Material Control – Determining & Minimizing Costs

1. Maximum Stock Level

This represents the stock level above which stock should not be allowed to rise. The main purpose of this
stock level is to ensure that capital is not blocked up unnecessarily in stores.
The maximum stock level is fixed after considering the following factors:
➢ Rate of consumption of materials.
➢ Lead time, i.e., time necessary to obtain deliveries of materials from the date of order.
➢ Capital required and available.
➢ Availability of storage space.
➢ Cost of maintaining stores including insurance costs.
➢ Possibility of change in fashion, habit etc. which will necessitate change in specification of materials.
➢ Restrictions imposed by Trade Association and Government.
➢ Price fluctuations.
➢ Possibility of evaporation.
➢ Economic Order Quantity.
Maximum Stock Level =
Ordering level + E.O.Q – (Minimum requirement x Lead Time)

2. Minimum Stock Level

The stock beyond this level should not be allowed to fall. This level is fixed after considering:
➢ Average rate of consumption of material.
➢ Lead time, i.e., the time required to receive material from supplier from the point of placing the order.
➢ Stock out costs which include loss of contribution margins, loss of goodwill etc.

Minimum Level/ Minimum Stock Level =

Ordering point – (Average requirement x Lead time)

3. Re-Order Level:
It is the point at which if stock of a particular material in stores approaches, the storekeeper should initiate
the purchase requisition for fresh supplies of material.
This point is fixed between maximum and minimum stock levels in such a way that the difference of quantity
of the material between the ordering level and the minimum level will be sufficient to meet the requirements
of production unto the time the fresh supply of material is received.
When stock of materials reach this point, the storekeeper will initiate purchase requisition. The re-order level
is generally higher than minimum stock level to guard.
i. Abnormal usage.
ii. Unexpected delay in supply.

Ordering Level / Record Level or Ordering Point =

Maximum Consumption x Lead Time
This consumption may be in days, weeks, or months. If safety stock is also maintained by the firm, then
Order Level = (Average Consumption x Lead Time) + Safety Stock
Another formula for calculation of Order level is:
Order Level = Minimum level + consumption during the time required to get fresh delivery

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4. Danger Level
Normally stock should not be lower than minimum or safety stock level. But if, for any reason, stock comes
down below the minimum level, it is called danger level which will necessitate immediate and urgent actions
on the part of management for acquiring of stock to prevent loss of stock outs. As the normal lead time is
not available in such a case, purchasing on an urgent basis may result in higher purchase cost. There is also
an emergency time to receive material to safeguard against lost.

Danger Level = Average Daily Requirement x Emergency time

ECONOMICAL ORDER QUANTITY: (EOQ)

EOQ is the amount of inventory ordered at one time that minimize annual inventory cost. It means smoothly
operation of production with small investment of inventories.
The important point after preparation of list of quotation is to determine the very economical buying quantity.
It is common thing that
➢ The Price will be lower if the large quantity is purchased, however the cost of handling the material
is equal to this saving,
➢ If the company purchases in small quantities the cost per order will rise.
So quantity to be ordered at a given time must be determined by balancing two factors:-
1] The acquisition cost.
2] The cost of processing the material.
And a point where both these costs are equal is the economic order quantity.
To be able to calculate Economic Order Quantity certain assumptions are necessary:
That there is a known, constant stockholding cost.
1. That there is a known, constant ordering cost.
2. That rate of demand are known i.e. Lead time is certain.
3. That there is a known, constant price per unit.
4. That replenishment is made instantaneously i.e., the whole batch is
delivered at once.
5. The model is applicable to purchases and lot sizes in a jog shop. It
is not applicable to continuous production.
FORMULA

E.O.Q = 2 x Annual Requirement x Cost per order

Cost Per unit x Carrying Cost %

E.O.Q can also be computed be computed by using a table, or we can prove the accuracy of the EOQ by use
of table, where total order cost is equal to total carrying cost, it is the point of EOQ.
Determine the Number of Orders To Place with the help of EOQ

