Materials Management

HARAMAYA UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF MANAGEMENT

MATERIALS MANAGEMENT HANDOUT

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CHAPTER ONE

INTRODUCTION TO MATERIAL MANAGEMENT

There are various types of materials that are used by enterprises. Commonly materials can be
classified as raw materials, work-in-process, finished goods and supplies. It is possible to
differentiate materials between production items (raw materials, fabricated parts, and component
parts), capital items (installation and equipments), operating items (maintenance, repair,
operating supplies), and industrial services (services). There are so many problems attached with
the management of these materials such as investment in materials, idle funds, storage and
obsolescence, wastage of materials in handling etc. which require immediate attention of
management so that the cost of production may be reduced to the minimum and the quality of the
product may be maintained. In recent years, the concept of materials management is being
widely accepted by industrially advanced countries for more effective coordination and control
over materials because materials costs (including investment in materials, handling cost,
transportation and storage costs, insurance, wastage and obsolescence costs etc.) constitute a
major part of the total cost of the finished product.
So, the control over material is essential to arrest the increasing cost of finished product since it
constitutes a major component of the total cost of goods sold. This can be achieved through
integrated and effective materials management. Thus, material management would embrace all
activities concerned with material such as materials-planning and programming, purchasing,
inventory control, receiving and inspection, stores, traffic and physical distribution. This makes it
an indispensable core activity of all types of organizations since organizations are continuously
involved in procurement, storage, and stock replenishment of different types of materials. In
some of the industries the cost of materials input ranges between 45% to 85% of the product
cost. Thus, the slightest efficiency in the materials management releases substantial gains to the
organization in terms of cost and capital requirement. Due to such strategic role materials
management has assumed greater importance in the modern management. In fact, along with
other areas of management like production, marketing, finance and personnel, materials
management has been recognized as fifth key area of management of the organizations.

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1.1 DEFINITION OF MATERIALS MANAGEMENT

Materials management is a term to describe the grouping of management functions related to the
complete cycle of material flow, form the purchase and internal control of production materials
to the planning and control of work-in progress, to the warehousing, shipping and distribution of
finished products. It differ from the materials control in that the latter term traditionally is
limited to the internal control of production materials. The material management would embrace
all activities concerned with material except those directly concerned with designing or
manufacturing the product or maintaining the facilities, equipment and tooling. It would
embrace the activities performed by major departments such as purchasing, Inventory control
receiving and inspection, stores, traffic and physical distribution.
Material management views material flow as a system. Thus, it includes: anticipating materials
requirements scientifically; sourcing, obtaining and inspecting materials; introducing materials
into organization; storing and handling materials, and disposal of scraps and unserviceable items;
monitoring the status of materials; replenishment of stocks; and strengthening materials
information system.
 It is an idea of an integrated management approach to: planning, acquisition,
conversion, flow, and distribution of production materials from raw material state to
finished product state.
 It is a function responsible for coordination of planning, sourcing, purchasing,
moving, storing, and controlling materials in an optimum manner so as to provide a
pre-decided service to the customers at a minimum cost.
 Materials management is a coordinating function responsible for planning and
controlling materials flow. Its objectives are as follows:
 Maximize the use of the firm‟s resources.
 Provide the required level of customer service.
From the above definitions, it is clear that the scope of materials management is vast. Broadly,
the coverage of materials management include forecasting and planning of material
requirement, purchasing, receiving, storing and warehousing, inventory control, material
handling and value analysis

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1.2 OBJECTIVES OF MATERIALS MANAGEMENT.

As explained above the objective of materials management can be stated as maximizing the use
of firm‟s resources or rationalizing the material costs provide better service to customers. The
following specific objectives of material management fall in either of the above broad objectives:
a) Provide an uninterrupted flow of materials suppliers, and services required to operate the
organization.
b) Keep inventory investment and loss at a minimum
c) Maintain adequate quality standards.
d) Purchase required items and services at least possible price.
e) Maintain the organization‟s competitive position
f) Find or develop competent vendors.
g) Standardize, where possible, the item bought.
h) Achieve harmonious, productive working relationships with other departments within the
origination.
i) Accomplish the purchasing objectives at the lowest possible level of administrative cost.
1.3 IMPORTANCE OF MATERIAL MANAGEMENT
In many organizations, materials form the largest single expenditure item. For example, Average
expenditure of materials for earthmoving equipments, sugar, wool, commercial vehicles etc
industries is above 65 while it constitutes 60-65% in textile industries. In general, an analysis of
the financial statement of a large number of organizations indicates that materials account for
nearly 60% of the total expenditure. Accordingly, effective materials management enables the
organization to:-
Minimize inventory losses from fraud, theft and the wastages of materials
Reduce loss of time and direct labor through effective planning and utilization of one‟s facility
Have low or no cases of late deliveries as a result of delays in production due to non-availability
or lack of materials since these are prevented by arranging the proper supply of materials in
required quantities to the production at the right time.
Reduce the length of manufacturing cycle through effective utilization of men, materials and
machine and thus reduces the capital tied up in inventories.
Purchase right materials from the right supplier and at a right price
Avoid congestion of materials in stores and/or at different points of manufacturing

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The importance of materials management, hence, lies in the fact that any significant contribution
made by the material manager in reducing material cost will go long way in improving the
profitability and rate of return on investment. Such increase in profitability, no doubt, can be
affected by increasing sales. But with the increased competition and government restrictions on
expansions this alternative is not easily achieved. Consider the following example to see the
importance or significance of effective material management for organizational profitability.
Example 1
To appreciate how materials management can do much to improve a company‟s profit, consider
the following income (profit and loss) statement for ABC manufacturing company:

Dollars Percent of Sales

Revenue (sales) $1,000,000 100
Cost of Goods Sold
Direct Material 500,000 50
Direct labor 200,000 20
Factory Overhead 200,000 20
Total Cost of Goods Sold $ 900,000 90
Gross Profit $100,000 10

Direct labor and direct materials are costs that increase or decrease with the quantity sold
(variable costs). Overhead (all other costs) does not vary directly with sales. For simplicity this
section assumes overhead is constant, even though it is initially expressed as a percentage of
sales. If, through a well-organized materials management department, direct material can be
reduced by 10% and direct labor by 5%, the improvement in profit would be:

Dollars Percent of Sales

Revenue (sales) $1,000,000 100
Cost of Goods Sold
Direct Material $450,000 45
Direct labor $190,000 19
Factory Overhead $200,000 20
Total Cost of Goods Sold $840,000 84
Gross Profit $160,000 16
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Profit has increased by 60% (160,000 – 100,000/100,000) or $ 60,000 (It is an increase of 60 %

to the total revenue). To get the same increase in profit ($60,000) by increasing revenue, sales
would have to increase to $1.2 million. Below is the computation:-
Gross Profit = sale – cost of goods sold
0.16 = sales – (direct material + direct labor + 0.2)
0.16 = sales – (0.5 sales + 0.2 sales + 0.2)
0.16 = sales – 0.7 sales – 0.2
0.16 = 0.3 sales – 0.2
0.3 Sales = 0.36
Sales = 0.36 = 1.2 sales should increase to 1.2 million or it should increase by 20%
0.3
Now let us try to see how the above level of sales (1.2 million) leads to the very same profit of $
160,000

Dollars Percent of Sales

Revenue (sales) $1,200,000 100
Cost of Goods Sold
Direct Material 600,000 50
Direct labor 240,000 20
Factory Overhead 200,000 17
Total Cost of Goods Sold $1,040,000 87
Gross Profit $160,000 13

Example 2

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A. If the cost of direct material is 60%, direct labor is 10%, and overhead is 25% of sales,
what will be the improvement in profit if direct material is reduced by 5%?
B. How much will sales have to increase to give the same increase in profit? (Remember
overhead cost is constant.)

A. Before Improvement After improvement

Revenue (sales) 100% 100%
Cost of Goods Sold
Direct material 60% 55%
Direct Labor 10% 10%
Overhead 25% 25%
Total Cost of Goods Sold 95% 90%
Gross Profit 5% 10%

Profit grows to 10% of sales, i.e., it has increased by 100% (10% - 5% / 5%). The dollar version
of the analysis is as follows if a sales volume of $1,000,000 is considered.
Before Improvement After improvement
Revenue (sales) $ 1,000,000 $1,000,000
Cost of Goods Sold
Direct material 600,000 550,000
Direct Labor 100,000 100,000
Overhead 250,000 250,000
Total Cost of Goods Sold 950,000 900,000
Gross Profit 50,000 100,000
Profit has increased by $50,000 or 100% (100,000-50,000/100,000)

B. Gross profit = total revenue – total cost of goods sold

Gross Profit = sale – (direct material + direct labor + 0.25)
0.1 = sales – (0.6 sales + 0.1 sales + 0.25)
0.1 = sales – 0.7 sales – 0.25
0.1 = 0.3 sales – 0.25
0.3 Sales = 0.35

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Sales = 0.35 = 1.17

0.3
Sales must increase by $117,000 or 17% to result the same increase in profit.

Dollars Percent of Sales

Revenue (sales) $1,170,000 100
Cost of Goods Sold
Direct Material 702,000 60
Direct labor 117,000 10
Factory Overhead 250,000 21
Total Cost of Goods Sold $ 1,069,000 91
Gross Profit $ 101,000** 9

** The additional $ 1,000 is due to rounding. In actual terms the sales should increase by 16.66%
and that is rounded to 17%
Note:-From the above examples it is possible to conclude that every dollar decrease in cost
amounts to a dollar increase in profit but every dollar increase in sales does not amount to a
dollar rise in profit since there is the cost element imbedded in it.
In addition to its contribution to profit maximization, materials management has also other
advantages like better accountability, better coordination, better performance, adaptability to
electronic data processing etc. For example, through centralization of authority and responsibility
for all aspects of materials function, a clear-cut accountability is established.
1.4 THE ORGANIZATION OF MATERIALS FUNCTION
In order to design the structure of materials management, one should learn the relationships
between materials management and the different functions in an organization. Broadly, the
materials management will have to work in close coordination with production, marketing and
finance departments. Only an atmosphere of mutual trust will ensure that these departments will
work towards the total organizational objectives. The following examples will help to understand
the relationships between materials management and other organizational units.

MATERIALS MANAGEMENT UNIT AND PRODUCTION UNIT.

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The production department will have to keep the materials management department informed
about its plans and schedules so that materials requirements can be planned in advance. Even the
adjustments in sales forecasting, or the changes in schedules must be duly conveyed to material
management department. In the same way, the materials management departments must keep
the production department informed about the lists of suppliers, availability of new materials and
anticipated delays so that re-scheduling of production could be done and costly stock-outs
avoided. The expertise of the materials management department could profitably used by the
production department in purchasing capital equipment‟s.
This shows that the production department is highly dependent on the supply of materials
provided by the material management unit. This strong interdependence between the two
departments tempted the production department to have the control of smooth flow of materials
and want to subordinates or structure material management under it.
MATERIAL MANAGEMENT UNIT AND MARKETING UNIT.
Marketing department will have to give advance information on forecasts and special
requirements so that planning can be done effectively. Materials management through efficient
operations can keep the prices at a competitive level and thus help the marketing department in
its operations. Because of the knowledge of the needs and wants of customers and information
on forecasted demand of products and special requirements, the marketing department wants the
materials management to be subordinated under it.
MATERIALS MANAGEMENT UNIT AND FINANCE UNIT.
The finance department also has to work in close coordination with materials management
department in anticipating funds requirements, payment of bills to suppliers, insurance and so on.
Such close coordination will ensure prompt payment of bills and improve relationships with the
suppliers. Since the finance unit is the one that provides the fund for the purchase of items
(materials) and wants to exercise control of costs, they want to structure materials management
under their domain.
As a matter of fact the question under which unit shall we structure material management does
not have a clear cut answer. Among other things, it depends on
 The size of the organization
 Management Philosophy of the organization.
 They type of business

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The following figures depict two alternative ways of structuring the materials management
functions.

G. Manger

HR/personnel Production Finance

Store Mgmt
Purchasing Production
& Inventory
control

Fig. 1.1

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G. manger

Marketing Finance
Production

Inventory Store Purchasing

control management

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CHAPTER TWO

MATERIALS DEMAND FORECASTING

Planning is a fundamental activity of management. Forecasting forms the basis of planning. Be it

planning for sales and marketing, production planning, or manpower planning, forecasts are
extremely important. Before making plans, an estimate must be made of what conditions will
exist over some future period. How estimates are made, and with what accuracy, is another
matter, but little can be done without some form of estimation. Forecasting is also a basic tool to
help managerial decision-making. Managerial decisions are seldom made in the absence of some
form of forecasting. This is because managers‟ have to take decisions in the face of uncertainty
every day, i.e., without knowing what would happen in the future. For example, keeping
inventory without knowing what the sales will be, buying equipment and machinery having no
knowledge about the demand for the products, and making investments in shares by a financial
manager of a company when no one knows what profits are going to result. The managers strive
to reduce this uncertainty and make better estimates of what is likely to happen in the future.
This is what forecasting aims to accomplish.
Forecasting can be understood as a scientifically calculated guess. “My salesman looks out of the
window and gives me the sales forecast for the next year” said one senior manager. This
salesman may be quite effective in his job, but he is only predicting and not forecasting.
Forecasting is a little more than looking in to a crystal-ball. The scientific basis for More
precisely, forecasting is defined as the process of estimating future demand in terms of the
quantity, timing, quality, and location for desired products and services. In a stable environment
with little or a predictable rate of change, the need for a forecast is non-existent. As the
environment becomes more complex and dynamic, however, a forecast of future conditions
becomes indispensable. Simply put it is a prediction of what will occur in the future. They are
usually concerned with timing, magnitude, or effects of events that are beyond immediate
control. Forecasts, therefore, are estimates of the occurrence, timing, or magnitude of future
events. They give operations managers a rational basis for planning and scheduling activities,
even though actual demand is quite uncertain. Accurate projections of future activity levels can
minimize short-term fluctuations in production and help balance workloads. This lessens hiring,

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firing and overtime activities and helps maintain good labor relations. Good forecasts also help
managers have appropriate levels or materials when needed, by anticipating employment and
material needs, the forecasts enable managers to make better use of facilities and give improved
service to customers.
2.1. IMPORTANCE OF FORECASTING

There are many circumstances and reasons why forecasting is important for predicting future
demand of materials in organizations. It, for instance, is inevitable in developing plans to satisfy
future demand. Most firms cannot wait until orders are actually received before they start to plan
what to produce. Customers usually demand delivery in reasonable time, and manufacturers must
anticipate future demand for products or services and plan to provide the capacity and resources
to meet that demand.
Forecasting provides the following benefits to firms:
 Improved employee relations,
 Improved materials management,
 Better use of capital and facilities
 Improved customer service
 provide relevant information
 Minimize short term fluctuations in production and balance workloads
 Estimate in physical units of future demand for a product or service
1.2. Process of forecasting
1. Determine the purpose of forecasting
2. Established the time horizon
3. Select the forecasting techniques
4. Gather and analyze data
5. Make the forecast
6. Monitor the forecast
1.3. DEMAND FORECASTING AND ITS CHARACTERSTCS

Before we discuss the patterns of demand, it is important to have a clear understanding of the
term demand management and then followed by the characteristics of demand.

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A. Demand management: Demand management is defined as the function of recognizing

and managing all demands for products. It occurs in the short, medium, and long-term. In
the long-term, demand projections are needed for strategic business planning of such
things as facilities. In the medium term, the purpose of demand management is to project
aggregate demand for production planning. In the short run, demand management is
needed for items and is associated with master production scheduling. Presently, we are
most concerned with the latter.

Demand management includes four major activities:

 Forecasting- a prediction of future events used for planning purposes.
 Order processing- this occurs when a customer‟s order is received. The product may be
delivered from finished goods inventory or it may be made or assembled to order. If
goods are sold from inventory, a sales order is produced authorizing the goods to be
shipped from inventory. If the product is made or assembled to order, the sales
department must write up a sales order specifying the product. This may be relatively
simple if the product is assembled from standard components but can be a lengthy,
complex process if the product requires extensive engineering.
 Making delivery promises
 Interfacing between manufacturing planning and control and the market place.
B. Demand Forecasting; Forecasts depend up on what is to be done. They must be made
for the strategic business plan, the production plan, and the master production schedule.
The purpose, planning horizons, and level of detail vary for each.
The strategic business plan is concerned with overall markets and the direction of the
economy over the next two to ten years or more. Its purpose is to provide time to plan for
those things that take long to change. For production, the strategic business plan should
provide sufficient time for resource planning: plant expansion, capital equipment
purchase, and anything requiring a long lead time to purchase. The level of detail is not
high, and usually forecasts are in sales units, sales dollars, or capacity. Forecasts and
planning will probably be reviewed quarterly or yearly.
Production planning is concerned with manufacturing activity for the next one to three
years. For manufacturing, it means forecasting those items needed for production
planning, such as budgets, labor planning, long lead time, procurement items, and overall

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inventory levels. Forecasts are made for groups or families of products rather than
specific end items. Forecasts and plans will probably be reviewed monthly.
Master production scheduling is concerned with production activity from the present to a
few months ahead. Forecasts are made for individual items, as found on a master
production schedule, individual item inventory levels, raw materials and component
parts, labor planning, and so forth. Forecasts and plans will probably be reviewed
weekly.
C. Characteristics of demand; In this chapter, the term “demand” is used rather than
“sales”. The difference is that sales imply what is actually sold whereas demand shows
the need for the item. Sometimes demand cannot be satisfied, and sales will be less than
demand. Before discussing forecasting principles and techniques, it is best to look at
some characteristics of demand that influence the forecast and the particular techniques
used.
1. Demand patterns; If historical data for demand are plotted against a time scale, they will
show any shapes or consistent patterns that exist. A pattern is the general shape of a time
series. The pattern of demand may be affected by the following major factors: General
business and economic conditions, Competitive priorities, Market trends such as
changing demand, and, the firm‟s own plans for advertising, promotion, pricing, and
product changes. Although some individual data points will not fall exactly on the
pattern, they tend to cluster around it. Figure 2-2 shows a hypothetical demand pattern.
The pattern shows that actual demand varies from period to period. There are four
reasons for this: trend, seasonality, random variation, and cycle.
 Trend- : is a long term movement of the item being forecast. For example, the
demand for personal computers has shown an upward trend during the last several
years without any long downward movement in the market.
 Seasonality – the demand pattern in figure 2-2 shows each year‟s demand
fluctuating depending on the time of year. This fluctuation may be the result of
the weather, holiday seasons, or particular events that take place on a seasonal
basis. Seasonality is usually thought of as occurring on a yearly basis, but it can
occur on a weekly or even daily basis. A restaurant‟s demand varies with the hour
of the day, and supermarket sales vary with the day of the work.

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 Random Variations: are movements that are not predictable and follow no
pattern (and thus are virtually unpredictable). Random variation occurs where
many factors affect demand during specific periods and occur on a random basis.
The variation may be small, with actual demand falling close to the pattern, or it
may be large, with the points widely scattered.
 Cycle- A Cycle is an undulating movement in demand, up and down, that repeats
itself over a lengthy time span (i.e., more than a year). Cyclical factors are more
difficult to determine because the time span may be unknown or the cause of the
cycle may not be considered. Cyclical influence on demand may come from such
occurrences as political elections, war, economic conditions, or sociological
pressures.

