UNIT 12 PURCHASE SYSTEM AND Purchase

System and
PROCEDURE AND INVENTORY Procedure and
Inventory
MANAGEMENT Management

Objectives

After completion of this unit, you should be able to:

• appreciate the need of professionalism in purchase, define the scope and

objectives of the purchasing department of an organization and prepare
the appropriate formats of input forms to the purchase departments for an
efficient processing
• identify the demand characteristics of materials and their specifications,
management policies, legalities, etc. to identify the suitable purchase
procedures, decide on selection of suppliers, timing, price, quality and
quantity and decide on the forms, records and reports relevant to purchasing
• evaluate purchase department, evolve the procedures for vendor
evaluation, design the organizational structure for the purchase activity in
an organization and introduce computerization of purchasing activities.
• understand the meaning of inventory and identify inventory related cost
parameters, learn about various types of inventory policies, appreciate the
role of selective inventory management, know the exchange curve
concept for aggregate inventory planning and get a feel of some
mathematical models of inventory analysis
• perform sensitivity analysis on a type of model, compute safety stocks
• understand the problems of slow moving items, appreciate the role of
computers in inventory control and have a brief idea about recent
developments in inventory management.

Structure

12.1 Introduction: Role of Purchasing Function

12.2 Inputs
12.3 Restraints and Factors
12.4 Purchasing Decisions
12.5 Purchasing Organisation
12.6 Procedures, Forms, Records and Reports
12.7 Evaluation of Departmental Procedures
12.8 Vendor Evaluation and Rating
12.9 Computerized Purchasing Systems
12.10 Purchasing in Government Organisations
12.11 Introduction to inventory Systems
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Materials 12.12 Functions of Inventory
Management
12.13 Classification of Inventory Systems
12.14 Selective Inventory Management
12.15 Exchange Curve and Aggregate Inventory Planning
12.16 Deterministic inventory Models
12.17 Probabilistic inventory Models
12.18 Inventory Control of Slow Moving items
12.19 Recent Developments in Inventory Management
12.20 Summary
120.21 Key Words
12.22 Self-assessment Exercises
12.23 Further Readings

12.1 INTRODUCTION: ROLE OF PURCHASING

FUNCTION
From our daily life we know that every one of us depends on commodities
and services supplied by other individuals or organisations. Similarly, every
organisation, big or small, to varying extents, depends on materials and
services from other organisations. These materials and services are
obtained through exchange of money. This process of exchange is known
as purchasing. In the present context, we shall concentrate on the purchase
of materials. Materials constitute an important ingredient of inputs to the
activities of several types of organisations. Industries require raw materials,
components and equipments for their production, service organisations
require supplies, spare parts are required for maintenance operations, and so
on.

Furthermore, in most of the organizations, the value of materials as compared

to other inputs to the system is high. In an industry, on an average about 40 to
60 percent of the total money is spent on materials and related services.
Similar estimates about the large sums of money involved can be made for
public works departments, electricity boards, developmental agencies and
corporations etc.
With the increasing complexities in materials' characteristics and their usage
vis-a-vis increasing competition, the purchasing function has emerged as a
specialized organizational activity. In many organisations, it is regarded as a
supportive functions. However, in order to attain the maximum contribution
to the efficiency and effectiveness of an organisation, the purchasing should
be treated as one of the functional areas.
Objectives
Purchasing principle are usually epitomized as buying materials of right
quality, in the right quantity, at the right time, at the right price, from a right
source and also at the right place. The main objectives are:
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1) To make the user departments of the organisation from time to time Purchase
System and
aware of the range of the quality of materials available in the market and Procedure and
to maintain the right quality of purchased materials based on standards, Inventory
Management
technical specifications and suitability as determined by the user
departments.
2) To procure at the lowest possible cost consistent with quality and service
requirements.
3) To ensure the minimum possible investment in service operations related
to purchased materials, such as transportation, inspection, storing and
record keeping etc.
4) To maintain continuity of the supply to ensure that scheduled activities are
not interrupted.
5) To integrate the requirements of all departments of the organisation in
order to take the advantage of economy of scale wherever possible and to
also avoid duplications of purchases resulting in wastes and
obsolescence.
6) To create goodwill for the organisation through healthy buyer-supplier
relationship.

Purchasing Functions

In order to meet the above objectives of the purchasing functions, the requisite
inputs and possible restraints and factors must be identified. The purchasing
function is responsible for a host of decisions. Figure I depicts the purchasing
function.

In addition the outputs shown in Figure I, responsibilities of the purchasing

department include other related activities:

1) Vendor Rating and Development, (2) Make or Buy, (3) Value Analysis,
(4) Surplus Disposal, (5) Control and Audit, Maintenance and
Development of Procedures, Forms, Records and Reports.

Figure I: Purchasing Decision Function

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Materials We shall discuss the relevant points with reference to Figure I in subsequent
Management
sections.

12.2 INPUTS
The Preparation of inputs constitute pre-purchasing activities and decide to a
great extent the success of the purchasing system. The inputs to purchasing
come in the form of requisition or indent from various departments and units
of the organisation. The success of purchasing department depends upon the
quality of these inputs and also upon the ability of the purchasing department
personnel to analyze the inputs to the fullest extent, The most important
inputs are: purchase requisitions and their accompanying product
specifications.

Purchase Requisitions or Purchase Indents

A purchase requisition is the primary and authorization document describing

the needed items. Most organizations have a standard requisition form for the
use of all its departments. The format, however, may change from
organization to organization.

The three most common types of the requisition forms are:

a) standard purchase requisition,

b) travelling purchase requisition, and
c) bills of materials (BOM).
a) Standard Purchase Requisition Form: This form is standard for a
given organisation. Different organizations may use different formats. A
standard purchase requisition form is used for non-recurring
requirements of items and normally contains the following information:
1) Requisition number (for identification, may use blocked codes
including a short code for the department, name of the requisitioner,
year, serial no. etc.).
2) Date of the requisition.
3) Name of the department/section.
4) Account to be charged (an appropriate head may be ticked out of
standard account heads).
5) Description and quantity of items.
6) Purpose of the items.
7) Date when items are needed.
8) Approximate unit price and the total cost.
9) Suggested suppliers' names and addresses.

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 10) Signatures of the requisitioner, head of the department, approving Purchase
System and
authority (as appropriate). Procedure and
Inventory
A sample format of standard requisition form is shown in Figure II. Space Management
may also be provided for the purchasing department to record:

1 Purchase order no.

2 Shipping instructions
3 Delivery date and quantity delivered.

b) Travelling Purchase Requisition: This type of form is used by stores

for recurring requirements for materials and standard parts. The
requisition form is in the format of a card for a single item containing the
information about the item (name and brief description, brief or coded
names of the user department, annual usage rate, re-order point, order
quantity) potential suppliers, records of receipts and issues, and so forth.
The card can be used for many requisitions. When the stock level drops to
or below the re-order point, the card is sent to the purchasing department
for placing the order with the supplier. Sometimes a separate requisition
form which is a brief version of standard form, is also used when it is not
convenient to send the card. To identify that the item is requisitioned, a
colored signal clip is attached with the card until the order is received.
The entire transaction can be handled with minimum delay and without
much of clerical paperwork.

A sample format of the travelling purchase requisition card is shown in

Figure III.

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Materials Travelling Requisition Form
Management
Material description: Order Quantity:
Part number: Re-order Level:
Annual usage: Suppliers: User Departments:
A ----
B ----
C-----
Requisitioned Received RFMARKS
Date Quantity Quantity Date Quantity
on hand requested

Figure III: Specimen Of Travelling Requisition Form

c) Bill of Materials: This is a list of all items for a finished product and is
prepared at the time of engineering drawing of the product. The bill of
materials and the production schedule are sent to the purchasing
department which computes the total requirements of each part for each
period of the production. This eliminates the necessity of typing
numerous requisitions for usually a large number of items.
Specifications

Specifications of an item intended to be purchased provide detailed

description of the characteristics and features of the item. These must be
provided by the requisitioning department by taking, if necessary, assistance
from the purchasing department which has acquired specialization in the
related matter. The major objectives of the specifications are: (1) to let the
purchasing department understand exactly the features required in the item,
(2) to let the supplier know exactly what the buyer wants, and

(3) to permit the easier, quicker and accurate verification of items upon
receipt.

Following are the common types of specifications used to describe and grade
the items:

a) Market Grade: Market grades are used in case of items bought and sold
in a market place. Grading is done by comparison with a standard
generally and widely accepted. Trade associations, commodity
exchanges and government agencies establish and regulate such grades.
Market grades are limited to natural products such as wheat, cotton, rice
and lumber, etc. The suitability and success of this system, however,
depend on the accuracy of grading and ability to ascertain the difference
by inspection.
b) Commercial Standards: These standards are used for the items above
commodity level because of their widespread use. When a material or
item is standardized with complete quality description and established by
customs, and accepted by the government, its agencies and industry in
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 general, the material or item is said to be commercially standardized. Purchase
System and
Standard specifications have been prepared for many items by the Procedure and
Bureau of Indian Standards. Commercial standards have proved to be of Inventory
Management
great assistance in interchangeability for the user, and simplification of
design, purchase procedure, inventory control and cost reduction. These
play vital role in mass production.
c) Trade or Brand Names: Trade or brand names are used by some
manufacturers to establish the identity of various models produced and to
protect them from other substitute. Branded products are simplest to buy,
procedurally. Specifying an item by brand name limits the scope of
competition and indicates a reliance upon the integrity and reputation of
the supplier to provide consistent quality. This system of specification
can be very economical for low-cost lot purchases.
d) Material Specifications: These specifications define the physical or
chemical properties desired in an item. Items such as metals (aluminum,
steel, copper, etc.), drugs, oils and paints are examples of products with
material specifications.
e) Performance Specifications: Rather than describing an item physically
or chemically, performance specifications describe the requirements
about the performance characteristics. The seller is free to choose the
materials, methods of processing and other details. These specifications
are commonly used in case of equipments, machines and tools etc. This
method, however, requires proper selection of supplier. The items
supplied are tested to see that stated performance features are met.
Purchase of computer system is a good example of this technique.
f) Samples: In case of special items of non-repetitive nature or where
quality requirement is not rigid or when the quantity of items is so low
that it does not justify the formulation of specifications, specifications
are established by specimens or samples. The supplier is supposed to
match the sample. Difficulty arises if the samples are subject to change,
physically or chemically. In case of mechanical parts for replacement
where the identification marks are not easily read, this method of
specifications by sample may be the only possible way of purchasing the
item.
g) Blueprints: A blueprint or engineering drawing is recommended for
accompanying a purchase requisition when close tolerance or a high
degree of mechanical perfection is required. Blue prints are used for
mechanical parts, and for construction and other projects.
h) Combined Specifications: Many products cannot be adequately
described by a single type of specification. In such cases, a combination
of two or more specifications may be used. Quite a few products for
industrial uses are so complex that a combination becomes a practical
necessity.
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Materials
Management
12.3 RESTRAINTS AND FACTORS
Restraints limit the alternatives available to purchasing department for its
decisions. Similarly, the type of purchasing procedure adopted will depend
on the factors related to the demand for the item. In this section, we shall
discuss some of these restraints and the demand factors.