Annual Requirement
Number of order = E.O.Q / order size
Carrying Cost:
The costs of carrying inventory are often expressed as percentage of the average investment, because the most
common variable cost is interest or the cost of capital. Other factors can be estimated and measured; they
should include only those costs that vary with the level of inventory.
Following is a list of costs that are generally considered as carrying costs and are expressed as percentage.
➢ Interest on capital invested in stocks.
➢ Storage charges (rent, lighting, heating, and air conditioning)
➢ Stores staffing, equipment, maintenance, and running costs.
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 ➢ Material handling costs.
➢ Insurance and security
➢ Evaporation, deterioration etc.
For easiness these expenses are expressed as a percentage.
FORMULA
E.O.Q x Cost per unit x Carrying Cost percentage
2
In case E.O.Q model is not used:
Carrying Cost = Units in one order x Cost per unit x Carrying. Cost percentage
2
Ordering Cost:
(Order Cost also called Setup cost, Purchase order cost, Cost of Initiation)
It Includes:
➢ Clerical and administrative cost of purchasing, accounting and goods reception.
➢ Transport costs
➢ Where goods are manufactured internally, the setup and tooling costs associated with each production
run plus planning, production control costs, associated with the internal order.
FORMULA
Ordering Cost = Number of Orders x Cost Per Order
 E.O.Q Formula and Production Run
The E.O.Q formula can also be used to compute the optimum size of a production run, in this case Cost per
order represents an estimate of the setup cost, and Cost per unit represents the variable manufacturing cost per
unit.
For example consider following.
Suppose Stock item G99 is manufactured rather than purchased ; the setup cost (CO) is such as cost of labour
to rearrange and adjust machines, is Rs 62; variable manufacturing cost (CU) is Rs 2 per unit; annual
requirements are 6000 units; and the carrying cost is 20 percent. The optimum size of a production run is
computed as follows:

2x Annual Requirement x Setup cost = 2x 6000 units x Rs 62 Setup cost

Variable manufacturing Cost x % Carrying cost Rs 2 x 20%
Buffer Stock Or Safety Stock:
A stock allowance to cover errors in forecasting the lead time or the demand during the lead time.

Explanation:
The Economic Order Quantity formula tells us how much to buy. However, for many companies the time to
purchase is also very important, this problem seems to have to perfect solution.
If the lead time and usage pattern for a given item were always as forecast, determining when to buy would
be relatively simple, but for most of the stock items there is variation in either or both these factors.
➢ If the lead time or usage is below expectations during an order period, the new material will arrive
before the existing stock is consumed, thereby increasing the carrying cost.
➢ On the other hand, when lead time or usage us greater than expected, a stock out will occur with the
costs associated with not carrying enough.
If average lead time and usage figures are used to determine an order point, a stock out could be
expected approximately on every other order.
The way to prevent such occurrences is to provide a safety stock or caution against such contingency.

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 Important Formulas
1. Order Level / Re-order Level / Order Point / Re-order Point
(a) Order Point = Maximum Consumption x Lead Time
(If Safety Stock / Buffer Stock./ Reserve Stock is given in the Question then use)
(b) Order Point = Average consumption x Lead Time + Safety Stock

2. Maximum Stock / Max. Inventory Level / Absolute Max. Level

Max Stock Level = Order Level – (Min. Consumption x Lead Time) +EOQ

3. Minimum stock / Minimum Inventory Level

Minimum stock Level = Order level – (Average Consumption x lead time)

4. Average Inventory Level

(a) Average Inventory Level = Minimum Level + Maximum Level
2
(If Safety Stock / Buffer Stock./ Reserve Stock is given in the Question then use)
(b) Average Inventory Level = EOQ_ + Safety Stock
2
5. Danger level
Danger level = Average Consumption x Emergency lead time

6. Material Turnover Ratio

Material Turnover Ratio = Material used
Average Material
7. Average Material / Stock
Average Material = Opening Stock + Closing Stock
2
8. Material Used / Consumed
Material Used = Opening Stock + Net Purchases – Closing Stock
9. No. of Days the Average Inventory is held
No. of days the Average Inventory is held = 365
Material Turnover Ratio
10. Normal / Average Maximum Level
Average Max. Level = Order Level – (Av. Consumption x Lead Time) +EOQ
11. Economic Order Quantity / Economic batch Quantity / Standard
Order Size / Re-order Quantity

EOQ = 2 x AR x OC
CC

EOQ = 2 x AR x OC
CC %age x P.U

EOQ = 2 x AR x OC
I + CC

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Where .
AR = Annual Requirement
OC = Ordering Cost per order
CC = Carrying Cost per unit per year
P.U = Per Unit Cost
CC. %age = Carrying cost in percentage
I = Interest per unit per year
12. Number of Orders
Number of Orders = Annual Requirement
Order Size / EOQ
13. Frequency of Orders
Frequency of Orders = 365
No. of Orders