Figure 2-2: Historical product Demand Pattern

Seasonal Trend
Number of
units
demanded
N

Average

1 2 3 4

Year

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2. STABLE VERSUS DYNAMIC DEMAND

The shape of the demand patterns for some products or services change over time whereas others
do not. Those that retain the same general shape are called stable and those that do not are called
dynamic. Dynamic changes can affect the trend, seasonality, or randomness of the actual
demand. The more stable the demand; the easier it is to forecast. Usually the average demand is
the forecast for both demand that exhibit stable and dynamic patterns.
3. NATURE OF DEMAND

There are two types of demand: independent and dependent. Independent demand is not related
to the demand for any other product. For example, if a company makes wooden tables, the
demand for the tables is independent. The demand for the sides‟ ends, legs, and tops depend on
the demand for the tables, and these are dependent demand items.
Requirements for dependent demand items need not be forecast but are calculated from that of
the independent demand item. Only independent demand items need be forecast. These are
usually end items or finished goods but should also include service parts and items supplied to
other plants in the same company (inter-company transfers).
1.4. PRINCIPLES OF FORECASTING

Generally, forecasts have the potential to greatly affect the success or failure of an organization‟s
plans. Good forecasts can enable an organization to take advantage of future opportunities; poor
forecasts can result in missed opportunities, inefficient operations, customer dissatisfaction, and
costs associated with attempts to compensate for inappropriate actions or failure to act.
The following shows pre-requisites to good forecasts:
 Determine the purpose of the forecast. This will generally govern the amount of
resources that can be justified for developing and maintaining the forecast.
 Determine the time horizon. Some techniques work better in the short term, others are
for intermediate range applications, and still others work best for the long range.
 Select an appropriate technique.
 Identify the necessary data, and gather it if necessary. Special purpose forecasts may
require special collection efforts, whereas more repetitive forecasting requires ongoing,
routine data collection.
 Make the forecast.

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 Monitor forecast errors in order to determine if the forecast is performing

adequately. If it is not, take appropriate corrective action.

It is important to recognize that all forecasts have the tendency to be inaccurate; there is no
technique in existence that will provide perfect forecasts outside of the carefully controlled
conditions that are possible in a laboratory. In the real world, the important question is not “Will
the forecast be perfect?” but rather, “How far off might the forecast be?”
In a more general sense, there are four major characteristics and principles of forecasts that you
have to understand to make more effective use of forecasts.
A. Forecasts are usually wrong. Forecasts attempt to look into the unknown future and,
except by sheer luck, will be wrong to some degree. Errors are inevitable and must be
expected.
B. Every forecast should include an estimate of error. Since forecasts are expected to be
wrong, the real question is, “by how much?” every forecast should include an estimate of
error often expressed as a percentage of (plus and minus) of the forecast or as a range
between maximum and minimum values. Estimates of the error can be made statistically
by studying the variability of demand about the average demand.
C. Forecasts are more accurate for families or groups. The behavior of individual item in
a group is random even when the group has very stable characteristics. For example, the
marks for individual students in a class are more difficult to forecast accurately than the
class average. High marks average out with low marks. This means that forecasts are
more accurate for large groups of items than for individual items in a group.
D. Forecasts are more appropriate for nearer time periods. The near future holds less
uncertainty than the far future. Most people are more confident in forecasting what they
will be doing over the next week than a year from now. As someone once said, tomorrow
is expected to be pretty much like today.
In some way, demand for the near term is easier for a company to forecast than for a time
in the distant future. This is extremely important for long lead-time items especially so if
their demand is dynamic. Anything that can be done to reduce lead time will improve
forecast accuracy.

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1.5. DEMAND FORECASTING TECHNIQUES

An organization needs several kinds of forecasts to plan for the future. In each case the forecast
to be used depends on the activity being planned and the length of planning horizon. Selection of
the appropriate method will be influenced by the constraints that exist when preparing the
forecast, e.g., the availability and quality of relevant data, time frame ((i.e., how far in the future
we are forecasting), expertise, computational facilities, existence of pattern in the forecast (i.e.,
seasonal trends, peak period) and the number of variables the forecast is related to.
The existing forecasting techniques fall into two major categories: Qualitative models and
quantitative models/methods. The qualitative models use personal judgment and involve
qualities like intuition and experience as the basis of forecasts, and are subjective by their very
nature. These estimates are judgmental and are based on intuition, estimates, and opinions.
Techniques under this category include Delphi technique, market research, historical analogy,
panel consensus, grass root estimate sales force composite and consumer panel survey.
On the other hand, quantitative models are objective in nature and they employ numerical
information as the basis of making forecasts. The quantitative models include time series
analysis, causal and Simulation models. Time series is a category of statistical techniques that
uses historical data to predict future behavior. In such models, the demand forecast is done on the
basis of the past demand values. They hold the future to be a continuum of the past and are based
on the premise that what would happen in the future is a function of what has happened in the
past. Simple moving average, weighted moving average, exponential smoothing, linear
regression (particularly least square method) etc are some of the methods of time series analysis
Causal models are used where one variable is related to and, therefore, dependent upon, the
values of some other variable(s). It assumes that a demand for a product is related to some
underlying factor or factors in the environment. The demand for a product, may, for example be
seen to be dependent up on the price charged, amount spent on advertisement, incomes of the
people and so on. Causal models employ such methods as regression analysis, input output
model, leading indicators etc. Simulation models allow the forecaster to run through a range of
assumptions about the condition of the forecast. These are dynamic models, usually computer
based, that allow the forecaster to make assumptions about the internal variables and external
environment in the model. Depending on the variables of the model, the forecaster may ask such

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questions as, what would happen to may forecast if price increased by 10 percent? What effect
would a mild national recession have on my forecast?
1.5.1. QUALITATIVE FORECASTING METHODS

Qualitative/Subjective forecasting methods refer to the variety of techniques that rely primarily
on the experience and opinions of people inside or outside the organization. Such techniques are
generally employed either when there is little time or no past relevant past data or when available
data may not be enough to cover possible developments in the more distant future. For example,
introducing a new product into the market, or a new commercial flight, presents activities or non-
existing historical data.
Qualitative forecasting approaches are important for a number of different reasons. Speed in
making a forecast sometimes is a factor in choosing a qualitative approach over a quantitative
one, especially if data acquisition for a quantitative approach will be time consuming. The
ability to incorporate experience and judgment are sometimes given as important reasons for
using qualitative methods. However, the two are not necessarily mutually exclusive; quantitative
forecasts can be modified by users in order to incorporate judgment and experience. Thus,
qualitative reasoning can be used to supplement (and hopefully improve) quantitative forecasts.
A. GRASS ROOTS
Grass root builds the forecast by adding successively from the bottom. The assumption here is
the person closest to the customer or end use of the product knows its future needs best. Though
this is not always true, in many instances it is a valid assumption and it is the basis for this
method. Forecasts at this bottom level are summed and given to the next higher level. This is
usually a district warehouse, which then adds in safety stocks and any effect of ordering quantity
sizes. This amount is then fed to the next level, which may be the regional warehouse. The
procedure repeats until it becomes an input at the top level, in the case of manufacturing firm,
would be the input to the production system.
B. MARKET RESEARCH
Firms often hire outside companies which specialized in marketing research to conduct this type
of forecasting. They can also do their own market research. It involves collecting customer data
in variety of ways such as survey, interviews etc to test hypotheses about the market. This
information is then used to typically to forecast long-range and new-product sales.

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C. PANEL CONSENSUS
In this method, the idea that two heads are better than one is extrapolated to the idea that a panel
of people from variety of positions can develop a more reliable forecast that a narrow group.
Panel forecast are developed through an open meeting with free exchange of ideas from all levels
management and individuals. The difficulty with this open style is lower level employees are
intimidated by higher level of management. For example, a sales person in a particular product
line may have a good estimate of the future product demand but may not speak up to refute a
much different estimate by the vice president marketing.
D. HISTORICAL ANALOGY
In trying to forecast a demand for a new product, an ideal situation would be where an existing
or a generic product could be used as a model. There are many ways to classify such an analogy-
for example, contemporary products, substitutable or competitive products and products as a
function of demand. The idea here is a demand for a certain product can be derived by using the
history of a similar existing product. For example, an analogy could be forecasting the demand
for digital video discs players by analyzing the demand for the historical demand of VCRs since
the products are in the category of electronics and may be bought by consumers at a similar rate.
Another example could be toasters and coffee pots. A firm that already produces toasters and
want to produce coffee pots could use the toaster history as a likely growth model.
E. DELPHI METHOD

The method is an iterative group process and it employs a group of experts, not an oracle, to
obtain the forecasts. Delphi technique overcomes the problem of panel consensus where since it
conceals the identity of the participants. As discussed above the opinion of higher level
individuals will weigh more than that of the lower level people. The worst case is when the lower
level employee s are threatened and do not contribute their true feeling. In this technique
everyone has same weight. Procedurally the moderator creates a questionnaire and distribute to
the participants. Their responses are summed and given back to the entire group along with a
new set of questions. The Delphi technique can usually achieve satisfactory results in three
rounds. The time required is a function of the number of participants, how much work is
involved for them to develop their forecasts, and their speed in responding.

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F. SALES FORCE COMPOSITE

In this method of demand forecasting, each of the members comprising sales force of a company
are asked to estimate the likely sales in their respective areas. The estimates are then reviewed to
ensure that they are realistic. After this, the estimates are combined at the district, regional and
national level to obtain the overall forecast.
G. CONSUMER PANEL SURVEY

Some marketing research methods employ consumer panels for making forecasts. Here, a
consumer panel is maintained and consumers on such a panel are questioned about their purchase
plans. The goal here is to forecast demand for products and services on the basis of the subjective
judgments of the subjects involved, about the possible purchases. This method works on a strong
assumption that the consumers on the panel are truly representative of the ultimate purchase.
2. QUANTITATIVE FORECASTING METHODS
2.1. TIME SERIES FORECASTING TECHNIQUES

Time series forecasting models attempt to predict the future based on past data. For example,
sales figures collected for each of the past six weeks can be used to forecast sales for the seventh
week. Quarterly sales figures collected for the past several years can be used to forecast the sales
figures in future quarters.
Time series forecasting models include (a) simple moving average, (b) weighted moving
average, and (c) exponential smoothing. In order to determine which model is most appropriate
to use, the data should be first plotted on the graph. For example, if the data points appear to be
relatively level, a moving average or exponential smoothing model would be appropriate; if the
data points show an underlying trend, then exponential smoothing with trend adjustment would
be appropriate. In addition, the errors associated with each model should be calculated and the
resulting errors should be compared.
Moreover, managers must consider the following factors in selecting a method for time series
forecasting: Time horizon to forecast, data availability, accuracy required, Size of forecasting
budget, Availability of qualified personnel, firms degree of flexibility(The greater the ability to
react quickly to changes, the less accurate the forecast needs to be). Another item is the

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consequence of a bad forecast. If a large capital investment decision is to be based on a forecast,

it should be a good forecast.
A) SIMPLE MOVING AVERAGES

A moving average forecast uses a number of the most recent actual data values in generating a
forecast. If the demand for a product is neither growing nor declining rapidly, and also does not
have any seasonal characteristics, simple moving average can be very useful in identifying a
trend within the data fluctuations. For example, if we want to forecast sales in June with a five
month moving average, we can take the average of the sales in January, February, March, April,
and May. When June passes, the forecast for July would be the average of February, March,
April, May, and June.
The simple moving average forecast can be computed using the following equation:
At 1  At 2  At 3  ....  At n
Ft 
n
Where, Ft = Forecast for the coming period
n = Number of periods to be averaged
At-1 = Actual occurrence in the past period
At-2, At-3, and At-n = Actual occurrences two periods ago, three periods ago, and
so on up to n periods ago.
Example 1: The demand for an item is observed for 15 months and recorded below:
Month 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Demand 280 288 266 295 302 310 303 328 309 315 320 332 310 308 320

Required: Calculate (i) 3- monthly and (ii) 4- monthly moving averages. What is the forecast for
month 16 for each one?
Answer: The given data are reproduced in Table 2-2. The three-monthly moving averages and
four-monthly moving averages are shown in the third and the fourth columns of the table. From
the third column, the forecast for month 16 is about 313 units, while a 4-monthly moving
average, in the fourth column, yields a forecast of about 318 units for this month.
Table 2-Forecasting Using Moving Averages.

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Month Demand (y) 3-Mohthly Moving Average 4-Monthely Moving Average

1 280
2 288
3 266
4 295 278.0
5 302 283.0 282.3
6 310 287.7 287.8
7 303 302.3 293.3
8 328 305.0 302.5
9 309 313.7 310.8
10 315 313.3 312.5
11 320 317.3 313.8
12 332 314.7 318.0
13 310 322.3 319.0
14 308 320.7 319.3
15 320 316.7 317.5
16 312.7 317.5

Example 2: Demand over the past three months has been 120,135, 114, and 129 units. Using a
three month moving average,
a. Calculate the forecast for the fourth month.

b. Calculate the forecast for the fifth month.

Answer:
120  135  114 369
a) Forecast for month 4 =   123
3 3

135  114  129

b) Forecast for month 5 =  126
3

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DISADVANTAGES OF SIMIPLE MOVING AVERAGES

1. All the individual elements used in the average must be carried as data since a new
forecast period involves adding the newest data and dropping the oldest data.

2. The data storage requirements can be significant, especially if large numbers of moving
average forecasts are being made. This is because individual values that comprise the
average must be separately identified so that with each new forecast the oldest value can
be discarded. The need to retain several periods of history for each item to be forecast
will require a great deal of computer storage or clerical effort in addition to the
cumbersome calculations. A common forecasting technique, called exponential
smoothing, gives the same results as a moving average but without the need to retain as
much data and with easier calculations.

3. A more serious consideration is that all the values in the average are weighted equally.
Hence, in a 10-period moving average, each value is given a weight of 1/10; the oldest
value is given the same weight as the most recent value. Decreasing the number of
values in the average will increase the weight of more recent values, but this will be at
the expense of losing potential information from less recent values.

4. It doesn‟t react well to variations that occur for a reason, such as trends or seasonal
effects (although this method does reflect trends to a moderate extent). Those factors that
cause changes are generally ignored. It is basically a “mechanical” method, which
reflects historical data in a consistent fashion.

However, the simple moving average method has the advantage of being easy to use, quick, and
relatively inexpensive, although moving averages for a substantial number of periods for many
different items can result in the accumulation and storage of a large amount of data. In general,
this method can provide a good forecast for the short run, but an attempt should not be made to
push the forecast too far into the distance future. As such, a simple moving average is
particularly useful for forecasting items that are relatively stable and do not display any
pronounced behavior such as trend or seasonal pattern.

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B) WEIGHTED MOVING AVERAGE

The moving average method can be adjusted to more closely reflect more recent fluctuations in
the data and seasonal effects. This adjusted method is referred to as weighted moving average
method. Whereas the simple moving average gives equal weight to each component of the
moving-average database, a weighted moving average allows any weights to be placed on each
element, providing, of course, that the sum of all weights equals 1.
In this method, weights are assigned to the most recent data according to the following formula:
F1 = W1 At-1 + W2At-2 + . . . + Wn At-n
Where; W1 = Weight to be given to the actual occurrence for the period t – 1
W2 = Weight to be given to the actual occurrence for the period t – 2
Wn = Weight to be given to the actual occurrence for the period t – n
n = Total number of periods in the forecast
While many periods may be ignored (i.e., their weights are zero) and the weighting scheme may
be in any order (e.g., more distant data may have greater weights than more recent data), the sum
of all the weights must equal 1.
n

w
i t
i 1

Note that experience and trial and error are the simplest ways to choose weights. As a general
rule, the most recent past is the most important indicator of what to expect in the future, and
therefore, it should get higher weighting. The past month‟s revenue or plant capacity, for
example, would be a better estimate for the coming month than the revenue or plant capacity of
several months ago. However, if the data are seasonal, for example, weights should be
established accordingly.
The weighted moving average has a definite advantage over the simple moving average because
it can vary the effects between older data and more recent data. With the forecasting software
that is now available, there is little computational difference between using a weighted moving
average and a simple moving average. Both can be obtained in “real time.” If there is a
disadvantage to the weighted moving average, it is that someone must determine the weights to
be used.

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Example 3: A department store may find that in a four-month period, the best forecast is derived
by using 40 percent of the actual sales for the most recent month, 30 percent of two months ago,
20 percent of three months ago, and 10 percent of four months ago. The actual sales experience
and the associated weights are given as follows:

Month 1 2 3 4 5
Demand 100 90 105 95 ?
Weights 0.10 0.20 0.30 0.40

Required: Determine the forecast demand for the fifth month.

Solution: The forecast for month 5 would be
F5 = 0.40(95) + 0.30(105) + 0.20(90) + 0.10(100)
= 38 + 31.5 + 18 + 10 = 97.5
Example 4: Suppose sales for month 5 of the above example is actually turned out to be 110.
Then the forecast for month 6 would be;
C) EXPONENTIAL SMOOTHING

It is a type of moving average forecasting technique, which weights past data in an exponential
manner so that the most recent data carry more weight in the moving average. Basically the
method provides a forecast, which is equal to that of the previous period plus some proportion of
the past forecasting error. The proportion or weights factor is called alpha (α). A high α place
heavy weight, 00n the most recent demand and a low α weights recent demand less heavily.
Suppose the demand is dynamic and unstable, then the α may be taken as 0.7 or 0.8 or 0.9 and
for stable demand the α may be taken as 0.1 or 0.2 or 0.3.When demand is moderate or slightly
unstable, smoothing coefficients of 0.4 or 0.5 or 0.6 might provide the most accurate forecasts.
The formal for exponential smoothing model is
Ft = Ft-1 + α (At-1 - Ft-1)
Ft = Forecasted demand for period t.
Ft-1 = Forecasted demand for previous period
α =Smoothing constant
At-1 =Actual demand for previous period.

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Example 4: A from uses simple exponential smoothing with α = 0.1 to forecast demand. The
forecast for the week of February 1 was 500 units, whereas actual demand turned out to be 450
units.
a) Forecast the demand for the week of February 8.
b) Assume that the actual demand during the week of February 8 turned out to be
505 units. Forecast the demand for the week of February 15. Continue on
forecasting though March is assuming that subsequent demands were actually 516
and 488 for Feb, 15 and Feb, 22 respectively.

a) For February 8
Ft = Ft-1 + α (At-1 - Ft-1)
= 500 + 0.1 (450 -500)
= 495 units

b) For February 15
Ft = 495 + 0.1 (505 - 495)
= 496

c) For February 22
Ft = 496 + 0.1 (516 - 496)
= 498

d) For March, 1
Ft = 498 + 0.1 (488 - 498)
= 497

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CHAPTER 3

PURCHASING

MEANING ROLES AND OBJECTIVES

Purchasing is an everyday function of almost everyone and occupies much of the time both of
business houses and ultimate consumers. There are three basic types of purchases:
Industrial buyers who buy raw materials stores and equipment for manufacturing
Merchant buyers who buy goods for resale and include wholesalers, retailers, speculators etc.
Ultimate buyers, i.e., consumers who purchase goods for consumption.
We are here concerned only with the first purchasing, i.e., purchasing of raw materials,
equipment stores etc, for the use in the manufacturing process.
Purchasing to a manufacturing concern is of extreme importance because it has its bearing on
every vital factor concerning the manufacture, i.e., quantity, quality, cost efficiency, economy,
prompt delivery, volume of production etc. It is the scientific purchasing that can save much
money, time and efforts of the management.

