximum usage : 60 units per week each Reorder quantity : 300 units Recorder period : 3 - 5 weeks Questions: Compute the following from the above information: 1. Re-order Quantity 2. Re-order Level 3. Minimum Level 4. Maximum Level 5. Average Stock Level

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Material and Store Management

Application III Inventory Models Following is the information about M/s Sangeeta industries. 1 2 3 4 5 6

Annual Requirement Units Ordering cost per order Carrying cost Price per unit Discount Quantity Units Discount Rate offered

Advise whether the company should accept the offer of discount. Question: Show your answer in the following format.

1 2 3 4 5 6 7

A) If EOQ model followed EOQ Units No. of orders No. of orders rounded off Ordering cost Carrying cost Material cost Total cost rupees

1 2 3 4 5 6 7

B) If discount offer is accepted Discount Quantity No. of orders No. of orders rounded off Ordering cost Carrying cost Material cost Total Cost rupees C) Benefit of discount offer D) Decision

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2,000 200 20% 100 400 1%

Bibliography References •

22nd March, 2011, Purchase Management [Online] (Updated 22nd March, 2011) Available at . [Accessed on 22nd March 2011]

•

22nd March, 2011, Purchasing Management [Online] (Updated 22nd March, 2011) Available at . [Accessed on 22nd March 2011]

•

Aher, Kiran, 22nd March,. 2011, Purchasing Management [Online] (Updated 22nd March, 2011) Available at < http://www.authorstream.com/Presentation/kiranaher1989-387753-purchase-management-mgmt-entertainmentppt-powerpoint/>. [Accessed on 22nd March 2011]

•

Deepak, 2008. ABC analysis [Online] (Updated 18th March, 2011) Available at . [Accessed on 18th March 2011]

•

Inventory Control Models [Online] (Updated 18th March, 2011). Available at . [Accessed on 18th March 2011]

•

Inventory Management [Online] (Updated on 16th March, 2011). Available at [Last accessed on 16th March 2011]

•

Inventory Management [Online] (Updated on 16th March, 2011). Available at [Last accessed on 16th March 2011]

•

Joshi, Amit, Juyal Ankur, Pasbola Prabhat Inventory Models [Online] (Updated 21st March, 2011) Available at [Accessed on 21st March, 2011]

•

Managing Facilitating Goods [Online] (Updated 21st March, 2011) Available at . [Accessed on 21st March 2011]

•

Materials Management [Online] (Updated on 16th March, 2011) Available at [Last accessed on 16th March 2011]

•

Purchasing Process Structure [Online] (Updated on 16th March 2011) Available at [Accessed on 8th April, 2011]

•

Statistical Inventory Control Models [Online] (Updated 18th March, 2011). Available at . [Accessed on 18th March 2011]

•

Stores Management and Stock control study guide, 24th March, 2011 [Online] (Updated on 24th March, 2011) Available at [Accessed on 24th March 2011]

•

Stores Management in Non government organizations, 24th March, 2011[Online] (Updated on 24th March, 2011) Available at [Accessed on 24th March 2011] 83/MITSDE

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•

Stores systems and procedures, 24th March, 2011 [Online] (Updated on 24th March, 2011) Available at [Accessed on 24th March, 2011]

Recommended Reading •

Anderson, Ernest L. & Morgan, James P., 1998. The Systems Purchasing Breakthrough. 1st ed., Cahners Pub. Co

•

Bartmann, D., 1992. Inventory Control: Models and Methods (Lecture Notes in Economics and Mathematical Systems). Springer

•

Beyer, D., 2009. Markovian Demand Inventory Models (International Series in Operations Research & Management Science). 1st ed., Springer.

•

Carter, R. & Price, P., 2004. Stores and Distribution Management. Liverpool Academic Press

•

Carter, R.J., 1982. Stores Management and Related Operations (M & E Handbook Series). Trans-Atlantic Publications

•

Emmett, S., 2005. Excellence in Warehouse Management: How to Minimise Costs and Maximise Value. Wiley.

•

Farrington, B., 2001. Creative Control of Purchase Prices. Spiro Press

•

Farrington, F., 2010. Store management-complete. Nabu Press

•

Frazelle, E., 2001. World-Class Warehousing and Material Handling. 1st ed., McGraw-Hill.

•

Heywood, J.Brian, 2001. e-procurement: A Guide to Successful e-procurement Implementation (Management briefings: finance). Financial Times Prentice Hall

•

Muller, M., 2003. Essentials of Inventory Management. AMACOM

•

Neef, D., 2001. e-Procurement: From Strategy to Implementation. FT Press

•

Piasecki, David J., 2009. Inventory Management Explained: A focus on Forecasting, Lot Sizing, Safety Stock, and Ordering Systems. 1st ed., Ops publishing.

•

Piasecki, Edward A., 1998. Inventory Management and Production Planning and Scheduling. 3rd ed., Wiley.

•

Richards, G., 2011. Warehouse Management: A Complete Guide to Improving Efficiency and Minimizing Costs in the Modern Warehouse. Kogan Page.

•

Sabri, Ehap H. & Gupta A., 2006. Purchase Order Management Best Practices: Process, Technology, and Change Management. J. Ross Publishing

•

Stoehr, T., 2002. Managing e-Business Projects. 1st ed., Springer

•

Tijms, H. C., 1972. Analysis of (s S) Inventory Models. 1st ed., Mathematical Centre Tracts.

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Self Assessment Answers Chapter I 1. b 2. a 3. d 4. d 5. c 6. c 7. a 8. b 9. a 10. a Chapter II 1. c 2. d 3. d 4. a 5. b 6. b 7. b 8. d 9. a 10. d Chapter III 1. a 2. d 3. b 4. a 5. d 6. a 7. b 8. a 9. c 10. a Chapter IV 1. b 2. a 3. d 4. a 5. d 6. b 7. b 8. a 9. c 10. a

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Material and Store Management

Chapter V 1. b 2. c 3. a 4. d 5. a 6. c 7. c 8. d 9. b 10. c

86/MITSDE