Practical Problems
P. 7 – 1: EOQ. The Hercules Equipment Company estimates its carrying cost at 15% and its ordering
cost at Rs. 9.00 per order .The estimated annual requirement is 48,000 units at a price of Rs. 4.00 per unit.
Required: 1. what is the most economical number of units to order?
2. No. of orders to be placed in a year.
3. About how often will an order need to be placed?
4. Proof of correctness of your answer for (1) in the form of a table.
Answer: (1) 1200 units (2) 40 orders (3) 9.125 Days
P. 7 – 2: EOQ with Storing cost & Interest. Following data are available with respect to a certain
material.
Annual requirement …………………. 1200 units
Cost to place an order ………………. Rs. 3.00
Annual interest rate …………………. 5%
Annual carrying cost per unit ……….. Rs. 0.25
Per unit cost …………………………. Rs. 5.00
Required: (1) Economic order quantity
(2) Number of orders per year.
(3) Frequency of orders.
Answer: (1) 120 units (2) 10 orders (3) 36.5 Days
P. 7 – 3: EOQ & Calculation of Saving. The Neely Bar Company has been buying a given item in lots
of 1,200 units which is a six months supply. The cost per unit is Rs. 12.00, ordering cost is Rs. 8.00 per order
and carrying cost is 25%.
Required: How much can the company save per year by buying in the most economical lots.
Answer: EOQ 114 units Approx. & Saving Rs. 1469
P. 7 – 4: EOQ with Interest & Calculation of Saving. Haider Corporation uses 1000 dozen
voles at Rs. 9 per dozen during two months. The cost to process an order is calculated to be Rs. 10.The Co.
assumes an interest rate of 6% and estimates the annual carrying cost, storage, insurance, etc. to be 10% of
average inventory
Required : (a) Calculate EOQ.
(b) About how often will an order need to be place.
(c) The saving per year by buying in EOQ.
Answer: (a) 289 approx. (b) 21 orders (c) Rs. 364

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P. 7 – 5: EOQ & quantity discount. King Company buys 500 boxes of item M-100 every two months.
Order costs are Rs. 187.50 per order; carrying costs are Rs.2 per unit and vary directly with inventory
investment. Currently the company purchases the item for Rs. 8 each.
Required:
(a) Determine total ordering and carrying costs under current policy.
(b) Determine the economic order quantity and the related ordering and carrying costs.
(c) What is the order size decision King Co. should make, if the supplier offers a 5% discount for
order sizes of 3,000 units?
Answer: (a) Rs. 1625 (b) 750 boxes, total ordering & carrying cost Rs.750 each.
(c) Loss 487.50, so recommended order size 750 boxes.

P. 7 – 6: EOQ with acceptance & rejection. A manufacturing company uses Rs. 200,000 material per
year, thus make purchase of 10000 units. The Cost per Order is Rs. 50 and Carrying Cost is 20% of the
Average inventory. The company currently uses an optimum purchasing policy but has been offered to
purchase five times per year, Should the offer be accepted?
Answer: EOQ 500 units, Cost Difference Rs. 2250 & offer rejected.
P. 7 – 7: EOQ & Calculation of Loss. The Electro Company manufactures some of its product lines
from raw materials, and for other products assembles purchased parts. For one product, 10,000 sub-assembled
parts at Rs. 100 each are purchased annually. This is only one of many inventory items the firm must carry,
and a capital rationing decision has been made to spend only Rs. 10,000 at a time on these sub-assemblies.
Units must be ordered in multiples of 100.The cost per order is Rs.200 & Carrying cost is 25% of the average
inventory.
Required: (1) Computation of the EOQ.
(2) The total loss by changing the EOQ and Inventory level to the availability of Capital.
Answer: (1) 400 units (2) Loss Rs. 11,250
P. 7 – 8: EOQ & Calculation of Saving. Wimbledon Club shall purchase 6,000 dozens of tennis balls
next year. Policy manual of the club prescribes to impute 10% interest on average inventory investment. Other
costs associated with storage amount to Rs. 21.60 per dozen. The cost involved in handling each purchase
order is Rs. 300. Price quoted by the supplier is Rs. 360 per dozen.
Required: (i) The economic order quantity
(ii) Secretary of the club propose to buy 2,000 dozens tennis balls in each order. Show how
much the club can save by buying in economic order quantity.
Answer: (i) 250 (ii) Annual saving Rs. 44,100
P. 7 – 9: EOQ. Chic Jeans uses EOQ model to help in the planning and control of its inventory. One of
the best items Jeans is sold to public for Rs. 600 per piece (at a markup of 400% of cost). Chic expects to buy
and sell 1200 pieces of this item during the year 2000. The relevant costs are:
Ordering cost Rs. 27 per order and Carrying cost 15% of the average inventory.
Required: Determine the EOQ and calculate the total ordering cost and carrying cost at this level
Answer: EOQ 60 pieces, Total ordering & carrying cost Rs.540 each

P. 7 – 10: Order Point & EOQ. An automobile manufacturer has a usage of 500,000 automobile tyres
of a certain size during the next year. The incremental cost of placing an order is Rs.8. The cost of storing one
tyre for one year is Rs. 2. Lead time on an order is 5 days, and the company is going to keep reserve supply
of two days usage; Usage is assumed to be constant over a 250 workday year.
Required: (1) Re-order point. (2) EOQ and Frequency of orders
Answer: (1) 14,000 tyres (2) 2,000 tyres and 1.46 days