Purchasing decisions are restrained by legal considerations, management

policies, resource availability and market conditions and so forth.

Legal Consideration

The purchasing department commits a good deal of finance when a purchase

order is placed. It is, therefore, necessary to have sufficient understanding
about the legal aspects of purchase. The Indian Sale of Goods Act, 1930 and
the Indian Contract Act of 1872 cover some of important legal aspects. The
important relevant laws are (1) Law of Agency, (2) Law of Contract, (3) Law
pertaining to Sale of Goods, including Patent Laws, Warrantees, Trademarks,
etc., and (4) Arbitration. Professional legal advice related to these laws is a
must for major contracts involving large sums of money or extending over a
long period of time like imports. Indian Chamber of Commerce and
International Chamber of Commerce have codified general business
terminology to minimize the friction between buyer and seller. In addition to
the legal precautions, emphasis should be on mutual trust and confidence.

Management Policies (Centralized vs. Decentralized Purchases)

Management may choose between centralized and decentralized organization

or a mixture of these two for purchases. Centralized purchasing has economic
advantage due to specialization and input standardization and thus, is an
attractive strategy for multi-plant and multi-location activities using related
items. In addition it offers:
1. Development of specialized purchasing skills.
2. Consolidation of order quantities which can result in quantity and cash
discount
3. Better control over inventory investment.
4. Less overlapping and duplication of effort.
5. Uniform quality and less variety of materials.

Centralized purchasing however, tends to be slow, rigid, and rule-bound, and

may turn out to be very costly for low-value purchases. Also, if item required
by various departments are unrelated and less frequently demanded, the
advantages of centralization may be lessened. In such cases, management
may decide to decentralize the purchase.

Resource Limitations

Finance is the major resource which can seriously influence the purchasing
activities. The corporate finance is shared by all the departments of the
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organisation and purchase department must operate within the allocated Purchase
System and
budget. This may lead sometimes to purchasing decisions somewhat less Procedure and
optimal than what it would have been had the purchase department been able Inventory
Management
to get the finance as and when desired. Thus sometimes the advantages of
quantity discounts might have to be foregone in favour of overall financial
planning of the organisation. Other resources such as manpower, storage
space, and handling equipments also place limitations on purchasing
decisions.

Market Conditions

The market conditions relate to short-term market situations which are

influenced by supply and demand as well as overall national economy. Thus
during shortage, the reliability of supply may be considerably more important
than the price. The purchasing strategies should, therefore, change to cope up
with these situations, and ability to anticipate these conditions measures, to a
good extent, professionalism acquired by purchase personnel.

Demand Factors

Based on the demand pattern, the items can be grouped into four basic
categories:

1) Items Used Continuously: Items that are continuously used with a fairly
predictable demand can be handled under blanket purchase orders (also
known as open-end purchase orders). A contract is negotiated with
supplier(s) for a fixed period of time (six months or one year) with
quantities, delivery dates, discounts etc. The price may be fixed, or kept
open in which case the market price at the time of delivery will be
applicable. Blanket orders conserve the time and effort of the purchasing
department,

2) Large Single Orders: The situation of large single orders usually occurs
in case of special machinery or other special goods, such as computers,
vehicles and buildings etc. Considerable planning and evaluation are
involved. The suppliers submit their bids with all relevant details and
purchases are negotiated by comparison and evaluation of the bids.

3) Small-value Purchases: The low-cost infrequently used items are

purchased usually by the concerned departments using petty cash or by
identifying some small local supplier. For the value involved, it is not
worth going through the complete cycle of purchase process.

4) Normal Purchases: Items other than mentioned above fall in this

category and are handled by the normal procedure, i.e., following the
complete cycle of the purchase process discussed above.

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Materials
Management
12.4 PURCHASING DECISIONS
With the purchase requisitions and specifications as inputs from the
departments and sections of the organizations, the restraints from the external
environment and the factors about the demand pattern, the purchasing
department has to make several decisions. Some are purely operational while
some relate to policy formulation having far-reaching impact on the long-
term success of the organisation. In this section we shall discuss the
operational decisions. Policy related decisions will be covered in subsequent
sections.
From purchase requisitions, the purchasing department generates purchase
orders which is a legal document. Purchase order forms vary in their format
and their routing through the organisation. A purchase order should contain at
least the following:
1) Purchase order number (for identification).
2) Date of issue.
3) Name and address of supplier receiving the order.
4) Quantity and description of item(s).
5) Required delivery date.
6) Shipping instructions.
7) Price and payment terms.
8) Other conditions governing the order.

A sample of the purchase order is shown in Figure IV

PURCHASE ORDER
No. …………………………………. Date: …………
………………………………….
………………………………….
………………………………….
Date.......
REF: Quotation No......................................... Dated ……………....
S. Description Quantity Unit Rate Amount
No. required Rs. P. Rs. P.
1 ……………. ……………. ……… ……….. ………
2 ……………. ……………. ……… ……….. ………
: Total Value

Payment Terms:
Delivery Terms:
Terms related to Sales Tax.
Other Information:
Copy to: All concerned departments Purchase Officer

Figure IV: Specimen of Purchase Order

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We shall now discuss some of the decision function leading to preparation of Purchase
System and
the purchase order. Procedure and
Inventory
Supplier Selection Management

Information on external sources of supply can be obtained from numerous

references:

(a) industrial advertisements of the supplier appearing in newspapers and

periodicals, (b) supplier catalogues, (c)supplier salesmen, (d) trade journals, (e)
trade directories prepared by government agencies and trade associations, (f) list
of suppliers approved by the government agencies, (g) enquiries through
advertisements or individual communications, and (h) records of the
organizations past purchases.

After compiling the information about suppliers for the needed item, relative
proficiency of each potential supplier must be assessed on the basis of
comparative quotations of price, quality, quantity, delivery, and other
services. Other relevant variables are the supplier's management capability,
technical ability, production capacity, quality of service, and financial
stability. The purchase order is then issued to the most promising supplier.
The information about other suppliers can be stored for future references.

Timing of Purchases

An organization is primarily interested in an adequate supply of material at

the best price consistent with quality requirements. Timing is not a critical
concern when the purchases are made in price stable market but it becomes
critical in unstable price market situation. Following approaches may be
adopted while trying to time the purchases in response to market conditions:

a) Speculative Buying: It involves purchasing in excess of foreseeable

requirements in order to make profit (or imputed profit) from rising
prices. Opportunities arise for such a purchase when price falls
temporarily and the organisation has sufficient working capital to finance
such speculative purchases.
b) Forward Buying: It involves purchasing in economical quantities
exceeding current requirements, but not beyond actual, foreseeable
requirements. This approach is often used when prices are stable over
time. It is adopted to obtain a favourable price, to get quantity discounts,
to secure items when they are available, and to protect against
prospective shortages. It, however, assumes the risk of increased
inventory holding cost which ties up working capital.
Hand-to-mouth Buying: This practice is resorted to satisfy only immediate
current requirements and may be uneconomical. This may be suitable in case
of high- value items. It is not recommended for normal operations.

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Materials There are inherent risks in all these approaches in the environment of
Management
fluctuating market and price instability. Two techniques may be used to
reduce the financial risk.

a) Time-budgeting Purchases: Using time-budgeting purchases, an

organisation can frequently purchase an item over a long periodic cyclic
fluctuation at an average price very close to average market price. This is
accomplished by purchasing small quantities over short operating
periods of equal length.
b) Hedging: The organization purchases the required quantity on the spot or
open market and at the same time sells the same quantity in the future
market contracting to deliver at a future date in order to mitigate the risk
associated with fluctuating prices. This approach, however, can be used in
case of those items for which organized commodity markets or exchanges
exist.

Price Determination

Price per unit of an item comprises the unit purchase price, transportation
cost, handling cost, inspection, insurance and the administrative variable cost.
The right price simply means the lowest possible total price for the
organisation.

The typical approaches for price determination are published price lists,
competitive bidding, and negotiation. Price lists published by the suppliers
give initial indication of the price. In competitive bidding, the requests for
bids are sent to several suppliers. Usually (not always) the lowest bidder gets
the order. Normal practice requires at least three competitive quotations
wherever possible. Generally competitive bidding is most applicable to
standardized products that are widely used and are produced to stock.

Bids are normally secured when the size of an order exceeds some minimum
amount.

Negotiation is the approach resorted to when time is too short, the number of
bidders is too small, value of purchase is high, willingness to compete is
lacking, or the specifications are too vague. In such circumstances, the buyer
contacts the potential supplier and negotiates for the fair price and prompt
delivery. An advance planning and analysis are expected to bring satisfactory
results out of negotiation.