In manufacturing organization "purchasing is the procuring of materials, supplies, machines,

tools and services required for the equipment, maintenance and operation of the business.
Purchasing must be of the right quality in proper quantity for delivery at the correct time and at
the most favorable price from outside the organization.

DEFINITION OF PURCHASING

According to Walter "Industrial purchasing is the procurement by purchase of the proper

materials, machinery, equipment and supplies of stores used in the manufacture of a product
adapted to marketing in the proper quantity and quality at the proper time and at the lowest price
consistent with the quality desired."

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In simple words, the task of purchasing is related to going to open market, finding the desired
materials at the lowest possible price, and selecting the suppliers who offers it at that price
having the quality of the materials in mind. It is indeed, a specialist activity calling for the
commercial rather than the technical training and outlook

OBJECTIVES OF PURCHASING
The basic objective of the purchasing function is to ensure continuity of supply for raw materials,
sub-contracted items and spare parts and at the same time reduce the ultimate cost of finished
goods. In other words, the objective is not so much to procure the raw materials at the lowest
price but to reduce the cost of the final product. For ensuring this, there are a large number of
well known parameters such as right quality, right quantity, right time, right price and right
vendor attitude. These are the five rights (five R‟s) of purchasing which discussed below:-
The Right Quality: Virtually all manufacturing –based definitions identify quality as
conformance to requirements. Once design or specifications have been established, any deviation
implies a reduction in quality. Therefore, determining the right quality is to obtain an
appropriate/ sufficient quality that will meet the organizational needs. The use of standards and
specifications are helpful in determining the right quality.
The Right Quantity: This refers to obtain sufficiently enough quantity so that organizational
operations and services will not be interrupted and at the same time minimizing operational and
service costs in association to the inventory of a firm. Materials must be purchased in right
quantity neither in excess of the requirements blocking the capital unnecessary nor shortage of
materials should be experienced, holding up the flow of production Determination of the right
quantity can be done through techniques: EOQ and EPQ models, which will be discussed in
chapter 4.
The Right price: It is the lowest price consistent with other requirements. As price is one of the
important factors in purchasing, materials should be purchased at a reasonable price. The
reasonableness of the price should be considered in terms of how well the other factors are met.
Pricing and negotiation help in determining the right price.
The Right Time: It is time when materials are required. Materials must be delivered when they
are required. If the materials are delivered either after or before they are required then there will
be increased cost of inventory. Concepts like reorder level and lead time are important.

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The Right Supplier: It is the supplier that will fulfill all the requirements and criteria set by the
organization. Concepts like the supplier analysis helps in determining the right supplier.
In general, the following are the objective of effective purchasing
 To support company operations with an uninterrupted flow of materials and services.
 To buy competitively and wisely.
 To keep inventory investment and inventory losses at a practical minimum.
 To develop effective and reliable sources of supply.
 To develop good relationships with the supplier community and good continuing
relationships with active suppliers.
 To achieve maximum integration with the other departments in the firm.
 To handle the purchasing and supply management function proactively in a professional,
cost-effective manner.

PURCHASING POLICIES

Dozens of times each day, most managers utilize basic policies as guidelines in making operating
decisions associated with their job. Precisely what is a policy? A policy is a statement, which
describes in very general terms an intended course of action. After the fundamental objectives of
an activity are established during the planning process, policies are developed to serve as general
guideline in channeling future action toward the objectives, policies, as distinguished from
procedures, do not set down a series of explicit steps to be followed in performing a Eask.
Rather, they state broadly the intended course of action. After a policy has been formulated
specific procedures are then developed for handling common recurring decision. The purchasing
policy can be classified into:
General purchasing policies
Specific purchasing policies
General purchasing policies
These are the fundamental operating policies-broad policies of particular interest to top
management. These policies deal with things such as purchasing authority, ethics, and vendor
relations. All of these policies lie close to the heart of the purchasing function. It is again
classified into:
Centralized purchasing

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Decentralized purchasing
Centralized purchasing
By Centralized purchasing, we mean to entrust the purchasing function to one person or
department that is authorized to make purchase for and on behalf of all departments situated in
one place. This type of purchasing is suitable where company operates only one plant or more
than one plant within the local limits.

Advantage of Centralized purchasing

Highly one skilled official is sufficient.
It is avoiding the duplication of purchasing.
They can give more attention to purchasing.
There is an economy of large-scale buying.
It is possible for better control over entire purchase.

Disadvantage of Centralized purchasing

It is possible for delay in procurement.
There may be wrong purchase for the departments.
It is not suitable to multi-plant operations.
There is a lack of getting local resources.

Decentralized purchasing
Decentralized or localized purchasing, on the other hand, permits different plants to have their
own purchase of materials for to their requirements. This type of purchasing is suitable where the
company runs a number of plants out a variety of products through different plants though
located at one place if they require different materials.

Advantages of Decentralized purchasing

Purchasing on time
It is possible for keeping minimum level of stock.
It more suitable for multi-plant operations.
Utilization of all local resources effectively.
It is possible for Munising g the lead time

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Disadvantages of Decentralized purchasing

Cost of purchase will be more
Carrying and orderly cost will be more.
It is not suitable for single plant operation
Specific purchasing policies
It is a policy to specific activity of materials management. It is very useful to effective
purchasing. The following are the some of the examples of specific purchasing policies:
Quality policy
It is describe the policy of purchasing towards the quality of materials. The purchaser can decide
the quality of purchase based on this policy.
Quantity policy
This policy is useful to guide the purchaser for quantity of purchase. Normally, this policy is
based on EOQ model which specify for optimum purchase
Price policy
It is policy for guiding the purchaser to decide the price of purchase. It is not necessary to lowest
price but it specifies the best price for the quality materials.
Vendor's selection policy
This is useful to selecting the vendor for purchasing the materials. It may be single source or
multi source of buying. This policy is clearly guiding the purchaser to decide the vendor.
Inventory management policy
It is very useful to managing the inventory in the stores. It is guiding the people to effective
management of inventory through various techniques and models.
PURCHASING PROCEDURE
A purchasing department buys many different types of materials and services, and the procedures
used in completing a total transaction normally vary among the different types of purchase and
organizations. However, the general cycle of activities in purchasing most operating materials
and supplies is fairly standardized.

Origination of the purchase Requisition:-

The first step in purchasing of an item is origination of purchase requisition. Purchase
requisition can be originated from different units and individuals in an organization. Actually,

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organizations set policies as to who should originate the purchase requisition. For instance, for
purchase of non-stock items, the using department can make the purchase requisition directly.
But, for stock items, the stores or the head of the stores makes the requisition.
Purchase requisitions are made on a purchase requisition form/slips which carries a number of
information such as:
The name and the title of the material
Quality of the items (specifications and standards)
Quantity of the items
The location where the items are to be used and others
Proposed supplier (Performa)
2. Clearance of the purchase budget: - When the purchasing department receives the
requisition, fear clarification must be made whether the requesting unit/ department has the
authority to request purchase and whether it has budget or not. If the requesting department has
the authority and budget to make the purchase we can proceed to the next step.
3. Request for Quotation/Bid
The purchasing department considers whether quotations or bids are required or not. In small and
repetitive purchases quotations is not required, but for large purchases quotation is a must.
Quotation is an invitation of potential suppliers to compete in supplying the items required.
Request for quotation (Notice for Bid) also uses forms which carry a number of information such
as:
Name and specification of the items
Quantity,
Time of delivery
Terms of Purchase
Date of opening for quotation
Legal requirements and etc

4. Evaluation of supplier:- When potential candidates quote to supply materials, evaluation and
selection of suppliers will be made. The organization sets polices and criteria for evaluation of
suppliers. Per to the factors set, suppliers will be evaluated against these factors. Usual and
common factors of evaluation are:

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Quality factors include the following:

Visit to the location of the supplier (Vendor)
Sample approvals,
Inspection costs
Rejects
Rework and etc.
Delivery factors:- Include the following:
Follow-up costs (fax, telephone, and etc)
Expediting costs
Transportation costs and etc.
Service factors:- Include the following:
Services facilities,
Financial stability,
Labor relation
Geographical location
Technical support and after sales services, etc
Price factor: This refers the lowest price consistent with other factors. Price factor should not
be at the cost of quality, delivery or services factors. Supplier evaluation can be facilitated if we
have approved list of suppliers (vendors)
Purchase Order:
Once a supplier is selected, the purchase order will be made. Purchase order is legally binding
document and hence great care should be exercised in designing and preparing it. Purchase Order
is “A contract between a buyer and seller that specifies the items to be purchased, the price that
will be paid for those items, and the date the items are to be delivered.” Purchase orders should
be made on a number of copies depending on the size of the organization and the number of units
that receive the purchase order. The following is just an example:
Two copies of the supplier (the supplier retains one copy, signs and returns the other copy to the
purchaser as an acknowledgment for the receipt of the purchase order)
One copy for the purchasing file
One copy for receiving, inspecting
One copy for stores

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One copy for finance.

Follow up and expediting: Once the purchase order is made the purchasing department may
require to follow-up or expedite the shipment of materials. Follow-up is reminding the supplier
about the orders and finding out what the supplier is doing to send the materials. Expediting may
be practiced in case the buyer requires the materials earlier than the agreed date of contract.
Before the agreed date of contract, the buyer may request the supplier to send the items earlier.
However, this may require additional arrangements and hence, definitely, the cost of purchasing
is going to increase.
Receiving, Inspecting and storing: When materials are sent by the supplier, they will be
received, inspected, and stored. At this step, different reports are make by comparing the
received materials with the purchase orders with respect to:
Quality (according to standard and specification given on purchase order)
Quantity (the right amount of the items ordered)
Specification number, and finally reports will be sent to the finance department.
Payment to the supplier: The finance department effects payment after comparing and making
the necessary reconciliation between the purchase order and the receiving, inspecting and store
report.
Evaluation of the Purchase: After the whole purchasing steps has been accomplished the
purchasing department finally makes the evaluation of the overall purchase so as to assure
whether it has fulfilled the needs of its user or not. This stage is important for planning the
future purchase of an organization.
SELECTION & MOTIVATION OF SUPPLIERS
FACTORS IN SUPPLIER SELECTION
How are good suppliers identified? Where do buyers begin to search to find the suppliers? who
can serve their company best? What problems must be solved before the search for a specific
supplier begins?
A buyer must consider many factors in selecting source of supply. This section consisting two
primary areas-characteristics of the supplying markets and acceptable ethical practices in these
markets. These are the area‟s most buyers consider before getting down to more specific factors
of supplier selection. The following are important factors which selecting the suppliers.
Assurance of supply

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The buyer always seeing the reliability of supply while selecting the supplier. The buyer should
confirm the continuous supply from supplier even during the scarcity of supply. Therefore the
selection of supplier should as on reliability of supply in future
Capacity and economic condition of supplier
Another factor for selecting the supplier is capacity and economic condition of the supplier. If
the economic condition of the supplier is good, then he will supply the raw material continuously
in predetermined price even the price is raising in future.
Local source of supply
The local source of supply is cheaper than the Global source of supply. All the buyers are interest
to purchase from local if it is suitable to their requirements. The local source of supply is free
from transportation cost. If local supply is not possible, then buyers are going for Global source
of supply.
Terms and Condition of supply
Always the selections of suppliers are based on the terms and condition of the supply. The terms
include the credit period, amount of discount, price, transport cost etc. If the term of supply is
favorable to buyer, then he will select the supplier.
Size and Number of supplier
If the size of supplier is less, then the buyer should select the supplier without his option and vice
versa. If the size of order is more, then the buyer selects more than one supplier. Both singly and
Multi source of supply having merits and demerits.
EVALUATION AND SELECTION OF SUPPLIERS

There are different methods of evaluating and selecting suppliers. In evaluating and selecting
suppliers, organizations first of all set policies and their own criteria to evaluate and select
suppliers. The two most important methods of evaluating and selecting suppliers are:
The weighted Point method
The Cost Ratio Method
Dear learner! Lets discus this methods in detail with a help of examples:
The weighted Point method: In a weighted point method, an organization determines in
advance a number of evaluation factors/ criteria such as:
Quality
Delivery cost

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Cost reduction suggestion

Price and etc.
And each factor is given a weight (point) on the basis of its importance to the organization. For
instance, for some materials, quality may be very important and hence very high point may be
given to it. On the other hand, for some materials, quality may not be very important and hence,
a very low point can be given to it. Let‟s see an example:
Example:
Assume that your organization has decided to apply the weighted point method of evaluating and
selecting suppliers using the following evaluation criteria and their respective weights:
Factors Weights (%)
Quality 45
Delivery 25
Cost reduction suggestion 20
Price 10
Total 100%
From the past records, the following information was obtained about the past performances of
three suppliers:
Performance
Suppliers Quality Delivery Cost reduction Price(birr)
Suggestion
XYZ 95 72 25 600
ABC 80 82 25 500
QST 75 100 50 700

Which supplier shall the tender committee of your organization select and offers the bid
award?
Answer can be provided by weighted point method (WPM) as follows: we rate each factor
according to the performance of each supplier.

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Quality factor can be rated as follows:

Past Total
performance in Weight given for Percentage
Supplier quality quality (45%) (%)
XYZ 95% 45% 43
ABC 80% 45% 36
QST 75% 45% 34

Delivery factor can be rated as follows:

past performance in Weight given for Total

Supplier Delivery Delivery (25%) Percentage
XYZ 72% 25% 18
ABC 82% 25% 20.5
QST 100% 25% 25

Cost reduction suggestion factor can be rated as follows:

past performance in Weight given for cost

cost reduction reduction suggestion Total
Supplier suggestion (20%) Percentage
XYZ 25% 20% 5
ABC 25% 20% 5
QST 50% 20% 10

Price factor can be rated as follows:

past performance in weight
Price factor(birr) given for Total
Supplier reduction suggestion % in price price factor percentage

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XYZ 600 83% 10 8.33

ABC 500 100% 10 10
QST 700 71% 10 7.14

In the case of price factor we take the lowest price to be our base and determine the percentage
for other suppliers‟ price.
In our example the lowest price is offered by supplier ABC which is 500 birr. Thus, the price rate
for supplier ABC will be 100%.
Therefore, the percentage in price supplier ABC, XYZ and QST is:
ABC%= 500 * 100 = 100%
500
XYZ % = _500__* 100 = 88.33%
600

QZT %=__500__ * 100 = 71.43%

700
Now, we can combine all the rating together as follows:

Combing ratings
Supplier Quality Delivery Cost Price Total
reduction
suggestion
XYZ 43 18 5 8.33 74.33
ABC 36 20.5 5 10 71.5
QST 34 25 10 7.14 76.14

Now, it is obvious that a supplier with the highest percentage of weights in its performance is
selected by the respective buyer. And hence, the rank of the tender committee‟s evaluation will
be:
Supplier QST= 1st
Supplier XYZ=2nd

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Supplier ABC= 3rd

Therefore, the award according to this evaluation will be given to supplier QST.
The Cost Ratio Method:
This method of evaluation and selecting supplier relates all idle variable costs of purchasing and
receiving to the value of purchasing. Purchasing organizations, in addition to price, spend
different types of costs such as: quality, delivery, service cost and others.

The higher the total cost of purchases means lower possibility of a supplier being selected for
possible bid award.
1. To evaluate quality, the percentage of total quality cost is computed as:

__Quality cost_
Total purchase X 100

To evaluate delivery, we compute percentage of total delivery cost as follows:

__Delivery cost__
Total purchases X 100

To evaluate services, we usually have norm or standard of performance and weight for services.
Thus, we calculate how much higher or lower a supplier has performed in relation to the standard
of an organization with respect to the services. After comparing with the standard set we
multiply the difference by the services weight.
Example: Assume that you are the member of the tender committee in your organization. The
committee has decided to use the cost ratio method to evaluate and select suppliers.
The tender committee has decided to use four (4) factors: quality, delivery, services and price to
evaluate the suppliers.
The past performance of suppliers with respect to: total purchased, quality, delivery and service,
is available from the records of the purchasing department. Total amount of previous purchases
is given on the following table.

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Supplier Purchase in birr

W 100,000
X 120,000
Y 80,000
Z 140,000

Data related to quality costs from the suppliers:

(Rejects, reworks and etc)

Supplier Quality costs in birr

W 1,000
X 3,600
Y 3,200
Z 2,800

Data related to delivery costs from suppliers:

(Telephone, fax and etc)

Supplier Delivery costs in birr

W 3,000
X 1,200
Y 3,200
Z 2,800

Service performance ratings (in points)

Supplier Delivery costs in birr

W 84
X 91
Y 56

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Z 49

Assume that service standard set by your organization is 60 points.

Recent price quotation for supply is:
Supplier Delivery costs in birr
W 94
X 95
Y 90
Z 92

By looking only the price factor, as it may be as well in your organization at present, company Y
with the least price (90birr) may be selected. Note that this type of supplier evaluation is so
inadequate that doesn‟t take into consideration other factors particularly quality. Low price
quoted by the supplier may be because of some quality problem in its product. And hence,
possibly all factors should be included to the evaluation spectrum to select a supplier with a
reasonable and standard level of supply. Let‟s evaluate the above listed suppliers with three more
factors in addition to price. Surprisingly, the decision of award is different from the earlier one.
Let‟s see it together.
Cost Ratio Rating
Now we have to rate all the factors in terms of the percentage of costs as follows:
Quality cost rating:

Suppliers Quality costs in Percentage of quality

terms of birr cost
W 1,000 (1000/100,000)*100=1
X 3,600 (3,600/120,000)*100=3
Y 3,200 (3.200/80,000)*100=4
Z 2,800 (2,800/140,000)*100=2

Delivery cost rating:

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Suppliers Quality costs in Percentage of quality

terms of birr cost
W 3,000 (3,000/100,000)*100=3
X 1,200 (1,200/120,000)*100=1
Y 3,200 (3.200/80,000)*100=4
Z 2,800 (2,800/140,000)*100=2

Service cost rating:

Supplier Services Percentage of Services (service

point services percentage percentage)*service
(+ or- ) weight (20%)
W 84 (84/60)*100=140% +40 (40%)(20%)=+8
X 91 (91/60)*100=152% +52 (52%)(20%)=+10.4
Y 56 (56/60)*100=93% -7 (7%)(20%) = - 1.4
Z 49 (49/60)*100=82% -18 (18%)(20%)= -3.6

N.B the service standard is 60 points and the weight of services is 20%.
In the last column of service cost rating, you see that the percentages are with + (positive) or –
(negative) signs. + (positive) sign indicates that the supplier has offered a service which is
above the standard and hence rather than being cost it will be an asset to the organization. On
the other hand – (negative) sign means that a supplier‟s level of service deliver is below the
standard. Your organization should get service elsewhere to make compatible service. To get
elsewhere a service means the organization is going to pay additional amount of money and
hence additional cost.
Now, we can summarize the above cost rating as follows:

SUMMARY OF COST RATING

Supplier Quality Delivery Service cost Total cost

cost cost percentage

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W 1 3 -8 -4
X 3 1 - 10.4 - 6.4
Y 4 4 + 1.4 9.4
Z 2 2 + 3.6 7.6

Note that in the case of supplier W and X, total cost percentage is negative. This means that
because of extra service delivery made by the two suppliers, respective quality and delivery costs
are off-stated. And hence, your organization has achieved cost reduction.
Now, these are costs, if suppliers perform to the standard with respect to quality, delivery, and
service can be avoided. However, the performance of many suppliers may not meet the standard
expectations in all factors and hence, thorough analysis should be made on these factors rather
than focusing on the offered price level. These are then to be added to the quoted price to give
the overall picture of the cost from each supplier.

