Materials: Controlling, Costing and Planning

Flowchart for Purchasing, Receiving, Recording & Paying for

Materials
Accounting Dept.
Purchase For accout no.
Requisition

Purchasing Dept. Vendor

account number
issues purchase order Returns acknowledge Accounting Dept.
to: - ment copy Uses:
Ships materials 1. Invoice
1. Vendor Sends invoice 2. Purchase Order
2. Accounting Dept.
3. Receiving Dept. Receiving Dept. 3. Receiving and
4. Materials Ledger Clerk Issues receiving inspection report(s) for
5. File Copy report to: invoice approval
1. Purchasing Dept. 4. Payment approved for
2. Own File voucher prepared
3. Copies to
Materials Dept. Inspection Dept. Materials Ledger
Storekeeper stores Makes distribution to: Clerk Posts quantity Treasurer
materials in 1. Own File and dollar amounts to For
proper location 2. Accounting Dept. materials ledger.
3. Materials Dept. Payment
materials ledger

Explanation:
- Purchase requisition is the principal form required in purchasing. It is like a
voucher, designed according to its demand.
- Purchase department issues purchase order. Purchase order is also a principal
form which gives the vendor a description of the goods and services desired as
well as terms, prices, and shipping instructions. Nowadays, purchase department
is also named as procurement department
- Accounting department finalizes the amounts that need to be paid but they are
not authorized to pay. Treasurer signs for the payment and they are not included
in the accounting department.

1
 Quantitative Models
Planning Materials
Requirements
Planning deals with two Fundamental Factors
1. The Quantity 2. The Time to purchase

Involves two conflicting kind of costs

1. Cost of carrying inventory 2. Cost of not carrying inventory
Interest on investment
Extra Purchasing, handling
Property tax & insurance
Transportation Costs
Warehouse or Storage
Higher Prices for Materials
Handling
Stock outs
Deterioration & Shrinkage
Additional Clerical Costs
Obsolescence
Lost sales & Bad will

Explanation:

1. Cost of carrying inventory:

- Interest on investment: this is the basic cost of capital.
- Property tax and insurance: this is actually the corporate tax.
- Warehouse / storage: this is a significant cost of carrying inventory.
- Handling: loading and unloading cost.
- Deterioration and shrinkage cost: normal or abnormal loss; it depends on raw
material.
- Obsolescence: this is a risk factor; it occurs due to technological innovation.

2. Cost of not carrying inventory:

- Extra Purchasing, handling Transportation Costs: if inventories are not carried
then goods need to be purchased frequently. It ultimately increases the cost in
discussed.
- Higher Prices for Materials: when goods are purchased at small lots, buyers are
unlikely to receive discounts that are given on bulk purchases. Thus they will
incur higher prices.
- Stock outs: occurs when shortage of raw materials stop production process.
- Additional Clerical Costs: incurred due to red tape.
- Lost sales & bad will: loss of customers or sales and thus good will when stocks
are not available at the time of sale or on demand.

2
 Economic Order Quantity (EOQ)
The order size where cost of material is
minimum
Carrying Cost = Ordering Cost
Total Cost
Low Point Annual Carrying Cost
Costs
Economic Order
Quantity (EOQ)

Annual Ordering Cost

Number of
Order

Explanation:
Economic order quantity (EOQ) is the amount of economic inventory ordered at one
time that minimizes annual inventory cost. If a company buys materials infrequently
and in large quantities, the cost of carrying the inventory is high because of the
sizeable average investment in inventory. If purchase is made in small quantities in
frequent orders correspondingly high ordering cost can result. Thus the optimum
quantity to order when carrying cost = ordering costs. We must also note that
carrying cost is inversely related to ordering cost. Economic order quantity is a
widely used traditional approach. Meanwhile, Enterprise Resource Planning (ERP) is
the advanced approach.