While determining the price, shipping terms should also be clarified. The
shipping terms established (1) who will pay the freight charges, (2) when
does the buyer take the legal title to the goods, and (3) who will prosecute
loss and damage claims against carriers. There are numerous terms of
shipment, but the most common ones are:

a) F.O.B. (Free on Board) Buyer's Plant: The buyer takes the title to the
goods when the goods are delivered at his plant and supplier pays all
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 transportation charges and processes all claims against the carrier for Purchase
System and
damages or loss of goods. Procedure and
Inventory
b) F.O.B. Seller's Plant: The buyer takes the title when goods are loaded Management
onto the carrier and he pays all transportation charges as well as
negotiates all freight damage claims with the carrier.
c) F.O.B.Seller's Plant—Freight Allowed: Legal responsibilities same as
in F.O.B. seller's plant, but the supplier pays the freight charges.
d) C.I.F. (Cost of Insurance and Freight) Contracts: The price includes
cost of materials, insurance and freight.
e) F.A.S. (Free Alongside Ship): Used in shipping by sea where supplier is
responsible for getting goods to the ship, and the buyer takes title as well
as all responsibilities thereafter.

Further, purchase contracts can be of fixed price (quite common), cost plus
contract (no definite limit to costs) or blanket order (for six months or one
year ) type.

Discounts: An important aspect of price determination involves discounts

that can be secured. Following types of discounts are common:

1) Trade Discount: To protect certain distribution channel when it is

economical to buy from the distributor rather than from the manufacturer.

2) Quantity Discount: For purchasing worth beyond certain amount of

money.
3) Seasonal Discount: For purchasing in off-season.
4) Cash Discount: For prompt and full payment.

Quality and Quantity

The process of determining right quality in purchasing implies striking a

balance between technical specifications and economic considerations. The
right quality has no absolute meaning but is specified in relation to a purpose.
As mentioned above most of the technical specifications are decided by the
requisitioning department. The purchasing department should be instrumental
in taking the quality decisions by making available various market grades,
trade names, commercial standards etc. and corresponding prices and sources
of supply to the requisitioning departments to enable them to specify quality
of items. Once the quality standards are specified, the purchasing department
makes arrangement in collaboration with the requisitioning department for
the inspection of the items after delivery. Sometimes, inspection is performed
by an organizational representative in the vendor's plant. On-site inspection
can save time and money while minimizing operational delays from the
inferior quality. For normal items supplied in lots, inspection for acceptance
is carried out by sampling.

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Materials Procedures should be established for handling inferior quality. Should the
Management
shipment be returned to the supplier and contract cancelled? Should the buyer
rework the item to an acceptable quality and bill the supplier? Should only
rejected items be returned for replacement and acceptable items retained?
Such issues must be resolved in advance to maintain a long-term relationship.

After determining the quality, the next important step is to determine how
much quantity to buy and when. For items continuously used, the purchasing
department can collect the projected demands from various departments and
then can incorporate these details into the blanket purchase order. For large
single orders, there is not much to decide about the quantity. Small-value
purchases are made as and when need arises. For normal purchases usually
two quantities govern the ordering decision: reorder-point and order quantity.
When the stock goes to or below reorder-point an order for the required
quantity is placed.

Reorder-point = Safety stock + average demand during the lead-time

A= fixed cost of ordering (Rs./order)

D= average annual demand (unit/year)

H = holding cost(Rs./unit/year)

Safety stock depends on the variation of demand and can be taken as 3 times
the standard deviation.(Safety Stock = 3Std Dev)

In case of production components, the determination of right quantity can be

linked with the concept of Materials Requirement Planning(MRP).

14.5 PURCHASINGORGANISATION
Purchasing department is usually under the General Manager at par with
other functional departments such as engineering, finance, accounts,
manufacturing and marketing etc. Sometimes it is kept along with other
related departments like stores, inventory and materials control, under
materials manager who in turn is under General Manager. Choice of an
organizational structure depends on the volume of work and value of the
purchase. A good structure encourages the assignment of specific
responsibilities, specific authorities and smooth chains of command of
delegation. It should lead to the development of policies that permit routine
decisions to be made by subordinates.

Within purchase department, the structure may be worked out using

following approaches:
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a) Organization by Function: It is based on the principle that job should be Purchase
System and
organized so as to promote maximum possible specialization of skills. Procedure and
Total purchasing job is broken up on the basis of specialization, such as Inventory
Management
(1) processing of purchase requisitions, (2) floating enquiries, (3)
selection of suppliers, (4) preparation of purchase orders,(5) receipt
inspection and storing, (6) liaison with accounts section, (7) records
maintenance etc. Each job, or a group of jobs, is assigned to individual or
group of individuals who specialize in that work. This approach has
obvious advantages but suffers from the disadvantage of people getting
bored doing the same kind of jobs for a long time, and sometimes it leads
to bureaucratization.
b) Organization by Product: The items purchased are classified into
groups and each group is assigned to a team of personnel who specialize
in purchase of that particular type of the materials. For example, a team
may be specialist in buying raw materials, while other in components
and sub-assemblies, and so forth.
c) Organization by Location : This is applicable for the organizations
which are large and have several plants. Each plant may have a
purchasing department under the overall supervision of the central
purchasing department.
d) Organisation by Stage of Manufacturing: In case of manufacturing,
sometimes it is advisable to organise the purchase activities according to
the stage of manufacturing, e.g. raw materials, parts and sub-assemblies
etc.

14.6 PROCEDURES, FORMS, RECORDS AND

REPORTS
Procedure

By procedure we mean the entire set of steps in which a purchase transaction

is carried through from its inception to its conclusion. These steps together
form the purchase policy of an organization. Since there are wide variations
among industries, companies, organizations, products and personnel, it would
not be feasible to establish a single set of procedures which would apply to
all cases. The following basic steps, however, must be taken in one way or
another:

1) Receipt and analysis of requisition to assess the need and description of

requirement.
2) Selection of possible sources of supply.
3) Determining the time, price, quality and quantity.
4) Placing the order.
5) Following up and expediting of the order.
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Materials 6) Checking. the invoice and receiving the order.
Management
7) Processing discrepancies and rejections after inspection.
8) Communicating with accounts' section for payment.
9) Closing completed records.
10) Maintenance of records and files.

A schematic purchase procedure involving some of these steps is shown in

Figure V.

Figure V: A Schematic Diagram Of Purchase Procedure

Purchase Forms

Forms are very important tools for purchasing department to standardize the
communication with internal departments of the organization and external
agencies such as supplier and local government bodies, etc. The number of
forms required depends on the size of the organisation, the purchasing system
employed in the organisation, and the accounting and internal control
methods in effect. Normally there should not be too many forms as they
create confusion and red tapeism. Certain links of communication can be sent
in copies of some forms (as shown in Figure V) instead of individual forms.
The forms should incorporate the principles of good design to facilitate data
entry and data retrieval, to minimize the possibility of errors, and finally, to
be just economically sufficient in size and number of entries required.

Purchase forms for the following functions are usually employed (some of
which have already been exhibited).

1) Purchase requisition

2) Request for quotation

3) Purchase order

4) Follow-up
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5) Receiving and Inspection. Purchase
System and
Procedure and
In addition, some other forms are also used by some large organizations. Inventory
Among such forms are: acknowledgement for quotation received, change of Management
order notice, purchase contract and sample test report etc.

Purchase Records

Since purchasing is a repetitive process, accurate records are a necessity for

efficient operation. These records provide a history of what has been done in
the past (supplier, price, discounts and quality of delivery etc.) and provide a
wealth of information upon which to base future decisions. Maintaining a
good-record system will increase operating costs but expectedly it should
bring some handsome savings in the long run.

Most purchasing departments maintain the following basic records:

1) Purchase Order Log: It contains a numerical brief record of all

purchase orders issued. It contains purchase order number, supplier's
name, brief description of purchase, total value of the order etc. The log
makes it possible to summarise several administrative data.

2) Open Order File: Contains the status of all outstanding orders. It

contains purchase requisition, purchase order and follow-up data.

3) Close Order File: Contains a historical data of all completed purchases.

4) Vendor Record : Contains the names and addresses of suppliers, materials

that a supplier can supply, delivery and quality records.

5) Commodity Record: Such record is maintained on each major material or

service that is purchased repetitively. It shows the list of suppliers, annual
usage rate, price, orders placed, orders received and disbursements to the
departments.

6) Contract File : Contains the purchase records of items under a term

contract. It is specially important when the contract is an open one, against
which orders may be placed.

Purchase Reports

Since the purchasing department handles a sizeable proportion of corporate

finance, it is desirable to have some summary reports periodically (quarterly,
half-yearly or annually) available to the management. Some of the important
reports are:

1) Total value of purchase.

2) Allocation of purchase value against major items.
3) Allocation of purchase value against each requisitioning department.
4) Budget for purchase for the next year.
367
Materials 5) Proposals for revisions of budget in current year.
Management
In addition, the purchasing department brings out the report for its own use.
They are:

1) Vendor Performance Report

2) Pattern of Consumption of materials.

3) Pattern of market prices.

12.7 EVALUTION OF DEPARTMENTAL

PROCEDURES AND VENDORS
Evaluation of the purchasing department is essential for the economic health
of the organization. At the same time, a good proportion of the efforts in
purchasing activities are not immediately visible and so the evaluation
becomes rather difficult. In any case, a consistent effort towards this aspect
must be kept on with the following objectives of evaluation:

1) Performance improvement of the department.

2) Aid to Organization.
3) Easy coordination amongst departments.

Establishing evaluation criteria is also very difficult. Following criteria can

be combined for an overall picture of purchasing performance:

1) Cost-Purchase Comparison (annual cost of purchasing department

divided by the total value of purchases).

2) Cost per Order (total purchasing department cost ddivided by the number
of orders).

3) Return on Investment (net savings per rupee. spent on purchasing).

4) Quality Criteria (measured by number of rejects).

5) Quantity Criteria (measured by down time).

6) Price Criteria (comparison with other organization or standard price

indexes).

The evaluation standards can be based on past performance, budgeted

performance, or performance of departments in other organization to judge
what is being done as compared to what should have been done.