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P. 7 – 11: Inventory Turnover. Pak Suzuki Company uses two raw materials “Alpha” and “Beta” in the
manufacturing process. The following information is available for the year ending June 30, 2008.
Particulars Alpha Beta
Inventory on 1-7-2007 Rs. 12,000 Rs. 5,000
Purchases during the year Rs. 76,000 Rs. 80,000
Inventory on 30-6-2008 Rs. 8,000 Rs. 15,000
Required: (a) Turnover Ratio for Alpha and Beta.
(b) No. of days average inventories are held.
(c) What do your infer from these calculations.
Answer: (a) 8 & 7 times (b) 46 & 53 Days approx.

P. 7 – 12: Inventory Levels. Habib Industries has developed the following data to assist in controlling
one of its inventory items.
Economic order quantity 1,000 Kg.
Average daily use 100 Kg.
Minimum daily use 80 Kg.
Maximum daily use 120 Kg.
Lead time 7 days.
Required: (i) Order point. (ii) Maximum inventory level.
(iii) Minimum inventory level.
Answer: (i) 840 kg (ii) 1280 kg (iii) 140 kg

P. 7 – 13: Inventory Levels with Varying Lead Times. From the following you are asked to compute:
(a) Ordering Point. (b) Minimum Limit.
(c) Maximum Limit. (d) Danger Limit.
AVAILABLE DATA
Average daily requirement 20 units
Time required for the receipt 40 to 50 days
Economic order quantity 1,000 units
Maximum daily consumption 30 units
Minimum daily consumption 10 units
Time to get emergency supply 5 days
Answer: (a) 1500 units (b) 600 units (c) 2100 units (d) 100 units
P. 7 – 14: Inventory Levels. Dawood Hercules has prepared following consumption forecast of material
‘M’ for the second half – year:
Month Consumption
July 22,200 units
August 24,000 units
September 23,500 units
October 24,500 units
November 26,000 units
December 25,000 units
It normally takes 30 days to receive the consignment of material ‘M’.
Required: (a) The order point for the second half of the year.
(b) The minimum inventory for the second half of the year.
(c) The maximum inventory for the second half of the year assuming the EOQ as 32,000
units.
Answer: (a) 26,000 units (b) 1,800 units (c) 35,800 units

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P. 7 – 15: Inventory Levels. The average daily requirement of 6″ diameter dish – shaped grinding wheel
is 3 pieces. Time required to secure delivery from the usual supplier is 2 weeks. From the records of Novelty
Tools works, it is found that maximum requirement of the wheel in any month of 4 weeks does not exceed
100 pieces and minimum requirement during any such period is not likely to fall below 50 pieces. You are
asked to fix minimum and maximum limits and also the ordering level. Assume the economic order quantity
to be 5 dozens. If 2 days are sufficient to receive emergency supply, fix also the danger level.
Answer: 14 pieces, 85 pieces, 50 pieces, 6 pieces
P. 7 – 16: Inventory Levels. From the books and records of Iqbal Art Press, it is found that average daily
requirement of 20 x 30 – 90 gm. art paper is 50 reams, maximum monthly requirement of the art paper do not
exceed 2,500 reams and minimum requirement during any month is not likely to fall below 1,000 reams. Time
required to secure delivery from supplier is usually 15 days. Economic order quantity is 1,200 reams.
Required: Determine, minimum and maximum limits and also order level. If three days are sufficient to
receive emergency supply, determine danger level also.
Answer: 500 reams, 1950 reams, 1250 reams, 150 reams
P. 7 – 17: Inventory Levels. The following information is available is respect of a component D 20:
Maximum stock level 8,400 units
Budgeted consumption Maximum 1,500 units per month
Minimum 800 units per month
Estimated delivery period Maximum 4 months
Minimum 2 months
You are required to calculate:
(1) Re-order level. (2) Re-order quantity.
Answer: (1) 6000 units (2) 4000 units
P. 7 – 18: Inventory Levels. Ali Manufacturing Co. uses a material Z in the manufacturing of its product.
The following data of material Z are obtained from company’s records:
Lead time 10 days
Maximum requirement per day 100 pieces
Minimum requirement per day 40 pieces
Average requirement per day 70 pieces
If EOQ is 1,000 pieces and the company maintains a safety stock of 140 pieces.
You are required to determine the following:
(1) Ordering level. (2) Minimum level. (3) Average Level
(4) Absolute maximum level. (5) Average maximum level.
(6) Danger level, if time required for emergency supplies in one day.
Answer: (1) 840 (2) 140 (3) 640 (4) 1440 (5) 1140 (6) 70