TOTAL COST RESULT

Supplier Price Price+ avoidable costs Service cost

W 94 94 + 94*-4 = 94+(3.8)=90.24 90.24=2nd

100
88.9= 1st
X 95 95+ 95*-6.4 =95+(-6.1)=88.9
100
99.6= 4th
Y 91 91 91*9.4 =91+8.6= 99.6
100
99= 3rd
Z 92 92 92*7.6 =92+7.0=99
100

Now, you can compare multiple factor and single factor comparisons. The award in the cost
ratio method goes in our case to supplier X. But, in the case of price factor evaluation it was

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supplier Y. As stated earlier, one factor evaluation of the suppliers does not give full picture of
each supplier.
MOTIVATION OF SUPPLIERS
The problems of supplier's motivation can be approached in two basic ways. First, buyers
attempt to secure satisfactory performance by persuading the supplier to want to perform
satisfactorily. Second, a buyer attempts to sewer satisfactory performance by regularly checking
the supplier's performance and rejecting unsatisfactory work. This discussion focuses on the
motivational approach. The following are the important ways to motivate the supplier:
Buyer-supplier relationship
Always the buyer should maintain smooth relationship with the supplier suppose any mistake on
the part of the supplier, then the buyer should inform the mistake to supplier and take the
remedial without affecting the future supply.
Prompt payment
The buyer should settle the account on time. If the buyer delaying the payment, it will affect the
future supply. Therefore, the buyer should settle the account on time to motivate the supplier for
better supply in future.
Equal treatment of all suppliers
The buyers should treat all the suppliers equally to motivate all suppliers. Buyers should treating
all suppliers fairly and impartially. The equal treatment means that the terms and condition
should be equal to all the suppliers.
Visiting the suppliers plants
The buyer should visit the suppliers' plants periodically. It will develop a more complete
understanding of the details of suppliers' operations materials to given quality levels. It will
motivate the supplier in all respect one supplier. Suppose the order size is less, then single and
multi source of supply having merits and demerits.
MAKE OR BUY DECISIONS
One of the important issues in materials management is the make-or-buy decision. More
recently, the term outsourcing has evolved to connote the buy side of the issue. When a firm
considers which components or subsystems it should make and which it should buy, it should
analyze the issue at two levels-strategic and operational or tactical. The strategic, obviously, is

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the more important of the two as far as the future of the firm is concerned. So this initial analysis
has a forward-looking, futuristic aura about it.
Factors Influencing Make-Or-Buy Decision
Two factors stand out above all others when considering the make-or-buy question at the
tactical level: cost and availability of production capacity. A good make-or-buy decision,
nevertheless, requires the evaluation of many less tangible factors, in addition to the two basic
factors. The following considerations influence firms to make or to buy the items used in their
finished products or their operations.
Considerations Which Favor Making
Cost considerations (less expensive to make the part)
Desire to integrate plant operations
Productive use of excess plant capacity to help absorb fixed overhead
Need to exert direct control over production and/or quality
Design secrecy required
Unreliable suppliers
Desire to maintain a stable work force (in periods of declining sales)
Consideration Which Favor Buying
Suppliers‟ research and specialized know-how
Cost considerations (less expensive to buy the part)
Small-volume requirements
Limited production facilities
Desire to maintain a stable work force (in periods of rising sales)
Desire to maintain a multiple-source policy
Indirect managerial control considerations
Procurement and inventory considerations
Cost Considerations
In some cases cost considerations indicate that a part should be made in house; in others, they
dictate that it should be purchased externally. Cost is obviously important, yet no other factor
is subject to more varied interpretation and to greater misunderstanding. A make-or buy cost
analysis involves a determination of the cost to make an item-and a comparison of this cost

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with the cost to buy it. The following checklist provides a summary of the major elements,
which should be included in a make-or-buy cost estimate.
To Make
Delivered purchased material costs
Direct labor costs
Any follow-on costs stemming from quality and related problems
Incremental inventory carrying costs
Incremental factory overhead costs
Incremental managerial costs
Incremental purchasing costs
Incremental costs of capital
To Buy
Purchase price of part
Transportation costs
Receiving and inspection costs
Incremental purchasing costs
Any follow-on costs related to quality or service
Factors be considered in Make-or-Buy Decision
Precautions in Developing Costs:
If a firm decides to buy a part that it has made in the past, it must exercise particular care in
interpreting the quotations it receives from potential suppliers. Some suppliers may prepare the
quotation carelessly, with the mistaken idea that the user does not really intend to buy the part.
Other suppliers may bid unrealistically low in an attempt to induce the user to discontinue
making the part in favor of buying it. Once the user has discontinued its “make” operation,
resumption of the operation in the future may be costly. Thus, the user may be at the mercy of
the supplier in case the supplier later chooses to increase the price. It is essential that the buyer
carefully evaluate the reliability of all quotations in his or her attempt to determine a realistic
estimate of the total cost to buy the part.
In estimating the cost to make a part, an analyst must ensure that the firm possesses adequate
equipment and technical know-how to do the job. Moreover, in an industry where technological
change occurs rapidly, a firm can find its equipment and know-how competitively outmoded in a

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few short years. Thus, the factor of obsolescence should also be given adequate consideration in
determining the ultimate costs of equipment and personnel training. The proper equipment to
make an item may sometimes be easier to acquire than the properly skilled manpower. Large-
volume requirements, complex skill requirements, or unique geographic locations can precipitate
shortages of adequately skilled manpower. In preparing cost-to-make estimates, the local
manpower situation must be evaluated. Should it be necessary to import adequately skilled
personnel? Total labor costs can substantially exceed initial estimates.
In the case of a “make” decision, it is equally important to investigate the availability and price
stability of required raw material. Large users of particular material generally find the
availability and price structure of these materials much more favorable than do small
unspecialized users. Wise analysts ensure that their estimates for raw material are realistic.
Finally, in estimating the cost to make a part for the first time, the analyst must also investigate
several practical production matters. The first deals with the cost of unacceptable production
work. What the expected rate is of rejected and spoiled part? Equally important, what learning
curve can the production department reasonably expect to apply? Answers to these questions
may vary substantially, depending upon the complexity of the job and the type of workers and
equipment available. The resulting influence on the make-buy cost comparison can be
considerable, however, and realistic answers should be sought.
The Capacity Factor: - When the cost to make a part is computed, the determination of
relevant overhead costs poses a difficult problem. The root of the problem lies in the user‟s
capacity utilization factor. As is true in most managerial cost analyses, the costs relevant to
a make-or-buy decision are the incremental costs. In this case, incremental costs are those
costs, which would not be incurred if the part were purchased outside. The overhead
problem centers on the fact that the incremental overhead costs vary from time to time,
depending on the extent to which production facilities are utilized by existing products.
Control of Production and Quality: -
Consider now some of the factors other than costs that influence make-or-buy decisions.
Two conditions weight heavily in some firms‟ decisions to make a particular part-control
of production and control of quality. The need for close control of production operations is
particularly acute in some firms. A company whose sales demand is subject to extreme
short-run fluctuations finds that its production department must operate on unusually tight

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time schedules. This kind of company often produces a small inventory of those parts used
in several different products. However, it produces to individual customer order the parts
unique to particular product or customer specification. Sales fluctuations for products
using unique parts therefore influence the planning and scheduling of numerous assembly
and subassembly operations, as well as single-part production operations. Efficient
conduct of assembly operations thus depends on the firm‟s ability to obtain the unique un-
stocked parts on short notice.
Most suppliers serving a number of customers cannot normally tool up and fit an order for
a unique part into existing schedules on a moment‟s notice unless it is operating under
some type of just in time (JIT) or partnering arrangement. If a user cannot tolerate
suppliers‟ lead-time requirements, its only other major alternative is to control the part
production itself. Thus, by making the item, the user acquires the needed control. It is
possible to quickly revise job priorities, reassign operators and machines to specific jobs,
and require overtime work as conditions demand.
Some firms also choose to make certain critical parts to assure continuity of supply of
these parts to succeeding production operations. This type of integration guards against
production shutdowns caused by supplier labor problems, local transportation strikes, and
miscellaneous supplier service problems. These are particularly important considerations
when dealing with parts that feed an automated production operation whose downtime is
tremendously expensive. If such action reduces the risk of a production stoppage, it may
well justify the incurrence of extra materials costs.
Quality Requirements: -
Unique quality requirements frequently represent a second condition requiring of part
production operations. Certain parts in technical products are occasionally quite
difficult to manufacture. Compounding this difficulty, at times, is an unusually exacting
quality specification the part must meet. In certain technological fields or in particular
geographical areas, a user may find that the uniqueness of the task results in
unsatisfactory performance by an outside supplier. Some companies find that their own
firm is in a better position to do an acceptable production job than external suppliers.
Small-Volume Requirements:-

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When a firm uses only a small quantity of a particular item, it usually decides to buy the
item. The typical firm strives to concentrate its production efforts in areas where it is
most efficient and in areas it finds most profitable. The work of designing, tooling,
planning, and setting up for the production of a new part is time-consuming and costly.
These fixed costs are recovered more easily from long production runs than from short
ones. More often than not, the Small-volume user consequently searches for a potential
supplier who specializes in production of the given part and can economically product it
in large quantities. Such specialty suppliers can sell to a large number of users in almost
any desired quantity at relatively low prices.
Small-volume production of unique, nonstandard parts may likewise be unattractive to
external suppliers. Every supplier is obligated to concentrate first on its high-volume,
high-profit accounts. Thus, cases may develop in which a user is virtually forced to
make a highly nonstandard part it uses in small quantities. Generally speaking,
however, as the part tends toward a more common and finally a standard configuration,
the tendency to buy increases proportionally.

Limited Facilities:-
Another reason for buying rather than making certain parts is the physical limitation
imposed by the user‟s production facilities. A firm with limited facilities typically
attempts to utilize them as fully as possible on its most profitable production work. It
then depends on external suppliers for the balance of its requirements. Thus, during
peak periods a firm may purchase a substantial portion of its total requirements because
of loaded production facilities, and during slack periods, as internal production capacity
opens up, its purchases may decrease markedly.
Work Force Stability:-
Closely related to the matter of facilities is the factor of work force stability. A
fluctuating production level compels a firm to face the continual problem of contracting
and expanding its work force to keep in step with production demands. Significant
continuing fluctuation, moreover, adversely affects the quality of workers such a firm is
able to employ. The less stable an operation, the more difficult it becomes to retain a
competent work force.

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At the time when a firm sizes the various segments of its production operation, many
make-buy decisions are made. One factor, which often bears heavily on the decision, is
the firm‟s desire to develop an interested, responsible group of workers with a high
degree of company loyalty. Awareness that stable employment facilitates the attainment
if this objective sometimes prompts a firm to undersize its production facility by a slight
margin. Its plan is to maintain as stable an internal production as possible and to buy
requirements in excess of its capacity from external suppliers. This policy is most
effective in firms whose products require a considerable amount of general –purpose
equipment in the manufacturing operation. Equipment, as well as personnel, that can
perform a variety of different jobs provides the internal flexibility required to
consolidate or split work among various production areas as business fluctuates. This
capability is necessary for the successful implementation of such a policy, because as
business increases, it is not feasible to place small orders for a large number of different
parts with outside suppliers. It is much more profitable to farm out large orders for a
small number of parts.
Managerial Control Considerations
Companies occasionally buy and make the same part for the purpose of developing
managerial control data. Some firms use outside suppliers‟ cost and quality performance as
a check on their own internal production efficiency. If an internal cost for a particular part
rise above a supplier‟s cost, the user knows that somewhere in its own production system
some element of cost is probably out of line. An investigation frequently uncovers one or
more problems, some of which often extend to other production areas. Consequent
improvements may therefore exhibit a compounding effect as they reach into other
operations where inefficiencies might otherwise have gone undetected.
Procurement and Inventory Considerations:
A “buy” decision produces several significant benefits in the management of purchasing
and inventory activities. For purchasing, such a decision typically means that it has
fewer items to buy and fewer suppliers to deal with. Usually, though not always, when a
component is made in-house a number of different materials or parts must be purchased
outside to support the “make” operation. A corresponding buy decision usually involves
only one or two suppliers and a relative reduction in the associated buying, paperwork,

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and follow-up activities. The same relative reduction in workload is passed on to the
receiving, inspection, stores, and inventory management groups. Typically, inventory
investment is also reduced. One of the goals of most purchasing departments today is to
achieve a reduction in the supplier base, simply to facilitate more effective purchasing
and supplier management.
Design Secrecy required: -
Although their number is small, a few firms make particular parts primarily because
they want to keep secret certain aspects of the part‟s design or manufacture. The secrecy
justification for making an item can be found in highly competitive industries where
style and cost play unusually important roles. Also, a firm is more likely to make a key
part for which patent protection does not provide effective protection against
commercial emulation.
If design secrecy is really important, however, a firm may have nearly as much
difficulty maintaining secrecy when it makes a part as it would when a supplier makes
it. In either case, a large number of individuals must be taken into the form‟s
confidence, and once information leaks to a competitor, very little can be done about it.
Nevertheless, a firm can usually control security measures more easily and directly in
its own plant. In either case, however, the element of trust is extremely important.
World-class firms work hard to create an atmosphere of trust surrounding both internal
and external activities.
Other Factors
Unreliable Suppliers:-
A few firms decide to make specific parts because their experience has shown that the
reliability record of available suppliers falls below the required level. The likelihood of
encountering such a situation thirty years ago was infinitely greater than it is today.
Competition in most industries today is so keen that grossly unreliable performers do not
survive the competitive struggle. With one major exception, unreliable delivery or
unpredictable service is confined largely to isolated cases in new, highly specialized lines
of business where competition has not yet become established. Such businesses are
usually characterized by low sales volumes, the requirement of highly specialized
production equipment, or the unique possession of new technological capabilities.

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The one major exception mentioned above is the case of the buyer who provides only an
insignificant fraction of a specific supplier‟s total volume of business. Even the most
reputable suppliers re forced at times to short-change very small accounts in order to give
proper attention to their major accounts. Regardless of the reasonableness of the cause,
however, consistently unreliable performance by a supplier is sufficient grounds for
shifting suppliers or possibly reconsidering the original make-buy decision.
Suppliers’ Specialized Knowledge and Research:
A primary reason underlying most decisions to buy a part than make it is the user‟s desire
to take advantage of the specialized abilities and research efforts of various suppliers. No
ordinary firm, regardless of size can hope to possess adequate facilities and technical
know-how to make a majority if its production part requirements efficiently. Large
Corporation spend millions of dollars on product and process each year. The fruits of this
research and the ensuing technical know-how are available to customers in the form of
highly developed and refined parts and component products. The firm that considers
forgoing these benefits in favor of making an item should, before making its final
decision, assesses carefully the long-range values that accrue from industrial
specialization.

The Time Factor: -

Costs can be computed on either a short-term or a long-term basis. Short-term
calculations tend to focus on direct measurable costs. As such, they frequently understate
tooling costs and overlook such indirect materials costs as those incurred in storage,
purchasing, inspection, and similar activities. Moreover, a short-term cost analysis fails to
consider the probable future changes in the relative costs of labor, materials,
transportation, and so on. It thus becomes clear that in comparing the costs to make and
to buy, the long-term view is the correct one. Cost figures must include all relevant costs,
direct and indirect, and they must reflect the effect of anticipated cost changes. Since it is
difficult to predict future cost levels, estimated average cost figures for the total time
period in question are generally used.

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PRACTICAL EXAMPLES ON MAKE-OR-BUY DECISIONS

Example 1:
1. XYZ Company has extra capacity that can be used to produce items the company has been
buying for birr 10 each. If XYZ makes the items, it will incur material costs of birr 3 per unit,
labor costs of birr 4 per unit, and variable overhead costs of birr 1 per unit. The annual fixed
cost associated with the unused capacity is birr 8,000. Demand over the next year is estimated
at 4,000 units.
(a) Would it be profitable for the company to make the items?
(b) Suppose the capacity could be used by another department for the production of some
sports equipment that would cover its fixed and variable costs and contribute birr 3,000 to
profit. Which would be more advantageous, item production or sport equipment production?

Solution
(a) In this part, we assume that the unused capacity has no alternative use.
Cost to make:
VC/unit = materials + labor + overhead
= 3 birr/unit + 4 birr/unit + 1birr/unit = 8 birr/unit
TVC = (4,000 units) (8 birr/unit) = 32,000 birr
Add: Fixed Cost +8,000 birr

Total costs to make 40,000 birr

Cost to buy:
Purchase cost = (4,000 unit) (10 birr/unit) = 40,000 birr
+8,000 birr
Total costs to buy 48,000 birr

Decision: Making the gears is advantageous because it can be done for 32,000 birr in variable
costs versus the 40,000 birr cost of purchasing the gears, the 40,000 birr total cost to make the
gears covers both fixed and variable cost, whereas the 40,000 birr purchase cost does not help
cover and fixed cost. Yet the fixed cost must be covered in this case the fix cost incurs
whatever the decision is.