12.8 VENDOR EVALUATION ANDRATING

It is not always easy to identify good suppliers. Records maintained or
procured from some other sources about the vendors help in their evaluation
and rating. Usually a combination of price, quality, quantity, delivery time
368
and service etc. giving relevant weightages to these factors is used to rate the Purchase
System and
vendors. 1n addition, a checklist can be used to facilitate rating from Procedure and
department standpoints. Some of the points are mentioned below: Inventory
Management
Reliability

1) 1s the supplier reputable, stable and financially strong?,

2) Are the supplier's integrity and ability above doubt?
3) Is the supplier going along with product improvement?
4) Is the supplier's competitive strength as to price and quality, etc. proved
by past experience?
Technical Capabilities
1) Can the supplier provide assistance as to application engineering?
2) Can the supplier provide assistance as to analytical engineering?
3) Can the supplier provide design assistance?
4) Can the supplier handle special needs and contribute to improve product
efficiency/basic processes?

Convenience

1) Can the supplier help reducing acquisition costs through personal visits,
telephone calls, incoming inspections, rejection of defects and spoilage,
etc?
2) Can he offer other related products?
3) 1s he qualified to help in solving difficult problems?
4) Does the supplier package his product conveniently?
Availability
1) Does the supplier assure delivery in time?
2) Are his stocks locally available, and or at short notice?
3) Is the supplier's location advantageous?
4) Can he plan his supply to minimise inventory?
5) Can he be depended on for a steady flow of materials?
After-sales Service
1 Does the supplier have a service organization?
2 Is an emergency service available?
3 Are parts available, when needed?
Sales Assistance
1 Can the supplier help building mutual markets?
2 Will he recommend our products?
3 Does the use of supplier's product enhance appearance of our products? 369
Materials Vendor Evaluation
Management
Recognizing that there is a need for having good vendor, it is essential that
supplies are obtained from vendors after an evaluation of his capabilities. The
buyer, who has to do the evaluation, is faced with two different situations;

1 Evaluating the performance before the vendor has delivered anything.

2 Evaluating the performance of vendor after the deliveries have been

made.

The latter one is normally called Vendor Monitoring and the former Vendor
Evaluation.

In case of Vendor Evaluation the buyer lacks the direct evidence on the
results achieved by the vendor and must get his information in other ways.
This includes (1) general reputation of vendor, (2) data from other buyers,(3)
vendor surveys.

Vendor Rating

Product quality submitted by vendors has always been evaluated and used as
a factor in making purchasing decisions. Recently, the evaluation has been
formalized by the use of vendor rating formulas which provide a quantitative
measure of vendor quality. These ratings are primarily meant to provide an
over all quality rating of a vendor for use in reviewing, comparing, and
selecting vendors. Vendor rating is not a tool for making decisions on
submitted lots.

To create a single numerical quality score is difficult because there are

several inputs, each involving its own unit of measure:

1 The lot quality, expressed as lots rejected versus lots inspected.

2 The parts qualities, expressed as per cent defective.
3 The characteristic qualities, expressed in numerous natural units, e.g.,
rupees per square cm., per cent active ingredient, MTBF (mean time
between failures) etc.
4 The economic consequences of bad quality, expressed in rupees.

The National Association of Purchasing Agents, New York, has published

three alternative vendor rating plans:

1 Categorical Plan: This is a non-quantitative system in which buyers

hold a monthly meeting to discuss vendors and rate each as plus, minus,
or neutral.

2 Weighted-point Plan: Each vendor is scored on various factors like

quality, price and service etc. These factors are weighted and a
composite rating is then calculated for each vendor. The details of this
performance evaluation scheme are as follows:
370
i) Quality Rating: Quality Rating for a consignment Purchase
System and
Procedure and
Inventory
Management
where,
Quantity supplied, Quantity accepted Quantity accepted
with concession, Quantity accepted with rectification
Quantity rejected and and X1 and are
weightage factors each less than
ii) Price Rating: Price rating for a consignment:

where, PL = Lowest price quoted, = Price agreed by supplier

iii) Delivery Rating: Delivery rating for a consignment:

Rating in excess of 100 shall be equated to

iv) Quantity Rating: Quantity Rating for a consignment:

Qty supplied within stipulated delivery time

RQty = ——————————————————— × 100
Quantity promised
Q
100
QP

v) Service Rating: Service Rating, , is to be assigned by Purchase

Department as per the following table for each consignment.

SI. No. Service Factor Max. Score

1 Cooperativeness and readiness to help in

emergencies

2 Readiness to replace rejected material

3 Providing support documents in time

4 Promptness in reply

5 Acceptance of terms without complaints

371
Materials vi) Composite Vendor Performance I Rating:
Management
VPR = f1RO + f2RP + f3RD + f4RQty + f5RS

where, f1 + f2 + f3 + f4 + f5 = 1

Fixing of Weightage Factors: In order to implement this scheme, it is

necessary to fix the weightage factors X1, X2, a1, a2, a3, a4,a5, f1, f2, f3, f4
and f5 as suited to the organization.

3 Cost-ratio Plan: This plan compares vendors on the total rupee cost for
a specific purchase. Total cost includes price quotation, quality costs,
delivery costs, and service costs. The final rating is in rupees of net value
cost. The net value cost is the product of the adjusted unit price and the
number of units. The adjusted unit price incorporates three cost ratios.

i) The quality cost ratio reflects the relative cost of quality.

ii) The delivery cost ratio reflects the relative cost of placing and
receiving an order. It also includes a promises-kept penalty based on
a ranking of past performance of vendors.
iii) The service cost-ratio reflects the technical, managerial, and field
service competence of the vendor.

All three of these plans recognize quality in the rating of vendors but the
rating is not restricted to product quality.

Vendor Relations

The ultimate objective in vendor quality assurance is the production of

materials which so adequately conform to the buyers, requirements that there
is no need for extensive acceptance or corrective procedures by the buyer.
The activities needed to achieve this objective include:

1 Communication of essential and helpful information, design,

specifications, standards and practices etc.
2 Communication of engineering changes, changes in specifications etc.
3 Developing methods for detecting deviations from standards promptly.
4 Helping the vendor in resolving quality problems. In case of vendors like
sub-contractors and ancillaries, rendering necessary technical assistance
as well.
5 Providing for use of vendor quality data in lieu of in coming inspection.
6 Using multiple vendors for major procurements of items.
7 Developing methods for identifying the qualified vendors, and for
eliminating those who are unable to meet the quality rrequirements.
8 Reviewing the performance of the vendor through vendor rating or other
plans and following up on the chronically poor vendors.

372
The guiding principle in vendor relations is the spirit of what is best for the Purchase
System and
partnership. The supplier must be made to realise that it is not sufficient to Procedure and
accept the returns willingly or to negotiate the disposition of materials not Inventory
Management
delivered to the specifications. The supplier should view such instances
objectively and work constructively with the buyer to correct the conditions
that brought about the delivery of unsatisfactory material or service.

12.7 COMPUTERISED PURCHASING SYSTEM

The attractive characteristics of computers such as high speed, huge storage,
quick retrieval accuracy, versatility and diligence on the one hand and
increasing complexities in purchasing on the other make an excellent match
for computerization of purchasing system. The declining cost of computer
system is an additive factor.

Although there are no complex arithmetic computations involved in

purchasing, the requirements of quick processing of requisition, follow up
and payment etc. find a computer of immense help. In this section, we shall
discuss broad outline of computerization of the system (not the computer
technology).

Let us visualize that the computer has the following files:

1 Inventory file for each item.

2 List of the suppliers (alongwith their performance history).
3 Budget allocation for each department.
4 Master purchase file condensing the previous purchases (item-wise,
department- wise, supplier-wise, price and quality etc.)

In addition, the computer has facilities to print and (may do so on a

preprinted stationery) the quotation request, purchase order, follow up and
inspection report etc.

When a requisition is received, the relevant data are entered through the
appropriate programme. Now a days, the screen and template designs are
proving much more convenient and fool proof. The computer checks the
inventory status of the items and if in-stock, items are issued and inventory
record is updated. If not in the stock, a programme finds the classification of
the item, that is, whether it is a continuously used item or a special item.
From the suppliers list, it finds the suppliers who can supply the items and
prints quotation requests. If it is a special item, then human intervention will
of course be needed to float the enquiries. The programme also checks the
budget of the department and account head to which the sum is to be debited.
The data from quotations are entered and the computer displays the
comparative statement. It will select the supplier and print the purchase order.
Upon receipt, it will update the inventory of the item. In addition, computers
373
Materials are very useful for monitoring the status of the purchase order to assist in
Management
follow-up actions.

So we see that computer performs all the actions displayed in Figure V and
generates the reports as desired above. In addition it is very useful in
processing exceptional reports, such as budget is over, orders not supplied in
time and payments not made in time etc.

It may be mentioned that most of the computers, specially small and mini-
computers, offer a host of utilities which are very useful for computerization
of tasks like purchase.

Computerization of purchase (such as receiving, issuing, instruction, stores,

inventory and handling etc.) can easily bring. the desire coordination among
other functions of materials management as well as among other departments
of the organization such as production, design, engineering, finance and
accounting, marketing etc. through suitable design of data base and
information systems.

12.10 PURCHASING IN GOVERNMENT

ORGANISATIONS
With the aim of providing the best possible service to the society out of the
limited resources and following its policy of mixed economy, the
Government of India has itself entered into manufacturing and other types of
commercial and trading activities. To gain the advantages of centralized
purchase all Governmental purchase operations are controlled by a central
agency, the Directorate General of Supplies and Disposal (DGS & D), New
Delhi headed by its Director General (Supplies and Disposal) under the
Ministry of Supply, Government of India. The DGS & D is responsible for
all purchase of materials of all kinds and functions as a purchasing and
inspection agency on behalf of:

1 All Ministries, attache's and subordinate offices of Government of India.

2 All State Governments and their departments.
3 All local bodies, such as, Municipal Corporations, District Boards, etc.
4 All Quasi-public Institutions, Statutory Corporations and Public Sector
industrial undertakings may also avail of the services of the DGS &D.

It also makes purchases from foreign countries through its subsidiaries like
the Indian Supply Mission in London and Washington. It also purchases from
East European and South-Eastern countries on trade agreements.

Organisation Set-up of DGS &D

The role of the DGS & D is very wide and, for smooth and efficient
functioning, it is divided into following wings:

374 a) Supply
b) Inspection Purchase
System and
c) Progress Procedure and
Inventory
d) Disposal. Management

The organisation has regional offices located at Kolkata, Mumbai, Kanpur

and Chennai. Besides, there is a regional-office at Mumbai exclusively for
textiles. The regional offices are empowered to purchase a large number of
items provided the individual demand for them does not exceed a pre-fixed
amount. All items financed through foreign loans are purchased by the HQ
irrespective of their nature and value.