3
 Mathematical Formulation of EOQ
Economic Order Quantity = 2  RU  CO
CU  CC

Where, RU = Annual Requirements

CO = Cost per Order
CU = Cost per Unit
CC = Carrying Cost Percentage

4
 Derivation of the Equation
RU
1. Number of Orders Placed Annually: EOQ
RU  CO
2. Annual Ordering Costs: EOQ

EOQ
3. Average Inventory: 2

4. Annual Carrying Costs: CU  CC  EOQ

2
RU  CO CU  CC  EOQ

5. Total Costs (AC): EOQ 2

RU  CO CU  CC  EOQ
AC  
EOQ 2

CU  CC  EOQ
 AC  RU  CO  EOQ 1 
2

dAC CU  CC
   RU  CO  EOQ  2 
dEOQ 2
dAC  RU  CO CU  CC
  
dEOQ EOQ 2 2
Assuming, dAC (Here marginal cost is minimum).
0
dEOQ

2  RU  CO
 EOQ 2 
CU  CC
RU  CO CU  CC
 
EOQ 2 2

 EOQ 2  CU  CC  2  RU  CO

2  RU  CO
 EOQ 
CU  CC
2  RU  CO
 EOQ 
CU  CC

5
 Determining the Time to Order
Factors:
1. Time Needed for Delivery (Lead Time)
2. Rate of Inventory Usage (LT * Daily Usage)
3. Safety Stock – to minimize the possible stock out
Safety Stock will be maintained where total stock out cost and carrying
cost will be minimum.
Materials Control Method
Order Cycling Method or Cycle Review Method
Min-Max Method
Two-bin Method
Selective Control – ABC Plan

Explanation: While determining the time to order, the following three factors should
be taken into consideration:

1. Time needed for delivery: Lead time is the interval between the time an order is
placed and the time when the materials arrive on the factory floor, ready for
production.

2. Rate of inventory usage: Lead time * daily usage. If lead time or usage is below
expectation during an order period, the new materials arrive before the existing
stock is consumed thereby adding to the cost of carrying inventory. If lead time
or usage is greater than expected, a stock out will occur with its many forms of
cost, including lost customers. If average or normal lead time and usage are used
to determine an order point, a stock out can be expected on every other order.

3. Safety stock: to minimize the possible stock out an inventory cushion or safety
stock is often the least costly protection. Stock outs will occur only in times of
lead time. The basic problem is to determine the safety stock quantity. Time to
order depends on whether we need safety stocks or not. The optimum safety
stock is that quantity that results in the smallest total cost of stock outs plus safety
stock carrying costs.

6
 - Method of Calculation of the Reorder point when the firm is:

a. Without safety stock: lead time*usage rate.

b. With safety stock: safety stock + (lead time*usage rate);
Where safety stock equals:

1. (maximum usage – normal usage) * lead time.

Or
2. (maximum lead time – normal lead time) * Usage rate.

 Normal maximum inventory = EOQ + safety stock

 Absolute maximum inventory =EOQ + safety stock +(Normal usage
-Minimum usage) *Lead time

Is holding or maintaining safety stocks rational?

Initially at every level of units we will conduct the trial and error method.
Thus, safety stock will be maintained where total stock out cost and carrying
cost will be at minimum.

7
1. Order Cycling Method or Cycle Review Method
Goods are examined at the end of each cycle, say, 30, 60, 90 days
Cycle time varies over the products
Costly items have lower cycle time and low-cost items have higher cycle time.

Quantities of most items are subject to definable limits

Maximum quantity is established for each item
Minimum level provides the margin of safety, sets the order point

Each stock item is stored in two bins, piles, or bundles

First bin contains enough stock required from receipt of an order to the placing
of the next order.
Second bin contains normal lead time usage + safety stock

Explanation:
 Order Cycling Method or Cycle Review Method : Goods
are examined at the end of each cycle, say, 30, 60, 90 days.
Cycle time varies over the types of material. High value
critical items usually require a short review cycle. For low-
cost, non-critical items a longer review cycle is common
because order quantities are large and a stock out is not as
costly. This is a rough and simple process.
 Min-Max method: Quantities of most items are subject to
definable limits. Maximum quantity is established for each
item. Minimum level provides the margin of safety,
necessary to prevent stock outs during a reorder cycle.
Minimum level sets the order point and the order quantity
usually brings inventory up to the maximum level but not
more than that.