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(b)
Make gears Purchase gears at 40,000 birr
& make sports equipment
TVC 32,000 birr 40,000 birr
FC 8,000 0
Total costs 40,000birr 40,000 birr
Less: Contribution to profit
Net relevant cost 0 3000___
40,000 birr 37,000birr

If the company makes the gears, the total cost is 40,000 birr, that is, TVC + FC. If it makes
the sports equipment, the relevant variable cost rises to 40,000 birr, which is the purchase
price of the gears. Because the sports equipment now covers the fixed cost, the total cost to
purchase remains at 40,000 birr. However, the profit contribution from the sports equipment
makes it advantageous to produce the sports equipment and buy the gears.
Example. 2:
Get-As Plc is in dilemma whether it has to produce an item or buy is from outside supplier at
cost of birr 10/unit. The management body is provided with the necessary information
concerning the decision by the production department engineering group. The cost making the
item is expected to be:
Labor cost-------------------- 4birr/unit
Material cost------------------5birr/unit
In addition there will be a fixed cost of birr 36,000 annually in acquisition of new machine for
this purpose. The estimated annual demand for the item in the next year is 24,000units.
Requirements:
Which decision will be profitable for the plc, making or buy?
Based on your decision on (a) above, what level of production the firm will be profitable?
Solutions
A. Cost of making the items
Labor cost………….. 4birr/unit

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Material cost…………5 birr/unit

Total Variable costs 9 birr /unit
Total cost equation for making:
Then, the total cost will be:

Y= 9Q+ 36000

Y=9(24,000) +36,000
= 216,000+36,000
=252,000 birr
Total cost of buying:
Y=10Q

Total cost= 10(24000) +36000

=240000+36000
= 276,000
Decision: Get-As plc Better to buy the item because the total cost of buying is less than the
total cost of making. (240,000<252,000)
B) In case of (a), we have already decided the firm should buy the item. So, at this condition
we should identify the point where total cost of making is equal to the total cost of buying
(Break-even point ) .
Total cost of Buying = Total cost of Making
10Q = 9Q+36,000
10Q-9Q = 36,000
Q = 36,000 units
As the co. produces 36,000 units of the item, it is indifferent; meaning the cost of making is
equal to the cost of buying at this stage. That is,
Cost of Making = 9Q+36,000
= 9(36,000) +36,000
= 324,000+36,000
=360,000 Birr

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If Get-As plc produces more than 36,000units ( point E) the decision is making the item
internally because at this stage of production the cost of making will becomes less than that
of the cost of buying .Let‟s see this condition graphically:

Cost
Break-even Point Buying

Making Making
E
360,000

Fixed Cost
Buying

24,000 36,000 40,000 Q

For example if Get-As plc produces 40,000 units annually, the total costs will be as follows.
Total cost of Making= 9Q+36,000
=9(40,000) +36,000
= 360,000 +36,000
= 396,0000birr
Total cost of Buying =10Q
=10(40,000)
=400,000 birr
VALUE ANALYSIS/ENGINEERING
Value analysis is defined as "an organized creative approach, which has, as its objective, the
efficient identification of unnecessary cost-cost which provides neither quality nor use nor life
nor appearance nor customer features"

Value analysis focuses engineering, manufacturing and purchasing attention to one objective-
equivalent performance at a lower cost. It is hence concerned with the costs added due to

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inefficient or unnecessary specifications and features. It makes its contribution in the last stage of
product cycle, namely, maturity stage. At this stage, Research and Development no longer make
positive contributions in terms of improving the efficiency of the functions to it. The other extra
costs shown in the following
Exhibit that of overheads
Total cost of product including Minimum that must be
spent on product

Work added by unnecessary design and Value analysis zone…….

Specification features

Work added by inefficient methods of Methods used study zone

Manufacturing
Overhead because men/machines are idle Production control zone

Product Life-circle

Sales Growth
R&D

Time

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and work added by inefficient methods are tackled during the growth stage. As the sales of
product pick up, the problem of overhead is automatically eliminated. The work methods
improve as a process of learning from repetitive manufacture of the product. At the same time
the industrial engineering team comes up with a lot of improvements in the working methods.
All along we have been taking of value analysis. It would be worthwhile to define value and
hence get another definition for value analysis. This would probably provide better insight.
Value is a broad term often used to denote cost and price. However, we would go a step further
and introduce the concept of function as well into the definition of value. Value can then be
divided into the following classifications:
Use of functional value:
The properties and qualities, which accomplish a use, work or service.
Esteem value
The properties, features or attractiveness which causes us to own it.
Cost Value
The sum of labor, material and various other costs required producing it
Exchange value
Its properties or qualities, which enable us to exchange it for something else we want.

Based on these classifications, value is defined as "the minimum money, which has to be
expended in purchasing or manufacturing a product to create the appropriate use or esteem
factor."

Value = Function
Cost

Value Engineering /pre production purchase analysis

Value analysis techniques find the unnecessary costs out of existing products. A growing number
of applications are emerging, however, in companies that are concerned primarily with
engineering unnecessary costs out of new products during the planning and engineering design
stages. This later application is sometimes called pre production purchase analysis or value
engineering.

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Value engineering utilizes all the techniques of value analysis. In practice, it involves very close
liaison work among the purchasing, production, and design engineering departments. This liaison
is most frequently accomplished through the use of various purchasing and production
coordinators who spend considerable time in the engineering department studying and analyzing
engineering drawings as they come off the drafting boards. Once coordinators locate problem
areas, value analysis techniques are employed to alleviate them."
GLOBAL PURCHASING
Global purchasing is an essential economic function, which cannot be completely eliminated.
Richardo's principle of comparative advantage states that it would be beneficial for an economy
to concentrate on the production of items in which it specialists export these items and import its
requirement of other items. Important to industries, which depend on imports for their
production.
Potential Difficulties in International Buying

Reduced tariffs, trade agreements, and the formulation of free trade regions, such as the common
market in Europe, have resulted in worldwide competition and reduced prices for many
materials. A brief overview of some of the more difficult foreign buying situations follows.

Communication
This usually the greatest difficulty in international purchasing. Not only must the buyer and
seller be able to communicate clearly in a common language, but and the customs of the foreign
country in which he or she is buying.
Financial, legal and Related Issues
Potential difficulties in these categories, to cite some of the more important ones, arise from
factors such as export-import license requirements, currency differences, no tariff barriers, laws
and ethics, exchange restraints, documentation requirements, payment terms, government
controls, and transportation facilities.
Quality
The principal difficulties in quality focus three dominant factors:
A scarcity of international standards

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The fact that the united states is the only major manufacturing nation that has not yet adopted the
metric system of weight and measurements, and
The real possibility that foreign products entail greater obsolescence risks and longer corrective
cycles for design changes than do U.S. products.
Lead Times
The buyer should maintain more inventory if the lead-time is long. In International Buying, the
lead-time is very longer than local purchases. Therefore, the buyer should maintain more
quantity of inventory, if the buyer goes for International Buying.
Selecting foreign suppliers
Selecting the foreign suppliers is very difficult process in the International Buying. The buyer
cannot ascertain easily about suppliers' capacity, economic conditions, and attitudes to wards
continuous supply.
Initial foreign purchases
Initially, the buyers are facing so many problems for foreign purchases. It includes the selection
of supplier, transport arrangement, communication problems, documentation etc.,
Stages of International purchasing
In case the important clearance is obtained or the items are not banned for imports, a company
has to go through the following stages to accomplish the purchase:
Getting the Import License
The first step of International purchasing is to getting the Import license from the government. If
the item is not banned for imports, then the buyer need not get the license or approval from the
governments.
Locating the foreign source of supply
This has to be done contacting the ministry of Trade, Foreign consultants, and Embassies etc., A
foreign consultant or embassy has a commercial attaché who is well versed the list of suppliers in
his country.
Finalizing the terms purchase
Then the buyer should discuss with the supplier regarding all the terms and conditions of the
purchase. It include the price, credit period, discount rate, mode of payment, transport cost and
other details.
Preparation of Documentation

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There are so many document should be arranged by the buyer and seller for foreign purchase.
The following are the important document for foreign purchase
Bill of lading
Invoices
Certificate of origin
Weight certificates
Insurance policy
Letter of credit
Marking of packages
Procurement of the Item
It is the final stage of the foreign purchase. It is the process of getting the material by buyer.
Based on the terms and condition, the buyer should claim the material form the concerned
transports.

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CHAPTER FOUR
4.1. INVENTORY MANAGEMENT
INTRODUCTION
Inventories are one of the major assets of most firms, ranging from perhaps 25 percent to 75
percent of their current assets, depending upon the firm and the type of industry. Along with
plant and equipment, inventories often constitute the bulk of the asset value of an organization.
The individual responsible for the management of these assets is usually the operations manager.
Inventory management has been the key to the success of many firms and the cause of failure of
numerous others. Insufficient inventories hamper production and fail to generate adequate sales,
whereas excessive inventories adversely affect the firm‟s cash flows and liquidity position. From
either perspective, poor inventory management can present a serious challenge to the viability of
an organization and can have a disastrous effect on its solvency.
No one can any longer rely on intuitive methods of establishing order quantities and setting
inventory stock levels. The competitive business world and responsible public administrators
will simply not permit this. Someone must intelligently set policies, establish guidelines for
inventory levels, and ensure that appropriate control systems are functioning properly. The
amount of inventory required (demand) and the delivery time (lead time) are two of the major
uncertainties associated with inventory management, and so we will go into some depth in
studying how to cope with these uncertainties.
4.2 DEFINITION AND PURPOSE OF INVENTORY
An inventory is an idle resource that possesses economic value. Inventories are usually in the
form of raw materials, semi finished goods used in the production process, or finished ready for
delivery to consumers. We typically associate them with manufacturing and distribution
activities. Unused labor or capital is also an idle resource, and in this sense it is essentially an
inventory, although we do not normally refer to it as such. Service industries are often unable to
inventory their final products, although they must manage their raw materials and supplies
inventories just as any other organization. An airline company, for example, may have the
seating capacity to provide a transportation service but lack the demand necessary to create the
end product (final inventory) of a transportation service.
Adequate inventories facilitate production activities and help to assure customers of good
service. On the other hand, carrying inventories ties up working capital on goods that is idle-not

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earning any return on investment. The major problem of inventory management thus consists of
trying to achieve an optimal balance between the advantages of having inventories (or the losses
that may be expected from not having adequate inventories) and the costs of carrying them.
The total supply of resources controlled by organization is limited, so the level of inventories of
any specific resource will necessarily affect levels of other resources. Thus, if inventories are
necessary to provide a certain level of service, they should be managed from a systems
perspective taking the total organizational objectives and policies into account.
PURPOSE OF INVENTORIES
Inventories serve a multitude of purposes, including the following:
1. They aid continuous production by ensuring that inputs are always available and that
economic production runs can be made.
2. They facilitate intermittent production of several products on the same facilities (even
though demand may be relatively constant for each product).
3. They decouple successive stages in processing a product so that downtime in one stage
does not stop the entire process.
4. They help level production activities, stabilize employment, and improve labor relations
by storing human and machine effort.
5. They provide a means of hedging against future price and delivery uncertainties, such as
strikes, price increases, and inflation.
6. They provide a means of obtaining and handling materials in economic lot sizes and
gaining quantity discounts.
7. They help service customer with varying demands and in various locations because an
adequate supply is maintained to meet their immediate and seasonal needs.
The inventory issue is viewed through the eyes of various operating department managers
differently. The marketing manager tends to favor larger inventory stocks to assure rapid
assembly and delivery of a wide range of finished product models. This capability obviously
can be used as an effective sales tool. The production manger is inclined to go along with the
marketing manager, but for quite a different reason. He or she argues for higher inventory
levels because they allow more flexibility in daily planning; unforeseen problems in producing
a given component can be mitigated if productive efforts can easily be transferred to another
component for which the required raw materials are on hand. Likewise, a reasonable inventory

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of the required items ensures against production shutdowns due to delivery problems, supplier
problems, and stock-outs, thus avoiding the incurrence of high production downtime costs.
The financial officers of the firm, on the other hand, argue convincingly in favor of low
inventory levels. They point out that the company‟s need for funds usually exceeds availability
and that reduced inventories free some of the needed working capital for other uses. They note
also that total indirect inventory carrying costs drop proportionately with the inventory level.
The purchasing and supply manager is the final participant; he or she is concerned with the size
and frequency of individual orders. Purchasing often favors a policy of placing fewer and larger
orders. Unless contractual arrangements with routine delivery-release systems can be worked
out with suppliers, fewer and larger orders usually increase the total inventory level. At the
same time, however, they tend to minimize operating problems with suppliers, and in some
cases they may reduce unit material prices. Large-volume buying also permits more efficient
utilization of buying personnel and more effective advance planning for major activities such as
market studies, supplier investigations, and so on. Thus, it is clear that departmental executive
supports his or her position with legitimate justification.
This shows that concepts and techniques useful in analyzing the inventory issue in order to
arrive at sound policy decisions so as to minimize inventory costs of an organization are then
necessary.
CLASSIFICATION OF INVENTORIES
Although inventories are classified in many ways, the following classification is convenient:
Production inventories:- Raw materials, parts, and components which enter the firm‟s product
in the production process. These may consist of two general types: (1) special items
manufactured to company specifications and (2) standard industrial items purchased “off the
shelf”.
MRO inventories: - Maintenance, repair, and operation supplies which are consumed in the
production process which do not become part of the product (e.g., lubricating oil, soap,
machine repair parts).
In-process inventories: - Semi-finished products found at various
of the production operation.
Finished goods inventories: - Completed products ready for shipment.
Inventory Model Building

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Because of their indispensable functions, inventories have been considered as important to an

organization as blood is to the human body. Furthermore, the sizable investment in
inventories, most apparent in manufacturing activities, warrants particular care in their
planning and control.
Definition: In operations management, inventory refers to any scarce resource that remains
idle in anticipation of satisfying a future demand for it.
In the above sense, the term covers not only materials in various stages of processing one is
likely to see in a factory but all the human and non human resources maintained but not
currently used by an organization in order to meet anticipated demand for its product(s) or
service(s). See the table below showing types of inventories maintained by various
organizations.
System Inventories
Factory Raw materials, parts, semi-finished goods, Finished goods.
Commercial bank Cash reserves, Tellers
Hospital Number of beds, specialized personnel, stocks of drugs, and etc.
Airline company Aircraft seat, miles per route, parts for engine repairs, mechanics, and etc.

The above table gives kinds of inventories held by various organizations. Because the output of
service organizations cannot be stored for later use, the concept of inventory for them is
associated with various forms of productive capacity. In a given period the available inventory
of a resource is reduced in the process of satisfying actual demand. Therefore, it becomes
necessary to replenish it in order to continue to cover new demand in subsequent time periods.
The Inventory Problem
An operation system‟s performance of firms is affected directly by the size of inventories held.
There is generally a penalty associated with having either too much inventory or too little.
Consider the situation of a TV manufacturer who has overestimated demand and is now stuck
with numerous unsold sets in the warehouse. This undesirable surplus represents capital tied up
that could be invested more profitably elsewhere. In addition, there is reason for concern with
other costs related to storage, insurance, depreciation, taxes, etc. Similar situations may be
faced by a commercial bank that has overstated its demand withdrawals and is keeping
excessive cash reserves or by an airline that flies its planes on a certain route half empty. The

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penalties from holding too much inventory may be serious enough to undermine an
organization‟s financial health.
This, however, describes only one side of the coin. If the above situations were reserved and
instead of overestimating demand management had underestimated it, there would be equally
serious penalties for failure to maintain adequate inventory. The TV manufacturer in our
example would be forgoing all the profits that would be possible from the lost sales and might
lose much of his good will for not supplying his wholesalers adequately. Similarly, the bank
without adequate cash reserves would have to secure funds at an increased cost to avoid
embarrassment, and an airline without a sufficient number of seats on a given route would lose
favor with the public because it is unable to satisfy actual demand for travel. The overall
conclusion here is that there must be a happy medium with regard to inventory levels.
The Inventory problem involves the formulation of decision rules that answer two important
questions:
1. When is it necessary to place an order (or set up for production) to replenish inventory?
2. How much is to be ordered (or produced) for each replenishment? The decision rules must
aim at satisfying anticipated demand at minimum cost or maximum profit.
The Need for Maintaining Inventory
The existence of inventories at successive stages of the production process serves a number of
important purposes. In general, through inventories we attempt to achieve a smooth and
economical operation of the production-distribution system. The following are some of the
functions served:
1. Pipeline (or transit) inventories: - When the producer is geographically removed from
suppliers and consumers, it takes time to supply the amounts ordered at different points
of the production distribution network. So, to satisfy demand without disruption, it is
necessary to hold extra stock at various points to handle demand while replenishments
are in transit from the preceding stage. These quantities are known as pipeline or transit
inventories. Their amounts depend on the time required for transportation and the rate
of use.
2. Economic Order Quantities: - An inventory is used up to cover actual demand and
there is a need for replenishment, it is important to decide on how much to order at a

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time. It is desirable to order in quantities that will balance the costs of holding too much
stock against that of ordering in small quantities too frequently.
3. Safety (or buffer) stocks: - In the real world there may be random departures from
what management expects in the level of demand, the production rate, the
replenishment time, or other factors. To protect against such reasonable but nevertheless
random, i.e., uncontrollable, occurrences it is necessary to maintain additional inventory
beyond what is needed for normal requirements. Such extra quantities are known as
Safety or buffer stocks because they provide a buffer, or a safety margin, against the
unpredictability‟s of the external environment.
4. Decoupling Inventories: - If two successive production stages operate so that when the
first breaks down, the second remains idle for the lack of material to work on, the
existing degree of dependence is both costly and disruptive for the entire system. It is
often possible to make the stages more independent by providing for in-process
inventory between them. Under this arrangement, even if the first stage fails, the second
can continue to function for some time, and this is possible for other stages that may
follow. Decoupling inventories are those used to reduce the interdependence of various
stages of the production system. Thus, raw materials are used to decouple the producer
from the supplier(s), in-process inventories to decouple successive production stages,
and finished goods to decouple the consumer from the producer.
5. Seasonal Inventories: - Demand for many products or services displays significant
seasonal fluctuations (agricultural products, fashion items, etc). If an adjustment in the
production rate were necessary each time demand changed, the result might be very
poor capacity utilization. Assuming that the item (s) are not perishable, one can produce
more than demanded in slack periods to build up inventories that can be used when
demand peaks and exceeds available capacity. These stocks are known as seasonal
inventories and help smooth out undesirable fluctuations in the production rate.
4.3. INDEPENDENT AND DEPENDENT DEMAND
If inventories are to achieve the purposes listed earlier, someone must decide how much to order
and when an inventory is required. Those decisions are the responsibility of the inventory or
production control manager, and we shall examine them both in this section. The “how much”
question is largely a function of costs, and our inquiry here will extend to the concept of an

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economic order quantity. The “when to order” question is a function of the firm‟s forecast or
scheduled requirements. If the item is a finished product and has a finished product and has a
demand that is “independent” of the demand for other items, an order point (or reorder point)
technique can help to answer the question. On the other hand, most items brought into inventory
in manufacturing firms are components or subassemblies of finished products. Their demand is
“dependent” upon the finished-product demand, and although the finished-product demand may
be uncertain, the requirements for components visa-vies other components are fixed by design.
There is no need to consider each component as an entity with independent demand
characteristics- in fact; it is better not do so.
4.4. COSTS ASSOCLATED WITH INVENTORIES (INVENTORY COSTS)
The problem of balancing the costs of less than adequate inventories versus the costs of more
than adequate inventories is a complex one due to the numerous and sometimes intangible costs
that are relevant. Inadequate inventories can result into costs due to production delays and
inefficiencies as well as the shortage costs of lost orders or even lost customers. More than
adequate inventories result in excessive expenditures to hold the inventories. The major costs
associated with procuring and holding inventories are classified as:
1. Ordering and setup costs:- ordering costs include the costs of negotiating purchases
and placing orders as well as the costs of expediting delivery, inspecting the shipment
and moving into storage. Set up costs arise because firms often use the same equipment
to produce different products and each change may require a different set up. Set up
costs include those for the set up labor and idle facilities during set up. Both ordering
and set up costs have a fixed component so the cost per unit decreases as larger
quantities are ordered or produced for inventory.
2. Carrying and holding costs: - these costs include: interest on invested capital, handling
and storage costs, insurance and taxes on the inventory held in the store, costs for
obsolescence and spoilage and etc. We can briefly examine the main carrying cost
components as follows:
1. Opportunity cost of investment funds:- when a firm purchases certain
amount birr worth of a production material and keeps it in inventory, it
simply has this much less cash to spend for other purposes. Since money
invested in productive equipment or in external securities earns a return for

