MEU 07322 FINANCE AND HUMAN RESOURCES MANAGEMENT

LECTURE NO.3: MATERIALS MANAGEMENT

3.1. INTRODUCTION
Materials Management is that aspect of management function, which is
primarily concerned with the acquisition, control, and use of materials
needed and flow of goods and services connected with the production
process having some predetermined objectives in view. The main
objectives of Material Management are:
1. To minimise material cost.
2. To purchase, receive, transport and store materials efficiently and to
reduce the related cost.
3. To cut down costs through simplification, standardisation, value
analysis, import substitution, etc.
4. To trace new sources of supply and to develop cordial relations with
them in order to ensure continuous supply at reasonable rates.
5. To reduce investment tied in the inventories for use in other productive
purposes and to develop high inventory turnover ratios.

If you were buying steering wheels for an automobile manufacturing

company, how many would you order “at a time?”

If you order a large quantity each time you order, you’ll end up holding
some steering wheels in inventory for a longer time than if you had ordered
a smaller quantity. With a higher quantity, inventory cost goes high.

If you order a small quantity, you’ll end up paying any setup and/or fixed
costs more frequently. For example, the driver of the truck delivering the
steering wheels is paid the same, whether the truck is loaded with 500
steering wheels or 5 steering wheels. If you order only 5 steering wheels at
a time, you’ll have to pay the driver 100 times more … than if you had
ordered 500 steering wheels at a time. With a smaller quantity, setup
and/or fixed cost go high.

Since a higher quantity is not best … and a lower quantity is not best …
there must be some “middle” quantity where the total cost (inventory cost
PLUS setup and/or fixed cost) is least expensive. Fig.3.1 illustrates the
relationship:

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 Total Cost

Inventory Cost
C
o
s
t

Setup Cost

Quantity

Fig.3.1: Least storage cost

The point of lowest total cost can be seen to be at the “very bottom” of the
Total Cost curve. The quantity associated with that point just also
happens to be the same quantity at which the two other lines intersect.

3.2. INVENTORY
Inventory generally refers to the materials in stock. It is also called the idle
resource of an enterprise. Inventories represent those items which are
either stocked for sale or they are in the process of manufacturing or they
are in the form of materials, which are yet to be utilised. The interval
between receiving the purchased parts and transforming them into final
products varies from industries to industries depending upon the cycle
time of manufacture. It is, therefore, necessary to hold inventories of
various kinds to act as a buffer (reserve) between supply and demand for
efficient operation of the system. Thus, an effective control on inventory is
a must for smooth and efficient running of the production cycle with least
interruptions.

Inventory is a complete list of the stocks of raw materials, components,

work-in-progress, and finished goods held by a business. The word stock

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means an amount of something that you keep so that you can use it when
you need it.

The inventory shows the amount, unit price, and total value of each type of
stock held. There are mainly three methods of inventory costing: First-In,
First-Out Method (FIFO); Last-In, First-Out method (LIFO); and Average
Cost method.

3.2.1 Types of Inventory

In a typical manufacturing company, inventory will be in the

following forms:

1. Raw Materials Inventory

Raw materials, as the name implies are in the raw stage without any
processing. They are in the stage as such purchased from the
supplier. They can also be extracted materials if not purchased from
the supplier. They contain the material or the parts required for
production.

2. Work-in-Progress Inventory

Work-in-Progress inventory is in a stage between the raw materials

stage and the finished goods stage. They are partly processed
materials and as such direct material, labour and overheads would
have been incurred to bring the raw materials into the work-in-
progress state. They cannot be called finished goods until they are
fully processed or produced.

3. Finished goods Inventory

Finished goods inventory is the final stage of inventory. All the

processes are over and the product fully manufactured and ready for
sale. Sometimes, companies also procure short-term finance
pledging the finished goods inventory as security. Finished goods

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 inventory will be then distributed to wholesalers, distributors or
retailers as the case may be.

3.2.2 Reasons for Keeping Inventories

1. To stabilise production: The demand for an item fluctuates because of
the number of Factors, e.g., seasonality, production schedule etc. The
inventories (raw materials and components) should be made available to
the production as per the demand failing which results in stock out and
the production stoppage takes place for want of materials. Hence, the
inventory is kept to take care of this fluctuation so that the production is
smooth.

2. To take advantage of price discounts: Usually the manufacturers offer

discount for bulk buying and to gain this price advantage the materials are
bought in bulk even though it is not required immediately. Thus, inventory
is maintained to gain economy in purchasing.