In addition to the activities carried through its wings, the DGS & D performs
the following functions and has directorates and offices all over the country.

1 Public Relations and Publications.

2 Standardization and Quality Control.
3 Development of Indigenous Sources of Supplies.
4 Purchases from Cottage and Small Scale Industries.
5 Registration of Suppliers.
6 Termination, Suspension and Black-listing of Suppliers.
7 Rate and Running Contracts.
8 Payment Procedure.
9 Indent Processing.

12.11 INTRODUCTION TO INVENTORY

SYSTEMS
Concept of Inventory .

‘Inventory’ may be defined as ‘usable but idle resource’. If resource is

some physical and tangible object such as materials, then it is generally
termed as stock. Thus stock or inventory are synonymous terms though
inventory has wider implications.

Broadly speaking, the problem of inventory management is one of

maintaining, for a given financial investment, an adequate supply of
something to meet an expected demand pattern. This could be raw materials,
work-in-progress, finished products or the spares and other indirect materials.

Inventory can be one of the indicators of the management effectiveness on

the materials management front. Inventory turnover ratio (annual
demand/average inventory) is an index of business performance. A soundly
managed organization will have higher inventory turnover ratio and vice-
versa.

375
Materials Inventory management deals with the determination of optimal policies and
Management
procedures for procurement of commodities. Since it is quite difficult to
imagine a real work situation in which the required material will be made
available at the point of use instantaneously, hence maintaining, inventories
becomes atmost necessary. Thus inventories could be visualized as
‘necessary evil'.

Inventory Related Cost

An inventory system may be defined as one in which the following costs are
significant:

a) cost of carrying inventories (holding cost)

(b) cost of incurring shortages (stock out cost)
(c) cost of replenishing inventories (ordering cost)
a) Cost of carrying inventory :This is expressed in Rs./item held in
stock/unit time. This is the opportunity cost of blocking material in the
non-productive form as inventories. Some of the cost elements that
comprise carrying cost are—cost of blocking, capital (interest rate); cost
of insurances; storage cost; cost due to obsolescence, pilferage and
deterioration etc. It is generally expressed as a fraction of value of the
goods stocked per year. For example, if the fraction of carrying charge is
20% per year and a material worth Rs.1,000 is kept in inventory for one
year, the unit carrying cost will be Rs. 200/item/year. It is obvious that
for items that are perishable in nature, the attributed carrying cost will be
higher
b) Cost of incurring shortages: It is the opportunity cost of not having an
item in stock when one is demanded. It may be amounting to lost sales or
back logging. In the backlogging (or back ordering) case the order is not
lost but is backlogged, to be cleared as soon as the item is available on
stock. In lost sales case the order is lost. In both cases there are tangible
and intangible costs of not meeting the demand on time. It may include
lost demand; penalty cost; emergency replenishment and loss of good-
will etc. This is generally expressed as Rs./item short/unit time.
c) Cost of replenishing inventory: This is the amount of money and
efforts expended in procurement or acquisition of stock. It is generally
called ordering cost. This cost is usually assumed to be independent of
the quantity ordered, because the fixed cost component is generally more
significant than the variable component. Thus it is expressed as
Rs./order.

These three types of costs are most commonly incorporated in inventory

analysis, though there may be other costs parameters relevant in such an
analysis such as inflation and price discounts etc.

376
Importance of Inventory Management Purchase
System and
Procedure and
Scientific inventory management is an extremely important problem area in Inventory
the materials management function. Materials account for more than half the Management
total cost of any business and organizations maintain huge amount of stocks
much of which could be reduced by following scientific principles. Inventory
management is highly amenable to control. In the Indian industries there is a
substantial potential for cost reduction due to inventory control. Inventory
being a symptom of poor performance we could reduce inventories by proper
design of procurement policies by reduction in the uncertainty of lead times
by variety reduction and in many other ways.

12.12 FUNCTIONS OF INVENTORY

As mentioned earlier, inventory is a necessary evil. Necessary, because it
aims at absorbing the uncertainties of demand and supply by ’decoupling' the
demand and supply sub-systems. Thus an organisation may be carrying
inventory for the following reasons:

a) Demand and lead time uncertainties necessitate building of safety stock

(buffer stocks) so as to enable various sub-systems to operate somewhat
in a decoupled manner. It is obvious that the larger the uncertainty of
demand and supply; the larger will have to be the amount of buffer stock
to be carried for a prescribed service level.
b) Time lag in deliveries also necessitates building of inventories. If the
replenishment lead times are positive then stocks are needed for system
operation.
c) Cycle stocks may be maintained to get the economics of scale so that
total system cost due to ordering, carrying inventory and back logging
are minimized. Technological requirements of batch processing also
build up cycle stocks.
d) Stocks may build up as pipeline inventory or work-in-process inventory
due to finiteness of production and transportation rates. This includes
materials actually being worked on or moving between work centers or
being in transit to distribution centers and customers
e) When the demand is seasonal, it may become economical to build
inventory during periods of low demand to ease the strain of peak period
demand.
f) inventory may also be built up for other reasons such as: quantity
discounts being offered by suppliers, discount sales, anticipated increase
in material price and possibility of future non-availability etc.

Different functional managers of an organisation may view the inventory

from different viewpoints leading to conflicting objectives. This calls for an
integrated systems approach to planning of inventories so that these
conflicting objectives can be scrutinised to enable the system to operate at 377
Materials minimum total inventory related costs—both explicit such as purchase price,
Management
as well as implicit such as carrying, shortage, transportation and inspection
costs. Concepts and techniques useful in analysis of these problems to arrive
at sound policy decisions are the focal point of presentation in this unit.

12.13 CLASSIFICATION OF INVENTORY

SYSTEMS
Lot Size Reorder Point Policy

Under this operating policy the inventory status is continuously reviewed and
as soon as the inventory level falls to a prescribed value called ‘Reorder
Point’, a fresh replenishment order of fixed quantity called Economic Order
Quantity (EOQ) is initiated. Thus the order size is constant and is
economically determined. This is one of the very classical type of inventory
policies and a lot of mathematical analysis has appeared on this type of
policy. Figure VI shows the typical stock balance under this type of inventory
policy. The solid line in this figure represents the actual inventory held in
practical situation with a finite lead time, the lead time being defined as the
time delay between the placing of a replenishment order and its
subsequent receipt. The broken line indicates the inventory that would be
held in the ideal situation if no lead time existed. Lot size and reorder point
are the two decision variables involved in the design of the policy.

Fig VI. Typical Inventory Balances for EOQ-Reorder Point Policy

Fixed Order Interval Scheduling Policy

Under this policy the time between the consecutive replenishment orders is
constant. There is a maximum stock level (s) prescribed and the inventory
status is reviewed periodically with a fixed interval (T) .At each review an
order of size Q is placed which takes the stock on hand plus an order equal to
the maximum stock level. Thus order quantity could vary from period to
period. This policy ensures that when the level of stock on hand is high at
review, a smaller size replenishment order is placed. Figure VII shows the
typical stock balances under this fixed reorder cycle policy. S, the maximum
stock level and T the review period are the decision variable under this policy
378
 Purchase
System and
Procedure and
Inventory
Management

Fig VII. Fixed Reorder cycle Policy

Optional Replenishment Policy (s - S Policy )

This is very popularly known as the (s, S) policy. Figure VIII shows the
typical stock balance under this policy. The status of stock is periodically
reviewed and maximum stock level (S) and minimum stock level (s) are
prescribed.

Fig VIII- Typical Inventory Balances in (s –S) Policy.

If at the time of review, the stock on hand is less than of equal to s, and order
of size Q is placed so that stock on hand plus an order equals the maximum
stock level S. If stock on hand at review is higher than s, no order is placed
and the situation is reviewed at the time of next review period. S, s and T
(review period) are the decision variables in the design of such inventory
policy.

Other Types of Inventory Systems

There may be other policies which may be special cases of the policies
mentioned above or may be a combination of these policies. As a special case
of (s, S) policy we may have (S-1, S) policy or one-for-one order policy when
the maximum stock level may be upto S and whenever there is demand for
one unit, a replenishment of one unit is ordered. Such a policy may be quite
useful for slow moving expensive items.

379
Materials We may use a combination of lot-size reorder point policy and fixed interval
Management
order scheduling policy. Yet another variation of inventory policy could be
multiple reorder point policy where more than one reorder point may be
established.

Other types of inventory systems may be static inventory systems when a

single purchase decision is to be made which should be adequate during the
entire project duration. Such decisions are not repetitive in nature. Other
initial provisioning decisions may be with respect to repairable assemblies
such as engines and gearboxes etc. in a bus which may have to be overhauled
and for which we have to find adequate number of spare engines to be
provided initially.

The right choice of an inventory policy depends upon the nature of the
problem; usage value of an item and other situational parameters. We must
first select an operating policy before determining optimal values of its
parameters.

12.14 SELECTIVE INVENTORY MANAGEMENT

Role of Selective Inventory Control

One of the major operating difficulty in the scientific inventory control is an

extremely large variety of items stocked by various organizations. These may
vary from 10,000 to 100,000 different types of stocked items and it is neither
feasible nor desirable to apply rigorous scientific principles of inventory
control in all these items. Such an indiscriminate approach may make cost of
inventory control more than its benefits and therefore may prove to be
counter-productive. Therefore, inventory control has to be exercised
selectively. Depending upon the value, criticality and usage frequency of an
item we may have to decide on an appropriate type of inventory policy. The
selective inventory management thus plays a crucial role so that we can put
our limited control efforts more judiciously to the more significant group of
items. In selective management we group items in few discrete categories
depending upon value; criticality and usage frequency. Such analyses are
popularly known as ABC, VED and FSN Analysis respectively. This type of
grouping may well form the starting point in introducing scientific inventory
management in an organization.

ABC Analysis

This is based on a very universal Pareto's Law that in any large number we
have ‘significant few’ and ‘insignificant many’. For example, only 20% of
the items may be accounting for the 80% of the total material cost annually.
These are the significant few which require utmost attention.