8
  Two-Bin Method: Each stock item is stored in two bins,
piles, or bundles. First bin contains enough stock required
from receipt of an order to the placing of the next order.
Second bin contains normal lead time usage plus the safety
stock. When the first bin is empty and the second bin is
tapped a purchase requisition for a new supply is prepared.

4. Selective Control – ABC Plan

Types of Items Characteristics

A – Type High value, Critical items – Tightest Control

B – Type Middle value – Moderate Control

C - Type Non-critical items – Simple Physical Controls (Two – bin Metho

Explanation:
So far this is the best method. It is also known as ABC plan. The term ABC is related to
material control method. Here inventories are classified into 3 types.
a. A – Type: High value, critical items are under the tightest
Control.
b. B – Type: Middle value items require moderate Control.
c. C – Type: Non-critical items are under simple physical controls
such as the two – bin method.

9
 Problems

Page: 9-32, P9-2

Selling price = $20/package

Annual requirement = 2000*12=24000 packages
Unit cost= $10 per package
Lead time = 3 days
Ordering cost = $1.20 per order
Carrying cost % =10%

 Requirement 1
2  RU  CO
 EOQ 
CU  CC
= √ (2 *24000*1.20)
10 * 0.10
= 240 packages
 Requirement 2

Number of Orders Placed Annually = RU

EOQ
= 24000
240
=100 times

 Requirement 3

Total cost of ordering and carrying blades, TC = RU *CO + CU*CC*EOQ

EOQ 2

=24000*1.20 +10*0.10*240
240 2
=120+120
=$240
 Requirement 4

Daily usage = 24000

360
= 66.67 package
Reorder point = lead time*daily usage
=3*66.67
=200 package

10
Extra inventory = 400-200
= 200 packages
Days can be used = 200
66.67
= 3 days
After 3 days, the next order should be placed.

 Requirement 5
The assumption that EOQ formula holds are always wrong, it is not fixed. So every time
the manufacturers will face problems. EOQ formula just gives a guideline for the
manufacturer.

Page: 9-33, P9-3

 Requirement 1
Order point = (Lead Time*Daily usage) + (maximum usage - normal usage)* Lead
Time
= (10*200) + (230-200)*10
=2000+300
=2300 units

 Requirement 2
Normal maximum inventory = EOQ + safety stock
= 4000+300
= 4300 units

 Requirement 3
Absolute maximum inventory =EOQ + safety stock + (Normal usage -Minimum usage)
*Lead time
= 4000+300+ (200-150)*10
= 4000+300+500
= 4800 units
 Requirement 4
2  RU  CO
 EOQ 
CU  CC
Let, CU*CC = X
EOQ = √ (2 *RU*CO)
X
Or, 4000 = √ (2 *(200*250)*80)
X
Or, (4000)² = (√ 2 *(200*250)*80)²
X

11
 Or, 2*(200*250)*80 = (4000)²
X

Or, (4000)² *X = 8,000,000

Or, 16,000,000X = 8,000,000
Or, X = 8,000,000
16,000,000
Answer: X = $ 0.5

Page: 9-33, P9-4

UNITS OF PROBABILITY NO. OF STOCKOUT CARRYING TOTAL

SAFETY OF RUNNING STOCKOUT COST COST COST
STOCK OUT OF
SAFETY STOCK

10 50% 2.5 200 30 230

20 40% 2.0 160 60 220

30 30% 1.5 120 90 210

40 20% 1.0 80 120 200

50 10% 0.5 40 150 190

55 3% 0.15 12 165 177

12
13