3. To meet the demand during the replenishment period: The lead time for
procurement of materials depends upon many factors like location of the
source, demand supply condition, etc. So inventory is maintained to meet
the demand during the procurement (replenishment) period.

4. To prevent loss of orders (sales): In this competitive scenario, one has to

meet the delivery schedules at 100 per cent service level, means they cannot
afford to miss the delivery schedule which may result in loss of sales. To
avoid the organizations have to maintain inventory.

5. To keep pace with changing market conditions: The organizations have

to anticipate the changing market sentiments and they have to stock
materials in anticipation of non-availability of materials or sudden increase
in prices.

6. Sometimes the organizations have to stock materials due to other

reasons like suppliers minimum quantity condition, seasonal availability of
materials or sudden increase in prices.

3.2.3 Meaning of Inventory Control

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Inventory control is a planned approach of determining what to order,
when to order and how much to order and how much to stock so that
costs associated with buying and storing are optimal without interrupting
production and sales. Inventory control basically deals with two problems:
(i) When should an order be placed? (Order level), and
(ii) How much should be ordered? (Order quantity).
These questions are answered by the use of inventory models. The
scientific inventory control system strikes the balance between the loss
due to non-availability of an item and cost of carrying the stock of an item.
Scientific inventory control aims at maintaining optimum level of stock of
goods required by the company at minimum cost to the company.

3.2.4 Objectives of Inventory Control

1. To ensure adequate supply of products to customer and avoid shortages
as far as possible.
2. To make sure that the financial investment in inventories is minimum
(i.e., to see that the working capital is blocked to the minimum possible
extent).
3. Efficient purchasing, storing, consumption and accounting for materials
is an importantobjective.
4. To maintain timely record of inventories of all the items and to maintain
the stock within the desired limits. 5. To ensure timely action for
replenishment.
6. To provide a reserve stock for variations in lead times of delivery of
materials.
7. To provide a scientific base for both short-term and long-term planning
of materials.

3.2.5 Benefits of Inventory Control

It is an established fact that through the practice of scientific inventory
control, following are the benefits of inventory control:
1. Improvement in customer’s relationship because of the timely delivery of
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goods and service.
2. Smooth and uninterrupted production and, hence, no stock out.
3. Efficient utilisation of working capital. In this way it helps in minimising
loss due to deterioration, obsolescence and damage and pilferage.

3.3 COST ASSOCIATED WITH INVENTORY

The basic costs of inventory are

6.3.1 Ordering cost - Also known as purchase cost, procurement costs or

set up cost, this is the sum of the fixed costs that are incurred each time an
item is ordered. These costs are not associated with the quantity ordered
but primarily with physical activities required to process the order.

For purchased items, these would include the cost to enter the purchase
order and/or requisition, any approval steps, the cost to process the
receipt, incoming inspection, invoice processing and vendor payment, and
in some cases a portion of the inbound freight may also be included in
order cost. It is important to understand that these are costs associated
with the frequency of the orders and not the quantities ordered.

3.3.2 Carrying cost.

Also called Holding cost, carrying cost is the cost associated with having
inventory on hand. It is primarily made up of the costs associated with the
inventory investment and storage cost. For the purpose of the EOQ
calculation, if the cost does not change based upon the quantity of
inventory on hand it should not be included in carrying cost. In the EOQ
formula, carrying cost is represented as the annual cost per average on
hand inventory unit. Below are the primary components of carrying cost.
o Storage costs (rent, heating, lighting, etc.)
o Handling costs - costs associated with moving the items such
as cost of labour, equipment for handling, etc.
o Depreciation, taxes and insurance,
o Costs on record keeping
o Product deterioration and obsolescence
o Spoilage, breakage, pilferage and loss due to perishable nature

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3.4. BASIC MODEL
Annual procurement cost varies with the number of orders. This implies
that the procurement cost will be high, if the item is procured frequently in
small lots. The procurement cost is expressed as amount of money per
order. On the other hand, the annual inventory carrying cost (product of
average inventory carrying costs X carrying costs) is directly proportional
to the quantity in stock. The inventory carrying cost decreases, if the
quantity ordered per order is small. The two costs are diametrically
opposite to each other. The right quantity to be ordered is one that strikes
a balance between the two opposing costs. This quantity is referred to as
“Economic order quantity” ( EOQ ). The cost relationships are shown in
Fig.3.2.