380
 Purchase
System and
Procedure and
Inventory
Management

Fig. ix: ABC Analysis Fig. ixa: Classification of Items

22

A- 10% items claiming approximately 75% of annual usage(Rs)

B-15% items claiming approximately 15% of annual usage(Rs)

C -75% items claiming approximately 10% of annual usage(Rs)

Figure IX shows a typical ABC analysis showing percentage of number of

inventory items and percentage of average inventory investment (annual
usage value).Annual usage value is the demand multiplied by unit price thus
giving monetary worth of annual consumption. It can be seen from this figure
that 10% items are claiming 75% of the annual usage value and thus
constitute the ‘significant few’. These are called A- class items. Another 15%
items account for another15% annual usage value and are called B-class
items. A vast majority of 75% items account for only 10% expenditure on
material consumption and constitute ‘insignificant many’ and are called C-
class items. To prepare an ABC type curve we may follow the following
simple procedure:

i) Arrange items in the descending order of the annual usage value. Annual
usage value = Annual demand x Unit price.
ii) Identify cut off points on the curve when there is a perceptible sudden
change of slope or alternatively find cut off points at top10% next 20%
or so but do not interpret these too literally— rather as a general
indicator.

A very simple empirical way to classify items may be adopted as follows:

Average annual usage value

A-Class items

C-Class items

In between we have B-class items.

381
Materials Once the items are grouped into A,B and C category, we can adopt different
Management
degree' of seriousness in our inventory control efforts. A class items require
almost continuous and rigorous control, these are subjected to highest level of
control, supervision and management. Whereas B-class items may have
relaxed control, these are subjected to medium level of control, supervision
and management. C-class items may be procured using simple rules of
thumb, as usual and these are not subjected to elaborate control and
management since the cost of effort is not worth it.

Other Variants of ABC Analysis.

VED Analysis

This analysis attempts to classify items into three categories depending upon
the consequences of material stockout when demanded. As stated earlier, the
cost of shortage may vary depending upon the seriousness of such a situation.
Accordingly the items are classified into V (Vital), E (Essential) and D
(Desirable) categories. Vital items are the most critical having extremely high
opportunity cost of shortage and must be available in stock when demanded.
Essential items are quite critical with substantial cost associated with
shortage and should be available in stock by and large. Desirable group of
items do not have very serious consequences if not available when demanded
but can be stocked items for the sake of efficiency and less fatigue.

Obviously the % risk of shortage with the ’vital' group of items has to be
quite small- thus calling for a high level of service. With ’Essential' category
we can take a relatively higher risk of shortage and for’ Desirable' category
even higher. Since even a C-class item may be vital or an A-class item may
be ’Desirable' we should carryout a two-way classification of items grouping
them in 9 distinct groups as A-V, A-E, A- D, B-V, B-E, B-D, C-V, C-E
and C-D. Then we are able to argue on the aimed at service-level for each of
these nine categories and plan for inventories accordingly.

FSN Analysis

Not all items are required with the same frequency. Some materials are quite
regularly required, yet some others are required very occasionally and some
materials may have become obsolete and might not have been demanded for
years together.

FSN analysis groups them into three categories as Fast-moving, Slow-

moving and Non-moving (dead stock) respectively. Inventory policies and
models for the three categories have to be different. Most inventory models in
literature are valid for the fast-moving items exhibiting a regular movement
(consumption) pattern. Many spare parts come under the slow moving
category which have to be managed on a different basis. For non-moving
dead stock, we have to determine optimal stock disposal rules rather than
inventory provisioning rules. Categorization of materials into these three
types on value, criticality and usage enables us to adopt the right type of
382
inventory policy to suit a particular situation. In this unit,we shall mainly be Purchase
System and
developing some decision models more appropriate for A- class and fast- Procedure and
moving items. Later on a brief discussion on the inventory management of Inventory
Management
slow-moving items will be given.

SDE Analysis: Based on the problems of procurement, it classifies the items

into scarce, difficult and easy classes

HML Analysis: Based on the price instead of usage value, it classifies the
items into high, medium and low classes.

XYZ Analysis: Based on the value of stocks in hand(i.e. capital employed to

procure inventory) it classifies the items as X category whose inventory
values are high, Z category whose values are low and Y category in between.

SOS Analysis: This analysis is based on seasonality of items as

seasonal(available only for a limited period depending on the season) and off
seasonal.

12.15 EXCHANGE CURVE ANDAGGREGATE

INVENTORY PLANNING
Concept of Exchange curve

Exchange curve (or optimal policy curve) is an effective technique to look at

the inventories at an aggregate level in the organisation. 1t is a plot between
the total number of orders (TO) per year and the total investment in
inventories (TI) per year. The rationale is that for an optimal inventory policy
the trade-off between total inventory and total procurement effort as indicated
by the total number of replenishment orders per year must be made such that
if total number of order are prescribed, we minimize total investment in
inventories. Alternatively, if the total investment in inventories (TI) is
prescribed then a rational inventory policy must aim at minimizing (TO).
Optimal inventory policy must exchange (TI) for (TO) in such a manner that

(TI) constant

Value of constant is given by

2
1 N
K Di Vi
2 i 1

where Annual requirement of ith item, Unit price for ith item,

Thus a plot between (T1) and (TO) is a rectangular hyperbola and is called as

’Exchange curve' or ’optimal policy' curve, Figure X shows a typical

exchange curve for a situation where the ordering cost is not explicitly 383
Materials known. 1t shows that any point on the exchange curve is an optimal trade-off
Management
between investment in inventories and total number of orders.

Fig X. Exchange Curve

Uses of Exchange Curve

Exchange curve is an effective instrument for aggregate inventory analysis to

quickly determine the rationality (or otherwise) of our existing stock
provisioning policies.

We first plot the exchange curve by computing the value of K for a chosen
group of items. Then we determine the total number of orders (TO) and total
investment in inventories (TI) under current practice.

If the current practice is at point C (in Figure X) above the exchange curve
then it shows that our present procurement policies are not rational. If we
want to rationalize these then there are two possible paths-AC or BC; so that
we reduce inventory to B for the same ordering effort or reduce number of
orders to A for the same inventory. Thus an exchange curve is a useful device
at macro-level.

12.16 DETERMINISTIC INVENTORYMODELS

Classical EOQ Model

In this section we discuss some elementary inventory models with

deterministic demand and lead time situations. The purpose is to provide an
illustration of the mathematical analysis of inventory systems. The most
classical of the inventory models was first proposed by Harris in 1915 and
further developed by Wilson in 1928. It is very popularly known as EOQ
(Economic Order Quantity) model or ‘Wilson's Lot Size formula’.

When dealing with stocked items, the two important decisions to be made
are- how much to order and when to order. EOQ attempts to provide answer
to former while the Reorder point (RoP) provides the answer to the latter.

The following assumptions are made in the standard Wilson lot size formula
to obtain EOQ:
384
a) Demand is continuous at a constant rate Purchase
System and
b) The process continues infinitely. Procedure and
Inventory
c) No constraints are imposed on quantities ordered, storage capacity, Management

budget etc.
d) Replenishment is instantaneous (the entire order quantity is received all
at one time as soon as the order is released).
e) All costs are time-invariant.
f) No shortages are allowed
g) Quantity discounts are not available.

The inventory status under EOQ-RoP policy is continuously reviewed. Figure

XI (a) shows the behaviour of such a simple system whereas Figure XI (b)
shows the total system cost behaviour highlighting the conflicting trend of
ordering and inventory carrying costs. EOQ aims at minimizing total system
cost.

Fig. XI (a) Inventory behaviour under classical EOQ model

Fig. XI (b) Total Cost Curve Under EOQ model

Let us use the following notation in developing the classical EOQ model:

D = Demand rate; unit per year.

A = Ordering cost; Rs./order.
C = Unit cost, Rs. per unit of item.
r = Inventory carrying charge per year.
H = Annual cost of carrying inventory/unit item = r.c. 385
Materials TC=Total annual cost of operating the system Rs./year (objective function).
Management
Q=Order quantity, Number of units per lot (decision variable).

Since demand is at uniform rate average inventory is Q/2 throughout the year
and the total number of orders are (D/Q) per year. Thus total annual cost of
operating the systems consisting of carrying cost and ordering cost can be
written as:

D H.Q
TC A Differentiating TC w.r.t. Q, we have
Q 2

d TC AD H
dQ Q2 2

Equating it to zero, we get:

d 2 TC 2AD
Q0 EOQ 2AD / H also positive quantity
dQ2 Q3

Hence Q is minimum at Q Q0 2AD 0 optional

H EOQ {Q = Q = EOQ)
Putting the value of Q in the equation of TC, we get TC (min) =
2AHD =TC0
Due to convex nature of total cost curve, it is obvious that Qo(EOQ) gives the
global minimum total cost. It can also be seen that EOQ is obtained at the point
of intersection of ordering cost and carrying cost in Figure XI(b).

Some interesting insight may be obtained using this classical system:

i) If ordering cost is of high tendency, the optimal policy is to have high

EOQ thus raising average inventory level.
ii) If r or C are high leading to high value of H, the tendency will be to go
for smaller lot sizes.

r may vary from 0.15-0.30 and will depend on the nature of item, ‘A’ the
ordering cost should be marginal ordering cost while H should be based on
total purchased cost of the items.

Finite Replenishment Rates(See also Section 6.3)

We will now relax the assumption (d) of the classical EOQ model and permit
finite replenishment rate (staggered deliveries). When the rate of procurement
is P in units / year and the demand rate is D, in units/year, the build up of
inventory is at a rate (P-D) due to simultaneous consumption. It is obvious
that P>D for inventory to build up. Figure XII shows the inventory behaviour
with finite supply rate. The stock builds up to a maximum level I during
supply period ts, after which stock depletion takes place at rate D. It can be
Q Q D
seen that I= ts (P-D), ts = and thus TC A D Q H 1
P 2 P

386
 Purchase
System and
Procedure and
Inventory
Management

Time

Fig XII- Inventory Behaviour Under Finit Replenishment rate.