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the organization, conceptually it is logical for the organization to charge all

money invested in inventory an amount equal to that it could earn if
invested in something else.
2. Insurance costs: - most organizations insure their assets against possible
loss from fire and other forms of damage.
3. Property taxes: - property taxes are levied on the assessed value of a
firm‟s assets, and the greater the inventory value, the greater the asset value,
and hence, the higher is the firm‟s tax bill.
4. Storage costs: - The cost conceptually can be charged against inventory
occupying the space
5. Obsolescence and deterioration: - a certain percentage of inventory items
will be: spoiled, damaged, pilfered, or eventually becomes obsolete. The
larger the inventory, the greater is the level of loss from this source.
Carrying material in inventory is so expensive. A number of studies determined that the
annual cost of carrying a production inventory averaged approximately 25 percent of
the value of the inventory. If a firm has estimated its approximate inventory carrying
cost, as percentage of inventory value, the annual inventory carrying costs that would be
generated by delivery quantities of various sizes can be calculated as follows:
(Carrying cost per year) = (average inventory value) x (material unit cost) x
Q
(Inventory carrying cost as a % of inventory value) or C C  (C)( I)
2
Where: CC = Carrying cost per year for the material in question
Q = Order or delivery quantity for the material, in units
C = Delivered unit cost of the material
I = Inventory carrying cost for the material, expressed as a percentage of
inventory value
If a firm‟s cost accounting department can estimate its approximate acquisition cost per order,
the annual ordering costs that would be generated by order quantities of various size can be
calculated as follows:

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(Ordering cost per year) = (number of orders placed per year) x (Ordering cost per order)
D
or C o  x Co
Q
Where: Co = acquisition (ordering) cost per year for the material in question
D = expected annual usage (demand) of the material in units
Q = order or delivery quantity for the material, in units
Co= acquisition cost per order or per delivery for the material
3. Purchase cost:- this cost consists of the actual price paid for the item or the labor,
material and overhead charges necessary to produce it.
Generally, the aforementioned group of carrying costs rises and falls nearly proportionally
with the rise and fall of the inventory level. The inventory level is directly related to the
quantity in which materials are ordered. Hence, costs of carrying inventory vary directly with
the size of the order quantity.
Looking at the inventory costs in another angle, a different set of indirect material cost factors
emerge. These factors all contribute to the cost of generating and processing an order and its
related paper work. These costs are called inventory acquisition costs or ordering costs and
include:
 A certain portion of wages and operating expenses of such departments as: purchasing,
production control, receiving, inspection, stores and etc.
 The cost of supplies; such as forms for: Production control, receiving, envelopes,
stationery and etc.
 The cost of services such as: telephone, telegraph and postage expended in procuring
materials.
4.5. ECONOMIC ORDER QUANTITIES
An optimal inventory policy is one that would provide adequate inventory levels when needed at
the minimum total cost of ordering, carrying, and purchasing.
TOTAL COSTS AND THE EOQ EQUATION
The total cost (TC) of stocking inventory is the sum of the cost of ordering, plus the cost of
carrying, plus the purchase cost. If we let D = demand in units on an annual basis, C o = cost to
prepare or set up for an order, Cc = cost to carry a unit in stock for a given time period, P =

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Q
purchase cost, Q = lot size, and = average inventory, then the relationship can be expressed
2
mathematically as follows:
Total cost  ordering cost  carrying cost  Purchase cost
D Q
TC  Co( )  Cc ( )  PD
Q 2
Differentiating with respect to the order quantity, Q yields the slope of the TC curve. The TC
equation can be differentiated by standard calculus methods, where the differential of
dY dTC 2 CcQ 0
Y  X is:
n
 nX n 1 ,  CoDQ  0
dX dQ 2
Setting this first derivative equal to zero identifies the point where the TC is a minimum.

Co D Cc D o 2C o D
0  0  Q  EOQ 
Q2 2 Cc

This equation is known as the economic order quantity (EOQ) or economic lot size (ELS)
equation. It is used to determine the order quantity that will satisfy estimated demand at the
lowest total cost. Note that although the purchase price, p, is an important component of total
cost, the term drops out upon differentiating. Thus, so long as the purchase price does not vary
with the quantity ordered, it should not directly affect the decision as to what is the most
economical lot size to purchase. The figure below describes the relationship between the relevant
ordering and carrying cost. Not also that total -cost curve is relatively flat in the area of the EOQ,
so small changes in the amount ordered do not have a significant effect on total costs.

EOQ Economic Order Quantity (EOQ)

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Once the economic order quantity, Q, has been determined, the minimum inventory cost can be
computed by substituting this Q value into the total-cost equation. The number of orders per year
D units /yr D
required is: Orders / yr  
Q units / order Q
Example1: Overland Motors uses 25,000 gear assemblies each year and purchases them at birr
3.40 each. It costs birr 50 to process and receive an order, and inventory can be carried at a cost
of birr 0.78 per unit-year.
(a) How many assemblies should be ordered at a time?
(b) How many orders per year should be placed?
Solution
2C D 25025,000
a. EOQ =   1,790 assemblies per each order
Cc 0.78

D 25,000
b. Orders/yr =   14 orders per year
Q 1,790
Carrying costs are sometimes denoted as an annual percentage (%) of the purchase price, p. If so,
Cc = (%) (p) and is still expressed in birr per unit-year. The time unit used (for example, year)
can vary, but both D and Cc must be in the same time units.
If one has to make decisions about managing an inventory, it is useful to understand the
behavior of the inventory-related cost factors just discussed. These factors often help a manager
determine which items should or should not be carried in inventory, what inventory levels
should be carried for specific items, and what order quantities are appropriate for given items.
The notion of an economic order quantity (EOQ) is that the appropriate quantity to order may
be the one that tends to minimize all the costs associated with the order quantity: carrying costs,
acquisition costs, and the cost of the material itself.
The above figure shows clearly that as the order or delivery quantity increases, carrying costs
rise-and at the same time acquisition costs decrease. To see the total picture more clearly, if
carrying costs and acquisition costs are added together over the order quantity range shown on
the graph, the total incremental cost (carrying costs and ordering costs) curve, TIC, is produced.
The economic order quantity concept simply says that the sum of all the indirect costs
associated with inventory will be minimized on an annual basis if the material, for which the
graph is drawn, is ordered (or delivered) consistently in the quantity that corresponds with the

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low point on the TIC curve. This level of quantity is called the economic order quantity. Note
that the low point on the total incremental cost curve coincides with the point at which the
carrying cost curve intersects the acquisition (ordering) cost curve. This makes it easy to
develop the formula that can always be used to calculate a material‟s basic EOQ. EOQ answers
the question of how much should be ordered by an organization. Given the carrying costs
and ordering costs, and the estimated annual demand, we can develop the EOQ formula.
ASSUMPTIONS OF THE ECONOMIC ORDER QUANTITY MODEL
The EOQ equation is a convenient and widely used expression for determining optimal order
quantities when the actual cost components and purchase conditions happen to coincide which
the variable of the EOQ model. Order tables and monographs have also been developed that
offer a quick and even simpler means of determining the EOQ without necessitating calculations.
However, it is well to keep in mind that in a manufacturing operation, obtaining an order at the
right time (scheduling) is usually far more crucial than obtaining the exact order quantity. The
enthusiastic and sometimes blind acceptance of the EOQ model has tended to obscure this fact in
the past. Aside from the real-world problems of constantly changing requirements, expediting
partial shipments, splitting lots, and so on, there are several assumptions underlying the basic
EOQ model. Four of them are listed below.
1. Demand and lead time are known and constant.
2. Replenishment is instantaneous at the expiration of the lead time.
3. Purchase costs do not vary with the quantity ordered.
4. Ordering and carrying-cost expressions include all relevant costs (and these costs are
constant).
Example2. Assume that XYZ enterprise buys and uses 24,000 units annually. Ordering cost
is estimated to be 70 birr per each order and carrying cost is estimated to be 1.5 birr per unit
per year. What should be the level of optimum order size?. Each unit of the items cost 3 birr
per unit.
a) Optimum order size is the level of quantity at which both ordering and carrying costs
are going to be equal. The quantity level is the EOQ level. Hence, optimum order
2C o D
size or EOQ level will be calculated as follows: EOQ 
CI

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2(24,000 units)(70 birr) 3,360,000

EOQ  = = 2,240,000
1.5 1.5
EOQ = 1,496.66 units.

This means that if XYZ enterprise orders 1,496.66 units at a time, its inventory costs will be
the least. Note that the annual demand for the units (items) is 24,000 units. Hence, XYZ
should order so many times to fulfill the demand.

b)What is the number of orders? Or how many times shall XYZ buy 1,496.66 units?
24,000 units
Number of orders = Demand/EOQ= = 16 times.
1,496.66 units
XYZ‟s purchasing department should buy in a year 1,496.66 units 16 times to fulfill the
required demand of 24,000 units (16*1,496.66).

We can also determine the estimated total incremental inventory as well as total inventory
costs
c) Total incremental inventory costs can be calculated as follows:

i) TIC= 2COCcD = 2(70)(1.5)(24,000) = 5,040,000 = 2,245 birr or

ii) TIC= Ordering cost + Carrying cost
TIC= 16(70 birr) + (1,496.66/2) (1.5 birr)
= 1,120 birr + 1122.5 birr= 2,243 birr.
The difference is due to the rounding errors. Also note that at EOQ level, ordering and
carrying costs are always equal.

d)Total cost can be determined by adding total purchase cost to the TIC.
TC= TIC + Pc (D)
TC= 2,245 birr + 3 birr (24,000) = 2,245 birr + 72,000 birr= 74,245 birr.

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REORDER POINTS
we have examined the cost factors in inventory control and the economic order quantity
approach as applied to the problem of determining how much to order. The question of how
much to order is one of the two basic questions in inventory management; the other question is
that of when to order. This question must be answered for many types of raw materials,
purchased parts, and operating supplies; it also must be answered when items are requisitioned
for production within the plant. One method which provides an answer to this question utilizes
the maximum-minimum system for the determination of reorder points. To use this method, the
inventory control manager must determine four things:
(1) What the maximum level of inventory carried will be,
(2) What the minimum level of inventory, or safety stock, will be
(3) How long the supply of inventory between the maximum and minimum stock will last
(4) How long it takes to get an order filled and delivered.
The determination of the maximum inventory must be made after considering the costs of
carrying inventories, the financial position of the firm, the market for the supplies in question,
and several other factors. The determination of the minimum or safety stock is based on
expectations of how much should be kept in inventory in case a new order does not arrive then
expected or the usage rate of supplies is greater than expected. The determination of how long
supplies will last can be made by examining past records and computing usage rates. The lead-
time for filling an order includes the time it takes to make the purchase requisition and the
purchase order, to send it to the supplier, to get the order filled, to ship the supplies to the buyer,
and put in inventory.
An example of a reorder point problem will clarify the method. Assume that the four items of
information required are:
Maximum inventory level = 700 units
Minimum inventory level = 100 units
Time the supply will last = 30 days
Lead time for a new order = 10 days

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A diagram of the problem appears as follows:

Quantity
Maximum 700-
-
500- Re-order
Quantity

Re-order
Point 300

Minimum 100
! ! ! ! ! ! ! ! ! ! ! !
0 5 10 15 20 30 35 40 45 50 55 60 Days

The first thing, which must be determined, is the usage rate. Since the maximum is 700 units and
the minimum is 100 units, 600 units will be used: this is also known as the cycle stack. From past
records, it is found that 600 units last 30days. Thus, the usage arte is 20 units per day (600
units/30 days)
Since it takes ten days of lead-time to get a new supply, an order must be placed early enough so
that the new supply arrives by the time the inventory level reaches the minimum. Since the usage
rate is 20 units per day and the lead-time is ten days, we should have 200 units available to use
while the order is being filled (20 units per day x 10 days). To find the reorder point, we add this
amount to the safety level. For the problem in this example, the reorder point in units equals 300.
In terms of days, the order should be placed on the twentieth day after a new supply is put into
inventory.
An equation for the reorder point problem is:
Reorder point = (U X L) +S
Where U=the usage rate.
L = the lead time
S = the safety level or minimum inventory
In the problem used as an example, the equation would be

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Reorder point = (20 units/day) (10 days) + 100 units = 300 units
ORDER QUANTITY WITHOUT THE ASSUMPTIONS
1. QUANTITY DISCOUNTS
Manufacturers often provide a price discount for buyers who purchase in large volume. A firm
should take advantage of these quantity discounts to the point where the incremental increase in
their annual carrying costs will just equal the saving in purchase cost. The assignment of a
different purchase price, depending on the quantity purchased, now makes the price a function of
lot quantity, Q, with the result that the total-cost function becomes discontinuous.
A mathematical expression for the optimal order quantity in a discount situation can be derived
on the basis of minimizing total costs. However, the mathematics of this approach is
unnecessary, for the technique of (1) determining the EOQ on the basis of the non discounted
base price and (2) comparing the total cost at this EOQ point with that for price breakpoints at
higher volumes usually provides a most practical and expedient solution to problem. If the
calculated EOQ happens to fall in a quantity discount range, it means that one of the quantity
discount amounts offers a lower total cost than the no discounted amount. The EOQ should then
be recalculated using the quantity discount price, and the same check should be made again.
Firms purchasing in large quantities tie up more capital and incur a greater risk of having an
obsolete inventory. However, they may benefit from lower prices, and may avoid later price
increase- especially if inflation rates are high. Some firms use blanket purchase order to obtain
lower price without releasing funds until materials are needed. Quantity discount decisions can
usually benefit from purchasing experience and a practical knowledge of the supply-demand
environment.
Example: Kodak and Sony PLC produce photographic equipment and buys lenses from a
supplier at birr100 each. The product requires 125 lenses per year, and the ordering cost is birr
125 per order. Carrying costs per unit-year (based on average inventory) are estimated to be birr
20 each. The supplier offers a 6 percent discount for purchases of 50 lenses and an 8 percent
discount for purchases of 100 or more lenses at one time. What is the most economical amount to
order at a time?
Solution
Disregarding quantity discounts, the EOQ amount would be:

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2c0 D 218125
EOQ    15 lenses per order
Cc 20

And the total annual cost associated with this EOQ is:
TC  ordering  carrying  purchase
 C o  C c  D P 
D Q
Q 2
 125   15 
 18   20   125100  Br.12,800
 15  2
For a 50-unit order, the purchase cost is reduced by 6 percent of Br.100, or Br.6. Assuming that
the ordering and carrying costs remain constant, the total annual cost associated with a 50-unit
order is:
 125   50 
TC  18   20   125100  6  Br.12,295
 50   2
Similarly, the total annual cost associated with a 100-unit order is:
 125   100 
TC  18   20   125(100  8)  Br.12,522
 100   2 
The 50-unit lot results in the lowest total annual cost. Although the purchase price per unit is less
with the 100-unit order, the carrying costs begin to outweigh such savings. The costs and
direction of change up   or down   are shown below.
Order quantity Ordering cost Carrying cost Purchase cost Total cost
15 unit order Br.150 Br. 150 Br.12,500 Br.12,800
50-unit order 45 500 11,750 12,295
100-unit order 22 1,000 11,500 12,522

In the above example we assumed that carrying costs remained the same after the discount was
applied. Since the discount reduces the amount of invested capital (that is, with the 6 percent
discount the purchase price per unit is only Br.94 instead of Br.100), carrying cost per unit
(Br.20 in this case) will most likely be reduced by some small but proportionate amount. This
correction should be accounted for if it is significant.

Price Breaks: Price breaks are prices discounts which are associated with different quantity
ranges.

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Example: Assume that yearly demand of items for XYZ company is 10, 000 units. The
ordering cost is birr 20 per order and carrying cost is 20% of the unit price. A supplier offered
the following price break discounts:
Quantity options Unit price in Br.
0-499 units Br. 5
500-999 4.5
1000 and above 3.9

How much shall the firm order?

Solution:
i) First calculate the EOQ level with each price break; because carrying cost is in percentage of
unit price.

2COD 2(20)(10,000)
EOQ1= = 633 units
CC 0.2(5)
This EOQ is not feasible because with 633 units‟ level we can get 4.5 birr discount.

2COD 2(20)(10,000)
EOQ2= = 666 units
CC 0.2(4.5)
EOQ2 is feasible. But, we should know its total cost.
D EOQ 2
Tc 2  CO  CC  PD
EOQ 2 2
10,000 666
Tc 2  20  0 .2 * 4 . 5  4.5(10,000) = Br.45, 599.7
666 2

2COD 2(20)(10,000)
EOQ3= = 716 units.
CC 0.2(3.9)
716 units are not feasible because at this level, the supplier will not offer 3.9 per unit price
reduction.
D EOQ 2
Total cost of purchasing 1,000 units will be: TC1000  CO  CC  PD
EOQ 2 2
10,000 1000
Tc1000  20  0.2 * 3.9  3.9(10,000)
1000 2
Tc1000  Br.200  390  39, ,000 = Br.39, 590

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Decision will be order exactly 1,000 units at 3.9 birr per unit since this level reduces total
inventory cost.
4.6. ECONOMIC PRODUCTION QUANTITY (EPQ)
When a firm is producing its own inventory rather than purchasing it, the same theory can be
applied to minimize total inventory costs. However, the order costs are replaced by
manufacturing setup costs. (Setup costs are of a fixed nature, like order costs. They represent the
one-time for machine adjustments, paper work, scheduling efforts, and the like, to begin
production of a different item.) The EOQ equation must also be modified to account for the fact
that it takes time to produce items and only a portion of the production goes into inventory. The
other portion is used concurrently in the production process or is sold as produced. The
production rate, p, is of course, no instantaneous and must be greater than or equal to the demand
rate, d.
Figure below illustrates the difference between the instantaneous and no instantaneous supply
situations. With the basic EOQ, all goods go into inventory when received (instantaneously) and
are withdrawn, or used, at a demand rate of d units per period. Carrying costs apply to whole
EOQ amount.