Annual total costs

Cost

Annual inventory carrying cost

Annual ordering cost

EOQ Order Quantity, Q

Figure 3.2: Inventory carrying cost

EOQ is essentially an accounting formula that determines the point at

which the combination of order costs and inventory carrying costs are the
least. The result is the most cost effective quantity to order. In purchasing
this is known as the order quantity, in manufacturing it is known as the
production lot size.

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Applications for EOQ are purchase-to-stock distributors and make-to-
stock manufacturers, however, make-to-order manufacturers should also
consider EOQ when they have multiple orders or release dates for the same
items and when planning components and sub-assemblies. Repetitive buy
maintenance, repair, and operating (MRO) inventory is also a good
application for EOQ. Though EOQ is generally recommended in
operations where demand is relatively steady, items with demand
variability such as seasonality can still use the model by going to shorter
time periods for the EOQ calculation. Just make sure your usage and
carrying costs are based on the same time period.
Doesn’t EOQ conflict with Just-In-Time? JIT is actually a quality initiative
with the goal of eliminating wasted steps, wasted labor, and wasted cost.
EOQ should be one of the tools used to achieve this. EOQ is used to
determine which components fit into this JIT model and what level of JIT
is economically advantageous for your operation. The basic Economic
Order Quantity (EOQ) formula is as follows:

2( Annual usage in units)(Order cos t )

EOQ =
( Annual carrying cos t per unit)

The Inputs
While the calculation itself is fairly simple the task of determining the
correct data inputs to accurately represent your inventory and operation is
a bit of a project.

Annual Usage.
Expressed in units, this is generally the easiest part of the equation. You
simply input your forecasted annual usage.

Formulation of EOQ
Assume:

• Stock used up at a constant rate (R units per year)

• Fixed set-up cost co for each order - often called the order cost
• No lead time between placing an order and arrival of the order
• Variable stock holding cost ch per unit per year

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Then we need to decide Q, the amount to order each time, often called the
batch (or lot) size.
With these assumptions the graph of stock level over time takes the form
shown in Fig. 3.3.

Consider drawing a horizontal line at Q / 2 in the above diagram. If you

were to draw this line then it is clear that the times when stock exceeds
Q / 2 are exactly balanced by the times when stock falls below Q / 2 . In other
words we could equivalently regard the above diagram as representing a
constant stock level of Q / 2 over time.

Hence we have that:

• Annual holding cost = Ch (Q 2)

where Q/2 is the average (constant) inventory level

• Annual order cost = C o ( R / Q)

where (R/Q) is the number of orders per year (R used, Q each order)
So total annual cost = Ch (Q 2) + Co ( R / Q)
Total annual cost is the function that we want to minimise by choosing an
appropriate value of Q .

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We can calculate exactly which value of Q corresponds to the minimum
total cost by differentiating total cost with respect to Q and equating to
zero.
d (total cost )
= (ch 2) − Co R / Q 2 = 0 for minimizations
dQ
2C R
which gives Q 2 = o
Ch
Hence the best value of Q (the amount to order = amount stocked) is given
by

2 RC o
Q=
Ch

and this is known as the Economic Order Quantity ( EOQ )

Comments
To get the total annual cost associated with the EOQ we have from before
that
Total Annual cost = Ch (Q 2) + C o ( R Q)
so putting
2 RC o
Q=
Ch
into this we get that the total

1 2 RC o Ch RC o C h RC o C h
Ch + Co R = + = 2 RC o C h
2 Ch 2 RC o 2 2

Hence total annual cost is 2 RC o C h

which means that when ordering the optimal ( EOQ ) quantity we have
that total cost is proportional to the square root of any of the factors (R, Co
and C h ) involved. For example, if we were to reduce Co by a factor of 4 we
would reduce total cost by a factor of 2 (note the EOQ would change as
well). This, in fact, is the basis of Just-in-Time (JIT), to reduce
(continuously) Co and C h so as to drive down total cost.

3.5 INVENTORY (STOCK) CONTROL

3.5.1 Terminology
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 • Demand – It is the number of items (products) required per unit of
time.
• Order cycle – Is the time between two successive orders.
• Lead time – The length of time between placing an order and receipt
of items
• Safety stock – It is also called buffer stock or minimum stock. It is the
stock or inventory needed to account for delays in materials supply
and to account for sudden increase in demand due to rush orders.
• Re-order level (ROL) – It is the point at which the replenishment
action is initiated. When the stock level reaches ROL, the order is
placed for the item.
• Re-order quantity – This is the quantity of material (items) to be
ordered at the re-order level. Normally this quantity equals the
economic order quantity.
• Economic order quantity (EOQ) – Amount of inventory that should
be ordered at one time so that the associated annual costs of the
inventory can be minimized.