2AD
For minimum TC we get, Qo = and TC0 2ADH 1 D P
H(1 D P

Some interesting observations can be made about the behaviour of such

systems. These are:

i) Qo under finite replenishment rates are higher than Qo under classical

EOQ model for the same values of other parameters.
ii) Total system cost under optimal Qo is lower than corresponding total
system cost under EOQ model. Thus staggering the supplies always
reduces inventory level and total operating system cost provided other
cost parameters remain the same.
iii) As P→∞,Qo and TC0 obtained are same as in standard Wilson's formula
of instantaneous replenishment.
iv) At P=D,Q0→ ∞,TC→0. Thus if we can have a fully devoted reliable
supplier, then placing a single supply order of large size but matching
supply rate with the demand rate is the optimal decision. Under such a
system, no stocks are built, no replenishments are made, no shortages are
incurred. This would seem to be an ideal system towards zero-inventory
provided we know our requirements for sure and we have a dependable
source to supply us at the rate to match the requirement. This brings out
the role of dependable source of supply as an important asset to materials
management function.

Planned Backlogging

Let us now consider the effect of relaxing assumption (f) of classical Wilson's
model by permitting back logging (shortages or back ordering) at a unit
shortage cost of S in Rs./unit short/year. 1n such a case negative inventory
shows the backlogging position. The order quantity Q is partly used to clear
the backlogging level B and (Q-B) is the maximum stock level. Figure XIII
shows the inventory behavior under planned backlogging.

387
Materials
Management

Figure XIII: Inventory behavior with planned backlogging.

Inventory is maintained for duration ti and demands remain backlogged for

duration tb. Total cycle time of each replenishment cycle is

It can be seen that, average inventory = and average back order level

Total annual system cost

Optimal values of Q and B can be obtained for minimum value of TC as

follows:

2AD
*

388
 2AD S Purchase
Maximum stock level = Q* B* M* System and
H H S Procedure and
Inventory
Some useful observations could be made about the behaviour of inventory Management

system with planned backlogging as follows:

a) Total system cost is lower with planned backlogging than the

corresponding total system cost under classical Wilson's lot size formula.
Thus for a deterministic system with finite backlogging cost, it is
economical to plan for backlogging. It can be seen that at S→ ∞,, the
model reverts to classical EOQ model.
b) EOQ under backlogging is higher and maximum stock level is lower
than the corresponding values under classical Wilson's lot size model.
c) If S = 0 then B* = Q*=∞. This means that with no charge for back orders
one would keep piling up unfilled demand until the backlog gets
infinitely large. Then one single order would be released to satisfy all
accumulated demand. However, considering intangible cost of
backordering such as loss of goodwill etc. it is debatable whether there
are situations when the unit cost of shortages (S) is really zero.

Model with Quantity Discounts

Frequently, the vendors offer quantity discounts on bulk purchases to

encourage users to place orders in large quantities. Quantity discounts may be
all unit discounts or incremental quantity discounts. In all unit discounts
entire order quantity is purchased at lower unit price If order size is higher
than or equal to the stipulated conditions. In incremental case only quantity
exceeding the threshold point is charged at lower unit cost. The immediate
reaction may be to avail the discount and place bulk orders but if we see the
total system cost, our decision may be otherwise. There may be a single or
multiple quantity discounts. Figure XIV shows total system costs under four
discounts.

Fig XIV- Total Cost Curves Under Quantity Discounts.

The broken lines show the total cost curves without price break whereas solid
lines show the actual total cost if price break takes place. The larger the
number of price breaks, the more difficult it becomes to analyse the situation
as more alternatives are to be evaluated. The important point to be made in 389
Materials such situations is that individual situation is to be analyzed to judge which of
Management
the options is suitable to avail discount and place bulk order to make it
realizable— reject the offer and place small order at higher unit price or place
order at the minimum possible quantity at which discount becomes valid.
Any alternative is optimal if that minimizes the total system cost. For
example, it can be easily seen from Figure XIV that for this case the
minimum total system cost occurs at Q* = b3 is the minimum quantity at
which discount level4 is applicable.

Sensitivity Analysis

It may not be operationally very convenient to stick to EOQ if it is an odd

figure. Then one may like to know the repercussions on total system cost if
one deviated either way from Q0. This is done through sensitivity analysis. If
Qa is actual order quantity, Qa =b. Q0 where b is sensitivity parameter. If
b=0.8 then actual Qa is 1.025 Qo and if b =1.2 then Qa is 1.016 Q0. Obviously
the TC will increase over TC0 in either case. If we substitute Qa as bQ0 in
total cost expressions in the classical EOQ model, we can easily get the
following relationship.

Where TCa is actual cost with order size being Qa. 1t can be seen that at
b=1,p=1. 1f b is allowed to vary within 0.9 to1.10 then p will be within1.005
indicating that ±10% deviation in EOQ leads to less than half a percent
increase in TC. Thus TC is not very sensitive to EOQ and for operational
convenience we should be able to vary EOQ within ± 10% of Q0 without
adversely affecting total system cost.(Proof is shown below)
D 1
TCa A bQ.H
bQ 2

TC0 2DAH
2DA
and Q0
H
TCQ 1 b2
Solving we get
TC0 2b

Case I let b = 0.9

TCa 1.81
p 1.005
TC0 1.8

Case II let b = 1.1

TCa 2.21
p 1.005
TC0 2.20

i,c ±10% variation in EOQ amounts to 0.5% rise in total cost.

390
12.17 INVENTORY CONTROL OF SLOW Purchase
System and
MOVING ITEMS Procedure and
Inventory
Management
Nature of Slow Moving Items- As stated earlier, slow moving materials are
those which are not regularly demanded and their movement off the shelf is
very occasional, say once in six months or so.

Examples of slow moving materials can be—spare parts and some special
purpose materials for projects required only for a certain kind of project
activity. Inventory models valid for fast moving models are not applicable for
slow moving items due to lack of regular demand pattern. Generally slow
moving items are quite expensive and therefore one has to first decide
whether to keep them all in stock and if to keep them in stock then in what
quantity. Further difficulty of slow moving parts is the initial over-buying
decision which could take years to remedy the situation due to rarely
occurring demands.

Some Inventory Policies for Slow Moving Spares

We shall illustrate our approach to manage the inventory of slow moving

items with spares inventory problem as a substantial percentage of spares
come under the slow moving categories. Some of the strategies that could be
possibly adopted for efficient inventory management of slow moving spares
are as follows:

a) If spares are required only at pre-specified time such as at the time of

major scheduled maintenance for replacement, then it is better not to
stock them but to place procurement order sufficiently well in advance,
keeping lead ttimes in mind, so that these arrive just in time when these
are needed
b) If the part gives adequate warning of impending break down, then also the
best policy is to place an order the moment we get the warning. Adequate
warning refers to the case when the lead time required is less than the
warning time. This shows that major improvements in slow moving
inventory are possible by cutting down the lead times.
c) For inadequate warning spares we must keep the stock. Generally maximum
stock level will be 1 or 2 or one-for-one ordering policy is very useful. This
means placing an order for one spare when one is consumed.

12.18 RECENT DEVELOPMENTS IN

INVENTORY MANAGEMENT
Multi-echelon Inventory Systems

The inventory models described in the preceding sections pertained to

situations where the stock is located at a single place. In practice the stock
may be distributed over several locations. For example in a multi-project
391
Materials organisation, there may be a central store and a number of field stores or
Management
project stores. Such types of inventory systems are called ’Multi-echelons
inventory Systems'. Since the inventory in all the locations belong to the
same system, it is better to look at the inventory management for the system
as a whole rather than treating each storage location independently.
Recently a lot of attention has been given by the researchers to the analysis of
such multi-echelon inventory systems. Important decisions concerning the
design and operation of such systems are the number of echelons, number of
storage points at each echelon (level), location of central store, optimal
inventory policy to be followed by each storage location and stock
redistribution policies etc. For very expensive slow moving item such as
complex assemblies it may be desirable to locate the inventory at the central
store rather than at the project (field) store provided the item is standardized
and is usable at each locations. Detailed mathematical analysis of multi-
echelon inventory systems tends to be rather complex and is beyond the
scope of this unit.
Materials Requirement Planning(Refer Section 6.5)

12.19 SUMMARY
Purchasing, in ordinary sense, is the procurement of materials, components,
machines, equipments and supplies etc. on payment, In the present
environment of frequently varying price conditions and increasing material
variety and competition, the purchasing function needs professionalism to
reduce the total investment in purchase while making the required materials
of right quality available on time. The purpose of this unit is to present and
discuss various aspects of purchasing to achieve this professionalism. Major
topics discussed include: scope and objectives of purchasing, inputs,
environmental and management factors influencing the purchasing decisions,
purchasing decisions, procedures, forms, records and reports, procedure
evaluation, vendor evaluation, and organisation for purchasing. The
presentation and discussions are aimed at an efficient information flow
amenable for computerization.

An efficiently designed purchase system, with appropriate procedure, forms,

and information flow, can generate the reports with required contents
intended for specified destinations at various levels of management in the
organisation.

This unit has also attempted to highlight the role of inventory management in
the successful operation of any production or service system. Functions of
inventory and various inventory related costs parameters have been
identified. Various operating inventory policies have been described.
ABC/VED/FSN analysis concepts have been outlined to enable selective
control on inventories and the role of exchange curve to quickly detect the
irrationality of existing procurement practice has been highlighted. Some
392
deterministic models to determine EOQ are presented and sensitivity of Purchase
System and
classical EOQ model is analyzed. Impact of demand/lead time variability on Procedure and
reorder point and buffer stock has been explained. Problems of slow moving Inventory
Management
items inventory control has been identified and some guidelines have been
given. Recent developments in inventory management have also been
touched.

12.20 KEY WORDS

Average Down Buying: Policy of purchasing items at a moment when the
market dips sharply in the course of gradual price change.

Bill of Materials (BOM): A list of all items incorporated into a finished

product produced by the organization. It is prepared on the basis of
engineering drawing.

Bill of Lading: A document signed by the shipping agency acknowledging

the receipt of certain specified goods for carriage and embodying an
undertaking that goods will be delivered to the consignee.