Production rate =p Amount used %used during

Demand rare=d during production production

EPQ
EOQ Demand rate=d

Time Time

Supply begins Supply Supply ends

And ends begins
Instantaneous supply No instantaneous supply

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The modification to the EOQ equation for non instantaneous supply does not affect Co, which
now becomes the setup cost, or the total demand, D, but only acts to reduce the carrying cost, Cc,
by deleting the carrying charge on that portion of the production run that does not go into
inventory. If d= demand per day and p= production per day, the ration d/p represents the
proportion of production that is allocated to daily demand, and 1- (d/p) represents that proportion
of the production run that goes into inventory. For example, if d= 75 units per day and p= 100
units per day, then d/p =75/100; 75 percent is allocated to daily demand, and 1 -0.75 or 25
percent, goes into inventory.
If we take into account the decreased carrying cost of this reduced level of inventory, the
economic run length (ERL) in number of units to produce per production setup is:
2C o D
ERL , EPQ 
C c 1  d / p 

Where Co= setup cost in Br./setup

D= annual demand in units /yr
Cc= carrying costs in Br. Per unit per year
d= demand rate, for example, units/day
p= production rate, for example, units/day

Example1: A small company manufactures an electronic device used for aircraft navigation
systems. The demand is based on contracted orders for aircraft and is known and uniform at the
rate of 6,400 units annually. A voltmeter used for this device can be produced internally at the
rate of 128 units per day. There are 250 working days for production each year. The setup cost
for each production run is Br.24, and inventory holding cost is Br.3 per unit per year. It is desired
to develop an inventory policy for this item. The optimal size of each production run will be

2c R D 2246,400
Qo  
C H 1  d / p  31  6,400 / 128250
 128,000  358 units / productionrun

The replenishment cycle time for voltmeters is

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t0
Qo 358
 0.056 yr  .056250  14working days
D 6,400

Qo 358
The production time required for each run will be t p  
P 32,000
t p  .011yr 250 days / yr   2.8 days

The maximum inventory level will be I max   p  Dt p

I max   p  Dt p  32,000  6,400.011  282 units

 D
The minimum incremental inventory costs will be TIC o  2c H 1  C R D
 p

 D  6,400 
TIC o  2c H 1  C R D  231  246,400
 p  32,000 

TIC o  737,280  Br.858.65 / yr

4.7. Materials Requirement Planning (MRP) System

The preceding inventory management systems are designed for items with independent demand.
These are end items, i.e., finished products, whose demand is estimated by some forecasting
technique. Independent demand reflects the marketer‟s response to a firm‟s final output. For
some organizations a finished product is assemble from several parts and subassemblies. Other
products are made by mixing or blending several ingredients. Given a production plan for such
an end item, the requirements for parts can be determined exactly. Demand for a finished product
is generally uncertain. Its estimation often involves a statistical forecasting approach. The
demand for components and parts, however, can be calculated with certainty consequently,
safety stocks are not required as they would be for the finished product. In short, demand for
components needed to produce a finished product is dependent, i.e., derived from the technology
used within the organization. This realization has led to an alternative approach for managing
inventories for dependent demand items known as material-requirements planning (MRP).
MRP, which can be viewed as a bridge between inventory management and production
scheduling.

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Wider spread use of computer based planning and control systems has greatly increased
management„s ability to analyze and manipulate large volume of data to produce more timely
and accurate information for decision making purposes. This data handling revolution has led
to the development of production and/or planning system. It is known as materials requirements
planning (MRP). The MRP concept provides a very basic and different way of looking at the
management of production inventories.
Materials requirement planning challenges the traditional concept that any significant level of
production inventory needed be carried prior to the time materials are actually required by the
production operation. Once a firm‟s master production schedule has been established and
product bills of materials have been finalized, it is possible to calculate precisely these
production material needs for a given period of operation.
Where a firm is concerned with the production of many products by batch production, and if
each product contains many components and materials requirement planning can be
considerable. The advent of computers for doing such tasks has, however, enabled this method
to be more widely used than otherwise would have been the case.
Purposes, Objectives, and Philosophy of MRP: The main purposes of an MRP system are to
control inventory levels, assign operating priorities to items, and plan capacity to load the
production system. These may be briefly expanded as follows:
Inventory:
 Order the right part.
 Order the right quantity.
 Order at the right time.
Priorities:
 Order with the right due date.
 Keep the due date valid.
Capacity:
 Plan for a complete load.
 Plan an accurate load.
 Plan for an adequate time to view future load.

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The theme of MRP is “getting the right materials to the right place at the right time.” The
objectives of inventory management under an MRP system are to improve customer service,
minimize inventory investment, and maximize production operating efficiency.
The philosophy of MRP is that materials should be expedited (hurried) when their lack would
delay the overall production schedule and de-expedited (delayed) when the schedule falls behind
and postpones their need. Traditionally, and perhaps still typically, when an order is behind
schedule, significant effort is spent trying to get it back on schedule. However, the opposite is
not always true; when an order, for whatever reason, has its completion date delayed the
appropriate adjustments are not made in the schedule. This will result in a one-sided effort-late
orders are expedited, but early orders are not de-expedited or delayed. Aside from perhaps using
scarce capacity, it is preferable not to have raw materials and work in process before they are
actually needed, because inventories tie up capital, clutter up stockrooms, delay the introduction
of design changes, and prevent the cancellation or delay of existing orders.
Benefits of an MRP System: Manufacturing companies with more than $10 million in annual
sales are most likely to have some form of a computerized MRP system. A computerized system
is necessary because of the sheer volume of materials, supplies, and components that are part of
expanding product lines, and the speed that firms need to react to constant changes in the system.
When firms switched from existing manual or computerized systems to an MRP system, they
realized many benefits, including:
 More competitive pricing.
 Lower selling price
 Lower inventory levels.
 Improved customer services.
 Faster response to market demands.
 Increased flexibility to change the master schedule.
 Reduced setup and tear-down costs.
 Reduced idle time.
In addition, the MRP system:
 Gives advanced notice so managers can see the planned schedule before the
orders are actually released.
 Tells when to de-expedite as well as expedite.

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 Delays or chancels orders.

 Changes order quantities.
 Advances or delays order due dates.
 Aids capacity planning.
In converting to an MRP system, many firms claimed as much as 40 percent reductions in
inventory investment.
Where MRP Can Be Used
MRP is being used in a variety of industries with a job-shop environment (meaning that a
number of products are made in batches using the same production equipment). Another factor
that affects the degree of benefit gained from an MRP system is the number of levels in the
product. The greater the number of levels, the greater will be the benefit of MRP. This is
especially true for companies producing complex expensive products requiring advanced
research and design. Under such circumstances, experience has shown that lead times tend to be
too long and too uncertain, and the product features that network scheduling techniques offer,
and thus would be better off using project scheduling methods.
MRP INPUTS
There are three basic MRP inputs:
B. The whole system is driven by the requirements forecast by time period (master
production schedule) which details how many end items are to be produced during a
specified time period. Master production schedule is a statement of which end item are to
be produced the quantity of each and dates they are to be completed.
C. The structured bill of material, the BOM
Uses information from the engineering and/or process records to detail the
subcomponents necessary to manufacture a finished item
American Production and Inventory Control Society (APICS) defined as” a listing of all
the assembles, intermediaries parts and raw materials that go into making the parent
assembly, showing the quantities of each required to make an assembly.
D. Inventory record,
It contains information such as open orders; Lead times and lot size policy, So that the
quantity and timing of orders can be calculated.

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Example: Assume that a firm wants to produce product A. Product A consists of 2 units of part
B, and three units of Part C. Part B consists of 1 unit of Part D and 4 units of Part E. Each Part C
consists of two units of Part F, five units of Part G and 4 units of Part H. The product structure
tree for Product A can be shown as follows:

B (2) C (3)

D(
D (1) E (4)
F (2) G (5) H (4)

Product Structure Tree for Product A

Example 2: Suppose that we want to produce product T, which consists of two parts U, three
parts V, and one part Y. Part U, in turn, is made of one part W and two parts X. Part V is made
of two parts W and two parts Y. (we want to produce 100 units of Product T in period 8)
Product Structure Tree for Product T (Bill of Materials) File:

U (2) V (3)

W (1) X (2) W (2) Y (2) Y (1)

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Inventory Records File

Assume that the lead times to make the parts and their respective on-hand inventories and
scheduled receipts are as follows:
Lead On-Hand Scheduled
Part Time (weeks) Inventory Receipts*
T 1 25 -
U 2 5 5
V 2 15 -
W 3 30 -
X 2 20 -
Y 1 10 -
* Subassemblies or parts that have been previously ordered but are not scheduled for
delivery until a future date (week three for subassembly U in this example).
Running the MRP Program
If we know when Product T is required, we can create a time schedule chart specifying when all
the material necessary to build T must be ordered and received to meet this requirement. Using a
lot-for-lot ordering policy, table 4.1 shows which items are needed and when. We thus have
created a materials requirements plan based on the demand for Product T and the knowledge of
how T is made, current inventories on hand, and the time needed to obtain each part.

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Part No. T 1 2 3 4 5 6 7 8 9
Gross requirements 100
Scheduled receipts
On-hand inventory: 25 25
Net requirements 75
Planned order releases 75

Part No. U 1 2 3 4 5 6 7 8 9
Gross requirements 150
Scheduled receipts 5 5
On-hand inventory: 5 5
Net requirements 140
Planned order releases 140

Part No. V 1 2 3 4 5 6 7 8 9
Gross requirements 225
Scheduled receipts
On-hand inventory: 15 15
Net requirements 210
Planned order releases 210

Part No. W 1 2 3 4 5 6 7 8 9
Gross requirements 560
Scheduled receipts
On-hand inventory: 30 30
Net requirements 530
Planned order releases 530

Part No. X 1 2 3 4 5 6 7 8 9
Gross requirements 280
Scheduled receipts
On-hand inventory: 20 20
Net requirements 260
Planned order releases 260

Part No. Y 1 2 3 4 5 6 7 8 9
Gross requirements 420 75
Scheduled receipts
On-hand inventory: 10 10
Net requirements 410 75
Planned order releases 410 75

Table 4.1 shows MRP for completing 100 units of Product T in period 8.

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4.8. ABC ANALYSIS OF INVENTORY ITEMS

ABC Analysis is a basic analytical management tool which enables top management to place
the effort where the results will greatest. This technique, popularly known as: Always Better
Control or the alphabetical approach has universal applications in many area of human
endeavor. The technique tries to analyze the distribution of any characteristic by money value
of importance in order to determine its priority. In material management, this technique has
been applied in areas needing selective control, such as inventory, criticality of items,
obsolete stocks, purchasing orders, receipt of materials, inspection, store-keeping, and
verification of bills.
The annual consumption analysis of any organization would indicate that a handful of top
high value items which are about 10-20 per cent of the total in number-will account for about
70 to 80 per cent of the total consumption value, and these few vital items are called „A‟ items
which need careful attention of the materials manager. B items which account 30 to 40
percent in number account only 15 to 20 percent in value. Similarly, a large number of
„bottom‟ items- about 40 to 50 per cent of the total number called the trivial many-account
only for about 5 to 10per cent of the consumption value, and are known as the „C‟ class.
ABC analysis helps the materials manager to exercise selective control and focus his attention
only on a few items when he is confronted with many of stores items. By concentrating on
„A‟ class items, the materials manger is able to control inventories and show „visible‟ results
in short span o f time. By controlling the „A‟ items, and doing a proper inventory analysis,
obsolete stocks are automatically pinpointed. Many organizations have claimed that ABC
analysis has helped in reducing the clerical costs and resulted in better planning and improved
inventory turnover. ABC analysis has to be resorted to because equal attention to „A‟, „B‟ and
„C‟ items will not be worthwhile and would be very expensive. Concentrating on all the items
is likely to have a diffused effect on all the items, irrespective of the priorities.
PURPOSE OF ABC ANALYSIS
The object of carrying out ABC analysis is to develop policy guidelines for selective control.
Normally, once ABC analysis has been done, the following broad policy guidelines can be
established in respect of each category:
„A‟ items merit a tightly controlled inventory system with constant attention by the purchase

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and stores management. A large effort per item on only a few items can cost only moderately,
but the effort can result in large savings. „B‟ items merit a formalized inventory system with
periodic attention by the purchase and stores management. „C‟ items use a simpler system
designed to cause the least trouble for the purchase and stores department, perhaps even at the
cost of a little extra inventory cost.
OBJECTIVE OF ABC ANALYIS:
ABC analysis enables the materials manager to exercise selective control when he is
confronted with a large number of items. Tighter and accurate procedures are essential for „A‟
value items relating to materials planning, forecasts, ordering, review, records, postings,
revisions, lead time analysis, safety stock, materials consumption control, purchase budget,
delivery schedule, value analysis, follow-up, clerical efforts, physical stock verification,
receipts, issues, store accounting and inspecting. The degree of control should be rigorous for
„A‟ items and should be minimum for „C‟ items.
MECHANICS OF ABC ANALYSIS
The mechanics of classifying the items into „A‟, „B‟ and „C‟ categories described in the
following steps:
1. Calculate birr annual issues for each item in inventory by multiplying the unit cost by the
number of units issued in a year. It is assumed that the issues and consumption are the
same.
2. Sort all items by birr annual issues in descending sequence.
3. Prepare a list from these ranked items showing item no., unit cost, annual units issued and
annual birr value of units issued.
4. Starting at the top of the list, compute a running total, item-by-item issue value and the
birr consumption value.
5. Compute and print for each item the cumulative percentages for the item count and
cumulative annual issue value.
6. The normal items in most organizations show the following pattern
Example:
The maintenance department for a small manufacturing firm has responsibility for maintaining
an inventory of spare parts for the machinery it services. The parts inventory, unit cost and
annual usage are as follows.

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Part Unit cost Annual usage

1 $60 90
2 350 40
3 30 130
4 80 60
5 30 100
6 20 180
7 10 170
8 320 50
9 510 60
10 20 120

The department manager wants to classify the inventory parts according to the ABC system to
determine which stocks of parts should most closely be monitored
Solution
First rank the items according to their total value and also compute each items percentage of
total value and quantity,
% of total % of total
Part Total value value quantity % cumulative
9 $30,600 35.9 6.0 6.0
8 16,000 18.7 5.0 11.0
2 14,000 16.4 4.0 15.0
1 5,400 6.3 9.0 24.0
4 4,800 5.6 6.0 30.0
3 3,900 4.6 13.0 43.0
6 3,600 4.2 18.0 61.0
5 3,000 3.5 10.0 71.0
10 2,400 2.8 12.0 83.0
7 1,700 2.0 17.0 100
$85,000

Based on simple observation, the ABC classifications are;

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Class Items % of total value % of total quantity

A 9,8,2 71.0 15.0
B 1,4,3 16.5 28.0
C 6,5,10,7 12.5 57.0

4.9. Just-in- Time (JIT)

Many successful organizations use a radically different philosophy popularly and descriptively
termed just-in-time (JIT). JIT production means that components and raw materials arrive at a
work center exactly as they are needed. This feature greatly reduces queues of work-in-process
inventory. The goals of JIT production are similar to those of MRP–providing the right part at
the right place at the right time; but the ways of achieving these goals are radically different and
the results impressive. Whereas MRP is computer based, JIT is industrial engineering based.
There are many JIT features that are good practice in any operation, public or private,
manufacturing or non-manufacturing.
In JIT, product design begins with two key questions- will it sell, and can it be made easily?
These questions imply cooperation between marketing and operations. Once these questions
have been answered positively, attention turns to design of the process itself. The emphasis is on
laying out the machines so that production will follow a smooth flow. Automation (often simple)
of both production and materials handling is incorporated wherever possible. Frequently, U-
shaped lines are used which facilitate teamwork worker flexibility, rework, passage through the
plant, and material and tool handling. In process design, designers strive to standardize cycle
times and to run a constant product mix, based on the monthly production plan, through the
system.
This practice makes the production process repetitive for at least a month. For example, a
manufacturer of three products (or models) A, B, and C of equal cycle time and monthly
demands of 1,000, 2,000, and 500, respectively might have a production schedule of BABABCB
or BBBBAAC repeated 500 times in the month.
The ability to smooth production, as in the above example, implies very low setup and order
costs to allow the very small lot sizes, ideally one. JIT treats setup and order costs as variable
rather than as the fixed ones implied by the EOQ equation. By continuously seeking ways to
reduce setup times, the Japanese were the first to have managed impressive gains. Setups, which

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traditionally required three to four hours, have been reduced to less than 15 minutes in some JIT
facilities. These dramatic improvements have been achieved by managerial attention to detail on
the shop floor, the development and modification of special jigs, fixtures, tools, and machines
and thorough methods training. Setup simplification is aided by their willingness to modify
purchased machines, their acquisition of machines from only a few sources, and their frequent
manufacture of machines in-house-often special purpose, light, simple, and inexpensive enough
to becomes dedicated part of the process. Order costs, conceptually similar to costs, have
similarly been reduced.
One of the necessary corollaries of having components and materials arrive just as they are
needed is that the arriving items must be perfect. In JIT a number of interrelated principles are
used to ensure high-quality output from each step in the production process.
First, responsibility for quality rests with the maker of a part, not with the quality control
department. In addition, workers and managers habitually seek improvement of the status quo,
striving for perfection. Quality improvements are often obtained from special projects with
defined goals, measures of achievement, and endings. Also, workers are responsible for
correcting their own errors, doing rework, and so on. Second, the use of production workers
instead of quality control inspectors builds quality in rather than inspecting it in. This feature and
the small lot sizes allow every process to be controlled closely and permit inspection of every
piece of output. Workers have authority to stop the production line when quality problems arise.
This aspect signifies that quality is a more important goal of the production system than is
output. Third, JIT insists on compliance to quality standards. Purchasers reject marginally
unacceptable items and visit supplier plants to check quality on the shop floor for themselves.
Because such visits are frequent, JIT manufacturers document their quality in easily understood
terms and post the results in prominent places. This process forces the manufacturer to define
precisely what quality is.
JIT control of quality is helped by the small lot sizes that prevent the buildup of large lots of bad
items. JIT tends to have excess production capacity so that the plants are not stressed to produce
the required quantities. In the same vein, machines are maintained and checked regularly and run
no faster than the recommended rates. Plant housekeeping is generally good. The quality control
department acts as a quality facilitator for production personnel and suppliers, giving advice in
problem solving. This department also does some testing but the tests tend to be on in final

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products not easily assignable to a single production worker, or special tests requiring special
equipment, facilities, knowledge, or long times not available to personnel on the shop floor.
Automatic checking devices are used wherever possible. Where necessary, sample lots are
chosen to consist of the first and last units produced rather than a larger, random sample.
Analytical tools include the standard statistical techniques; often known by workers, and cause-
and-effect diagrams to help solve problems.
JIT requires great dedication by both workers and managers to hard work and helping the
organization. By Western standards, JIT workers must be flexible. They are trained to do several
different jobs and are moved around frequently seek ways to improve all facets of operations,
and are rewarded for finding problems which can then be solved. The JIT plant has a high
proportion of the line workers that add value in the production process and correspondingly
fewer staff personnel. The environment is much like many quality-of-work-life programs-
consensus decision making involves and commits everyone.
Sequential JIT is a term applied to production systems where each operation is part of the
sequence and where the withdrawal of product by the subsequent operations signals the need to
start the operation. This is the typical “pull system.” In sum, JIT is a mixture of high-quality
working environment, excellent industrial engineering practice, and a healthy focused factory
attitude that operations are strategically important. The order and discipline are achieved through
management effort to develop streamlined plant configurations that remove variability. The JIT
system has often been described as one that pulls material through the factory rather than
pushing it through.