Inventory can best be dealt with by considering two basic approaches:

• Stock control systems
• Design of ordering systems

3.5.2 Stock control systems

There two fundamental types of stock control system:

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3.5.2.1 The maximum-minimum order quantity, it is also known as
‘two-bin system’, ‘Fix order quantity’, ‘perpetual inventory system’ or ‘Q-
system’. In this system, the order quantity is fixed and ordering time varies
according to the fluctuation in demand. During the design of such an
ordering system, we must determine the
1 Re-order level ( ROL )– This equals the sum of safety stock and lead
time consumption – ROL = m + L  C
where m – is the minimum or safety stock
L – lead time (days/weeks/months)
C – consumption rate (per day/per week/per month)
2. Re-order quantity ( Q ) – This normally equals Economic order
quantity EOQ
3. Maximum stock level (M) – It equals the safety stock + order
quantity
M = m+Q
Where Q is order quantity
m = Safety stock
M = Max stock
4 Average inventory
Average inventory = 1 2 (Min.Stock + Max.Stock)
= 1 2 (m + M )
= 1 2(m + m + M )
= m + 1 2Q
The system is represented graphically as in Fig.3.4

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 Stock Level

T1
Lead Time

T2
T3
ROL

Min. Stock Fix Order Quantity

Time

Max. Stock

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3.5.2.2 The Order cycle System

This system is based on the fixed order interaval (cycle or time). The
system can be depicted as shown in Fig.3.5
Order quantity
Stock quantity

Qa Qd
Qb
Qc

t t t Time

3.5.2.3 Pareto analysis / ABC analysis

The word Pareto comes from an economist, Vilfredo Pareto, who observed
that 80% of Italy's wealth was owned by 20% of the population. Pareto
analysis (sometimes referred to as the 80/20 rule and as ABC analysis) is a
method of classifying items, events, or activities according to their relative
importance. It also intends to group Inventory Items into three categories.
The analysis is based on the concept that a small percentage of Items will
provide the most Sales Revenue (A Items). The next group will contain
more Items, but comparatively less Sales Revenue (B Items). The final
group will be a large number of Items that have few Sales (C Items). From
a management perspective, it is most efficient to expend time, energy and
resources on the A Items, and little to no effort on the C Items. If I want to
make sure that my quantity on hand is always accurate, and be able to
identify and research problems quickly, but we don't have the time and
resources needed to do a physical count every month, the average
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company solution will be to use the ABC Analysis to identify the items
that generate the most sales. The average company generates most sales
with only 20% of their Inventory Items (A Items). Another example: If I
have one item that makes up 30% of my Inventory Sales and Issues, how
can I use ABC Analysis to manage my inventory? The solution is that most
companies can use the default definition of: "A Items" - top 20% usage, "B
Items" - 21% to 50%, and "C Items" - 51% to 80%. However, these defaults
can be set to the percentages that make the most sense for your company.

100

C
Cumulative inventory cost (%)

B
80

60

40

20
A

0
0 20 60 80 100
40
Cumulative stock products (%)

Figure 3.5 : Pareto curve

3.6 SUMMARY

Annual holding cost = Ch (Q 2)

Annual ordering cost = C o ( R / Q)

Annual total Inventory cost = Ch (Q 2) + Co ( R / Q) = 2 RC o C h

2 RC o
Economic Order Quantity ( EOQ ) = Q =
Ch
Number of order = R/Q
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Annual purchase cost = RC

Total annual cost = annual purchase cost + annual ordering cost + annual
holding cost

TC = RC + (R/Q) x Co + (Q/2) x Ch,

where:

• TC = Total annual cost

• R = Demand in units per year
• C= Cost per unit
• Q = Quantity to be ordered
• Co = Ordering cost (Setup cost or cost of placing an order)
• Ch = Holding cost (Carrying cost) per unit per year of average inventory (often
holding cost is taken as a percentage of the cost of the item, such as
• Ch =IC, where
• I = the percent of carrying cost.
• Expected time between orders T = Days per year / N, where
• N = number of orders
• N = R/Q
• Demand per day d = R / Days per year
• Reorder point = d x L + m, where
• m = safety stock (minimum)
• L = Lead time (in days)

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