Blanket (or Open- end) Purchase Order: A purchase order in the form of a
contract for continuously used items for a fixed period (usually a year) with
delivery dates and quantities. The prices may be negotiated for the whole
period or kept open in which case the prevailing market price applies.

Commercial Invoice: Statement showing the details of items and their

prices. It is a preliminary document sent by supplier to buyer and is used by
the buyer to check the goods received.

DGS and D (Directorate General of Supplies and Disposal): The central

purchasing organization of Government of India for public buying.

Forward Buying: Policy of purchasing items in economical quantities

exceeding current requirements, but not beyond actual foreseeable
requirements.

Hand-to-mouth Buying: Policy of purchasing items only to meet immediate

short term requirements.

Hedging: Practice of entering simultaneously into two transactions of a like

amount— a cash transaction and a futures transaction. The cash transaction
involves the current exchange of the buyer's cash for the physical goods and
the futures transaction involves the buyer's sale of a future contract on the
item with promised delivery at a specified date in future.

Letter of Credit: An arrangement by which the obligation to pay an exporter

is undertaken by a bank.

393
Materials Negotiation: Purchaser approaches the suppliers for price determination.1t is
Management
used when the number of bidders is small, value of purchase is too high and
time is too short for competitive bidding or willingness to bid is lacking.

Product Specifications: Detailed description of the characteristics and

features of an item. Some common types are: blue-prints, market grades,
commercial standards material specifications and performance specifications
etc.

Reciprocal Buying (or Reciprocity): Practice of giving preference in buying to

those suppliers who are customers of the buying organisation.

Speculative Buying: Policy of purchasing items in excess of foreseeable

requirements in order to make a profit from rising prices.

Standard Purchase Requisition: A requisition form used by internal

departments of an organisation to raise the indents for non-recurring
materials. The completed form is submitted to the purchase department.

Travelling Purchase Requisition: A requisition card maintained

continuously for each item and used to procurer currently needed materials
and parts. It originates from stores or inventory control section.

ABC Analysis: Arranging items according to annual usage value in three

categories A, B and C to identify significant few and insignificant many.

Backlogging: Process of accumulating unsatisfied demand till fresh

replenishment of stock is made available.

Buffer Stock: Extra safety stock needed to absorb variation in demand and
supply to provide cushion.

Carrying Cost: Cost associated with holding one unit in inventory for one
time period (year).

Exchange Curve: A curve indicating optimal trade off between total

inventory and total number of orders (also called optimal policy curve.)

EOQ: Economic Order Quantity; the quantity for procurement which will
result in minimum total system cost associated with carrying, ordering and
back logging.

FSN Analysis : Classification of items according to frequency of usage in

Fast, Slow and Non-moving groups.

Inventory Turnover Ratio: Annual demand divided by average inventory.

Lead Time: Time that elapses between placement of an order and actual
receipt of materials.

MRP: Materials Requirement Planning; a system of order scheduling for

dependent demand situation.
394
Multi-echelon Inventory System: A system of inventory control where the Purchase
System and
stock is located at different levels (echelons) at different locations. Procedure and
Inventory
Optional Replenishment Policy: An operating policy based on maximum and Management
minimum stock levels with periodic review, popularly known as (s,S) policy.

Ordering Cost: Cost associated with placing a purchase order expressed as

Rs./order.

Quantity Discount : A sales promotion strategy by vendor in which bulk

purchases can be made at lower unit prices.

ROP: Reorder point; the stock level when the action for replenishment of
stock be initiated by placing an order.

Service level: Percentage of times an item is available in stock when

demanded.

VED Analysis: Process of grouping items into Vital, Essential and Desirable
categories depending upon the criticality of the items.

12.21 SELF- ASSESSMENT EXERCISES

I Review Questions
1 What are the common objectives of the purchasing function?
2 What are the activities in the purchasing function which require high
consideration for legal aspects?
3 What are the approaches for price determination.
4 What are the various purchase forms and records usually employed by a
purchasing department?
5 How are vendors evaluated?
II Design Exercises (Purchase System and Procedure)

1 Design a suitable form to be used for preparing the comparative

statements to enable the purchasing manager to take the decision about
the best supplier.

2 Design an inspection report form to enable the purchasing department to

release various installments of the payment and to enter the appropriate
data in the supplier's file.

III Problems (Purchase System and Procedure)

1 An item is demanded at the rate of 20,800 units per year and the lead
time is 2 weeks. The unit price is Rs.50 and the holding cost is Rs.10 per
unit per year (i.e. 20 percent of the unit price).1t costs Rs.20 for each lot
of procurement. The standard deviation of the demand over the lead time
is 10. Calculate the order quantity, reorder point and safety stock and
prepare the purchase plan and the budget for the whole year. [Ans: 1year 395
Materials = 52 weeks assumed. Q=289, safety stock=30(3 times std deviation),
Management
Reorder point=830, number of orders=72(approx.)]

2 Consider a problem of comparing suppliers by weight point plan. A total

of 100 points are allocated among those factors considered important by
an organisation. The supplier with the largest number of weight points is
the most desirable. The following weights are used to compare the
suppliers: quality (40points), price (35points), and service (25 points).
Based on the data given below, rank the four suppliers:

Supplier Shipment Shipments Unit price Fraction of

received accepted commitments
fulfilled
A 500 480 10.00 0.94
B 600 560 9.60 0.90
C 80 78 1.20 1.00
D 200 192 8.90 0.98
[Ans: Fraction of commitment fulfilled i.e service rating factor
VPRA= f1 . RQ + f2 .RP + f3 . RS= 40 (480/500) + 35(1/1) + 25 (0.95) =96.90(III)
VPRB=94.83(IV), VPRC=99.00(I), VPRD=97.90(II)]
NOTE: Price rating factor (RP)= PL (100/P) =100 or 1
Where PL= Lowest price quoted
P= price agreed by supplier
It is assumed that for each supplier PL=P

Inventory Management

1 An organization is spending Rs.20 crores annually in procuring a total of

50,000 different items. Using simple empirical decision rule to group
items into A,B and C category, determine the cut off values of annual
usage that will decide whether the item should be A, B or C class item.

2 Write true or false against the following statements:

i) Perishable items should have higher value of inventory carrying

charge than imperishable.
ii) EOQ is smaller if backlogging is permitted under deterministic
demand.
iii) ±10% variation around EOQ is not very serious.
iv) Finite replenishment rates enable more economical operation of an
inventory system.
v) Buffer stocks have no relationship with the amount of demand/lead
time uncertainties.

396
3 In an inventory system the cost of placing an order is Rs.100/ order. The Purchase
System and
annual demand is 5000 units and the inventory carrying charge is 20% of Procedure and
the value per year. The item costs Rs.75 each. Find EOQ and total Inventory
Management
system cost if shortages are not to be allowed. [Ans: Qo=258, TC= Rs
3873]

4 If shortages are permitted and allowed to remain back logged at a cost of

Rs.60 per unit short/year, determine the EOQ , maximum stock level,
maximum backlog level and the total system cost under optimal
condition for the data pertaining to problem number 3 above.
[Ans: Qo=289, Max stock=231, Max backlog=58, TC=Rs 3464]

5 In an inventory system using classical EOQ model of Wilson, determine

the range of variation of EOQ if 1% increase in cost over the minimum
total cost is permissible. EOQ has been determined to be 400units.[Ans:
86.83% - 115.47%,(348 to 462)]

6 An item is demanded at the rate of 2000 units per year at a uniform rate.
Ordering cost is Rs.350 per order. Inventory carrying cost is 24% of the
unit price per year. The supplier has offered a unit price of Rs.100/ item
but he is willing to reduce it to Rs.95/ item if a purchase order of 1000
units or more is placed. Should you accept this offer? [Ans: TC(EOQ)=Rs
2,05,797 > Rs 2,02,100 therefore offer accepted]

7 “Inventory management for slow moving expensive items should focus

more on lead time reduction than any thing else”. Critically examine the
statement.

8 Who should be responsible for inventory control? Discuss this statement

from a departmental as well as top management points of view.

9 Consider the following situation:

An inventory system has four items to be procured from different sources.

Procurement action is based on each item to be considered individually and
independently. The following data have been obtained for demand and unit
prices for each item:

Item, i Demand Di (units/year) Unit price Vi (Rs./unit)

1 7500 200

2 4000 90

3 500 500

4 100 80

The inventory control manager argues vehemently that there is no way to

estimate ordering and carrying costs but he is prepared to accept that ordering
cost to fraction of carrying charge is constant for each item. Currently he is
397
Materials following an ordering policy of using a 4-month supply of each item. He is
Management
under pressure to cut down inventory by 25% and is therefore about to adopt
a policy of 3-month supply. Use exchange curve to show that he has better
options available to him. What should he do? [Ans: Adopt a policy of 3-
month supply]

12.22 FURTHER READINGS

Ammer, D.S.,. Materials Management and Purchasing, Richard Irwin, Ind.
Rept. edn., D.B. Taraporevala: Bombay.
Datta, A.K.,. Integrated Materials Management-A Functional Approach,
Prentice-Hall of India: New Delhi.
Gopalakrishnan,P.and Sundaresan, M.,. Materials Management- An Integrated
Approach, Prentice-Hall of India: New Delhi.
Tersine, R.J. and Campbell, J.H.,. Modern Materials Management, North
Holland: New York.
Westing, J.H., Fine, LV., and Zenz, G.J.,. Purchasing Management, John
Wiley,., Wiley Eastern Limited: New Delhi.
Dobler, D.W.,Lee.L.,Jr. and Burt, D.N.,.Purchasing and Materials
Management:Text and Cases,McGraw,Hill,Inc.:NewYork.
Hax, A.C., and Candea, D.,. Production and Invenotory Management,
Prentice.Hall Inc.: Englewood- Cliffs.
Lewis, C.D.,. Scientific Inventory Control, Butterworth: London.
Peterson,R.and Silver,EA.,.Decision Systems for Inventory Management and
Production Planning, John Wiley & Sons: NewYork.
Plossl, G.W. and Wight O.W.,. Production and Inventory Control, Principles
and Techniques, Prentice-Hall of India Ltd.: New Delhi.

398