JIT Implications for Materials Management

There are a number of implications of JIT for supply management. One of the obvious includes
the necessity to deal with suppliers of high and consistent quality and with reliable delivery. This
implies that concentrating purchases with fewer nearby suppliers may be necessary. The frequent
delivery of small orders may require a rethinking of the inbound transportation mode. For
example, it is normal to have a trucker follow a standard route daily to pick up, from 6 to 20
different suppliers, small lots in a specially designed side-loading vehicle. Having delivery
arranged directly to the place of use eliminates double handling. Special moving tracks designed

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for proper protection, ease of counting, insertion, and cooperation is required to assist in the
design and operation of an effective JIT system.
In the minimum sense, JIT can refer to arranging for delivery just before a requirement is
needed. In this context JIT has wide applicability beyond manufacturing, in public, service, and
other non-manufacturing organizations. Reliability of delivery reduces the need for buffer or
safety stock, with the benefits that arise out of such inventory reduction.
Research has shown that a full-blown JIT-based operating system has 11 achievable dimensions:
1. setup time reduction,
2. Small lot production,
3. small-lot transportation,
4. Multi-process handling through automation,
5. zero defect quality control,
6. Equipment maintenance,
7. Leveling (and mixing) of production,
8. Withdrawal by subsequent processes,
9. In-house modification and production of equipment
10. JIT supply arrangements, and
11. Employee involvement in continuous improvement.
In JIT there is a close cooperation between supplier and purchaser to solve problems, and
suppliers and customers have stable, long-term relationships. In keeping with the JIT philosophy,
suppliers, usually few in number, are often located close to their customers to facilitate
communication, on time delivery of small lots of parts, low pipeline and safety stocks, and low
purchasing costs. The situation in many JIT companies is much like extensive backward vertical
integration. The organizations avoid formal ownership ties but achieve many of the same ends by
close coordination and systems integration that smooth operations. The job of a purchaser in the
JIT environment is one of a facilitator, negotiator, communicator, and developer rather than of an
expediter.
Research into communication links between purchaser and supplier in a JIT environment
considered written exchanges, computer-to-computer hookups, telephone exchanges, and one-
on-one and group meetings. Findings showed more information was supplied to JIT suppliers
than to others. Also, manufacturers believed open and reliable communications lead to improved

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quality, while similar suppliers‟ communications lead to improved cost and delivery
performance.

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CHAPTER 5
STORAGE
5.1 STORAGE FUNCTION & RESPONSIBILITIES
Materials form a very high percentage of the cost of production of a product. It is, therefore,
necessary to have a close watch on the proper use of the materials. The best method of
maintaining materials properly is store keeping. It is a service function in a manufacturing
concern, which deals with the physical storage of goods under the custodian of a well trained and
experienced person termed as "storekeeper" or "store controller". Un worked or raw materials are
usually known as stores and the place where such materials are kept in stores
DEFINITION OF STORE KEEPING
Alford and Beatty defined, as "storekeeping is that aspect of materials control which is
concerned with the physical storage of goods. H.B. Maynard defined as "the responsibilities of
storekeeping management are "to receive materials, to protect them in storage from damage or
unauthorized removal, to issue the materials in the right quantities at the right time to the right
place and provide these services promptly and at least cost".
Storekeeping should be given a due place in the organization otherwise the miss handling of
goods, wastage in storing and handling will add to the cost of production. The properly
recognized by the manufacturing 80 far. Many organizations spend lavishly on machines and
wages are housed in cramped quarters, ill-equipped and ill-ventilated storekeepers are also ill-
paid in comparison to others in responsible for wrong or short issue, loss of stock of raw
materials, unexpectedly running out of stock and preparation of incorrect vouchers all these leads
to production. In the light of the above explanation, storekeeping can be described as the keeping
of materials in stores in a systematic and scientific way.
OBJECTIVES OF STOREKEEPING
From the above discussion, it is clear that the main objectives of storekeeping are to receive, to
store and to issue the raw materials or goods at the minimum cost. In brief, the objectives of
storekeeping are:
1) Receiving handling and issuing goods economically and efficiently.
2) Using the storage available space and labour effectively.
3) Protection of all goods in stores against all losses, fire, theft and obsolescence

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4) Facilitating inventory taking from time to time by the internal audit department or the
management.
5) Mini missing the investment in Inventories.
6) Maintaining regular supply of raw materials at all times when properly authorized.
7) Facilitating ordering of required materials
FUNCTIONS OF STOREKEEPING
In order to achieve the above objectives the stores department or the storekeeper must perform
the following function:
1) To collect materials from vendors against orders placed and from manufacturing
departments at the end of a particular job or activity.
2) To verify the goods received from vendors by the orders forms and to report of return the
goods to them if they are not up to the mark as per order placed.
3) Storing all materials in a safe and in a convenient manner so that it may be immediately
available as and when required.
4) To use the storing space to the maximum of its capacity with the minimum of labor.
5) To ensure cleanliness and tidiness in the store.
6) To issue materials against requisition slips to the manufacturing department.
7) To maintain all records of receipts, issues and balances in hard.
8) To provide maximum store keeping services to the manufacturing and sales departments
at a minimum cost.
9) To cooperate closely with the buying officer, planning officer, production manager for
planning effectively for Inventory control.
10) To carry out physical store taking and to check it with the bin cards and stores ledger.
11) To inform the purchase department from time to time about the materials required in the
store.
5.2. LOCATION & LAYOUT
More often than not, in the matter of locating the stores, materials management is rarely
consulted. The normal practice is to locate the stores near the consuming departments. This
minimizes handling and ensures timely despath. In stores layout, the governing criteria are easy
movement of materials, good housekeeping, sufficient space for men and materials handling
equipments, optimum vitalization of storage space, judicious use of storage equipments, such as

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shelves, racks, pallets and proper preservation from rain, light and such elements. These
problems are more important in the case of items that have limited shelf life other important
factors governing the location are the number of end users and their location, the volume and
variety of goods to be handled, the location of the central receiving section and accessibility to
modes of transportation such as rail or road.
Since stores have to be nearest to the user, large organizations usually have stores attached to
each consuming department whereas receiving is done centrally. Items of common usage are
stocked in the control stores so that inventory is kept at an optimum level. These factors are
considered at the planning level of layout.
In case of warehouses stocking finished goods, factors as proximity to parts, railway lines,
quality of roads, availability of power, etc., become quite important. It is also important that the
stores are constructed with a futuristic orientation, so that sufficient flexibility for expansion
needs is goods, stocking in appropriate locations, material handling and issues must be done
swiftly and economically. The stores building must have adequate facilities for preservation of
stores. Sometimes facilities, such as cold storage, heating equipments, air conditioning and
similar facilities may be required. These should be planned in advance. Comfortable working
conditions must be provided to the stores personnel to get maximum efficiency and morale while
layout the store-room, the following points should be borne in mind and be given due attention:
1) Minimum handling and transportation of materials.
2) A straight line flow with adequate dimensions of gangways.
3) Efficient use of space vertically and horizontally.
4) Minimum handling travel and waste motions of the personnel.
5) Safety-fire hazards, insurance and nearness to the point of use.
6) Provision for flexibility for future expansion of activities.
7) Proper illumination and ventilation.
A good storeroom layout yields the following advantage:
a) A high degree of flexibility of arrangement can be obtained.
b) Efficient utilization of space horizontally and vertically is possible.
c) Physical counting of materials is easy. It facilitates stocktaking and proper
inspection and check of materials.
d) Good accessibility of major materials, permitting efficient service to users.

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e) The materials rarely required may be located easily and quickly.

f) Minimization of materials deterioration and pilferage is possible because a shoes
watch can be had.
g) Reduced need for materials handling.
h) Reduced proper work and records keeping but a better control over stock can be
maintained
5.3. STORES SYSTEM & PROCEDURES
The real function of storekeeping starts only after the materials are received in stores. A store is a
place where materials can be kept scientifically and safely. It is obvious that materials should be
kept in stores where they will be safe against deterioration and pilferage. They should be kept in
a manner that they can be quick delivered to the other departments as and when it is
requisitioned. The following are some of the important points to be noted in this connection.
In large factories several storerooms may be provided. They may be located in different plants or
at several places in the same plant or at different places for different places for different
commodities. In such cases where a number of storerooms are maintained, separate storekeeper
is appointed as a in charge of individual storerooms and they report for their activities to the
general or head storekeeper. The head storekeeper is usually appointed to control and coordinate
the storekeeping activities properly of all the storerooms. The number of storerooms depends
upon the size and the importance of the materials and the nature of materials. The activities
generally undertaken by the stores department are as follows:
a) Receiving in coming materials from the receiving section or vendors.
b) Classification of goods.
c) Identification of materials.
d) Placing the goods at appropriate place
e) Storing
f) Maintaining stores records and accounts.
g) Issuing materials.
Two basic systems can be used in physically controlling stores materials:
1) A closed stores system.
2) An open stores system.

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The application of each depends on the nature and requirements of a specific production
operation. As a general rule, most firms use one system for certain materials and the second
system for others.
1) Closed system
All the materials are physically stored in a closed or controlled area. Wherever possible, the
general practice is to storage physical control by locking the storage area. As a rule, no one other
than stores personnel is permitted in the stores area. Material enters and leaves the area only with
the accompaniment of an authorizing document.
2) Open system
It represents the second major type of stores system. Its widest use is in highly repetitive, mass
production types of operations that exhibit a continuous and predictable demand for the same
materials. Most JIT manufacturing systems exemplify this situation.
STORES PROCEDURE
The procedure generally adopted by the stores for performing the activities is as follows.
The clerk or the storekeeper, the in charge of the storeroom, receives the materials along with the
goods receives note from the receiving section. The materials are then classified according to the
nature of the material. The classified goods marks. Several numbers, codes or colors may be used
for this purpose. After proper identification, the material should be arranged in bin especially
meant for the materials. A bin card is attached with bin or rack displaying the identification mark
or code, minimum and ordering maximum and ordering levels of materials and receipts, issues
and balance of materials in hand so that the exact position may be known at any time whenever
desired. Lastly, the materials are issued on the instance of dispatching section.
5.4. STOCK RECEIPT, ISSUE AND DISPATCH
Storekeeping is a very important activity in a manufacturing concern. The storekeeper performs
several functions and bears all liabilities as to receiving storing and issuing of materials. The
internal organization of the stores largely depends upon the size of the business, the storing
problems in an organization does not have several function divisions of stores and storekeeper
has to perform all activities of receiving the materials. However, a large firm usually has many
function diversions of the stores namely receiving section, stores section, Accounting section and
Issuing and dispatching section. A brief description of these may be given below:

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1) Receiving section
In large firms, a separate section is assigned the task of receiving the materials from the vendors
or from the production departments. Their duties are as follows:
a) Receiving the materials, making them unpacked and recording the receipts in
"Goods Received Book".
b) Checking or companying the goods with the order placed by the purchasing
department.
c) If there is any discrepancy, it should be immediately reported to the purchasing
department so that the necessary steps may be taken for the return of goods by the
department.
d) In order to satisfy itself with the quality of goods received, the services of
engineers or chemist etc. may be obtained and getting the quality of materials
checked. In large firms, testing laboratory may be maintained for the purpose or
inspecting staff may be appointed for inspection.
e) Once the goods are thought fit for acceptance, receiving section will prepare a
"Goods Received Note". Four copies of this note are prepared and three copies
are sent to the storekeeper along with the goods received, storekeeper then sends
two copies of it to the account department and concerned department of which
materials required after having one copy with them. The accounts section makes
the entries in the stores ledger.
Receiving section also receives the finished goods from the production department and issues the
acknowledgment receipts and intimates the sales department about the latest consignment of
stock received.
2) Issuing and dispatching section
The issue section undertakes the responsibility of issuing the materials to the using departments.
In order to prevent malpractices, the materials must be issued only against the properly
authorized requisition slips. These requisitions must be properly checked and scrutinized to
avoid over issue of materials. All requisitions received must be posted immediately or daily on
the bin cards and on the stock control cards. The finished goods are also dispatching from this
section based on the advice from yhe sales department. It should be properly recorded in terms of
scientific manner for the purpose of knowing exact quantity of inventory at any times.

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5.5. STORES ACCOUNTING & STOCK VERIFICATIONS

5.5.1. Stores accounting
In relation to the estimation of the product for pricing decisions, stores accounting assumes a key
role. Material costing is very important in terms of the valuation of the cost of materials
consumed by the production department as well as in terms of the estimation of the value of
materials held in stock. We will discuss the materials costing under classification of receipt of
materials, issue of materials, and of the stocks held at the end of the accounting period. We will
see the various methods used in costing.
1) First-in-First Method (FIFO)
Under this system, it is assumed that the materials first received are to be issued first. Thus units
issued are priced at the oldest cost price listed on the store-ledger sheets. It does not, however,
mean that the materials received first are physically issued on first in first out basis but an
endeavour is made to issue the materials first which run the risk of obsolescence. As soon as the
oldest lot is exhausted in records, the price of the next oldest lot is charged and this practice goes
on.
Merits
a) It is most suitable when the prices are falling.
b) Simple to understand and easy to operate
c) It is correctly as curtained for cost of job or work-order
d) Closing stock of raw materials are valued at recently purchased price.
e) It is logically correct because it takes into account the normal procedure of
utilizing the oldest materials in stock.
Demerits
a) Possibility of clerical errors in ascertaining the prices.
b) The comparison of two jobs be comes more difficult because the price may be
different for different jobs.
c) It is not suitable when the prices are rising.
2) Last-in-first-out Method (LIFO)
It is just reverse of the FIFO method as it assumes that the materials most recently received are to
be issued first and the jobs and work orders are charged out the jobs and work orders are charged
out on that basis. Thus, in this method the price of the last consignment is used for pricing

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materials issues until it is exhausted, then the next consignment pricing is used and so on through
succession consignments.

Merits
a) It is most suitable when the prices are rising
b) It recovers current prices of materials and possibility of as curtaining the job or
work order accurately.
c) Current costs are correlated with current sales and management gets a accurate
picture of profit or loss.
Demerits
a) It is possible for clerical error.
b) Comparison of jobs becomes difficult.
c) Closing stock is not valued in recent price of purchase.
d) It is not suitable when the prices are falling.

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Average cost method

The principle underlying the average cost method is that the identity of materials of different lots
is lost as soon as they are received in store and therefore, it is not then proper to charge the
production at a purchase price of a particular lot. The correct approach to this problem may be
the average cost method at which the issues of materials should be priced. Average may be of
two types:
a) Simple average price
b) Weighted average price
a) Simple average price method
Under this method, the price is calculated by dividing the total of units purchase price of
different lots of materials in stock by the number of prices used in the calculation. The quantity
of stock is ignored for this purpose suppose there are 4 lots of materials in stock. The purchase
prices of these are Birr 2,2.5, 3, 2.75 per unit, the average price to be charged for the next issue
will be:
= Birr 2+2.5+3+2.75 = 10.25 = Birr 2.56 per unit
4 4
Merits
i) It is very easy to operate.
ii) It gives satisfactory results when the prices are not fluctuate more.
iii) Issue price is calculated only when new lot of materials is received.

Demerits
i) It is not charging actual cost to the production.
ii) It is not a scientific method for not considering the quantity of
materials at different prices.
iii) It is possible for clerical errors

b) Weighted average price method

Under this method, the issue price is calculated by dividing the total cost of materials in hand by
the total quantity of materials in hard. This average price is thus calculated by taking the quantity

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of materials in hand into considerations. The average price so calculated will be charged to
production until a new purchase is made.
Merits
i) It is more scientific method.
ii) It is most suitable when the prices are not fluctuate more.
iii) Issue price are calculated only when the new lot of materials is purchased.

Demerits
i) It is possible for clerical work.
ii) It is not a actual cost to the production.
3) Market price or Replacement price method
Under this method, the issue of materials is priced at the replacement price or market price on the
date of issue of materials. A replacement price is a price at which an identical asset can be
replaced or purchased from the market. Thus, under this method, cost price of the material issued
is not considered at the material issued is not considered at all.
4) Standard cost method
Under this method, issue price of materials is fixed in advance which is termed as standard price.
All receipts of materials under this method are recorded at based neither on cost nor on market
price. The standard piece is fixed for each material after taking into account various factors such
as quantity of materials to be purchased, market conditions, freight and warehouse expenses etc.
This method is widely used by concerns between the actual purchase price and the standard price
of issues is charged to an account known as 'purchase price variance account'.
5.5.2. Stock verifications
It is the process of physically counting, measuring or weighing the entire range of items in the
stores and recording the results in a systematic manner. The purposes served by stock
verification are as follows:
To reconcile the stock records and documents for their accuracy and use fullness. To identify
areas, which require more, disciplined document control. To either the materials manager or the
internal audit. One person is usually given the exclusive responsibility with adequate facilities
and authority physical verification can be carried out periodically or on continuous basis:

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a) Period verification
Under this system, the entire cross section is verified at the end of one period, which is usually
the accounting period. In big organizations this is not achieved in a day and usually several days
are taken to complete this task. As no transactions can take place during the verification, this
could pose some problems. Physical verification requires careful planning and execution.
b) Continuous Verification
Under this system, verification is done throughout the year as per a predetermined plan of action.
A-items may be verified thrice a year, B- items twice a year and C- items once a year. It,
therefore, presupposes that a perpetual inventory record for each item is maintained showing all
transactions so that reconciliation can be done. The advantages here are:
Work can be independently carried out by materials audit department staff. Investigations with
regard to discrepancies are spread over the year and hence detailed analysis is possible. Final
account can be prepared expeditiously if continuous verification is done as per plan. There is no
need to 'freeze' the entire operations of the stores as verification is done throughout the year
based on perpetual inventory records. Any time stock records are more up-to-date when
compared with periodic verification system.
5.6 Stores Security
Stores security is the most important aspect in the stores management. In stores a large volume
of goods are handled every day. Accidents considerably reduce the moral and effectiveness of
the system. The following measures are necessary for stores security.
a) Safety and security consciousness should be installed in the minds of stores
personnel through training programmes, visual aids and literature.
b) Safety appliances, such as goggles hand gloves etc, must be encouraged.
c) Good housekeeping is essential. This means the gangways must be clean,
adequately wide so that movement of forklifts, trolleys and industrial tractors is
smooth. Stocking must be in appropriate locations so that handing is minimum.
d) All stores equipment must be kept in good order. This include adequate
maintenance practices cranes, trolleys, conveyors, etc. operation must be trained in
safety aspects so that safety precautions are not over looked.

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e) Healthy competition can be stimulated by installing 'safety awards' and cash prizes
which bring recognition to the concerned stores personnel for safety practices. This
also motivates others to practice safety.
f) Provision of fire fighting facilities is necessary especially where inflammable
materials are fact stores and handled. In point of fact, large organizations have a
well-maintained fire fighting equipment with the stores in preparedness. This has
in the long run reduced losses and reduced insurance expenses. Fire extinguishers
fire escapes, alarms and sprinklers must be available and personnel should be
familiar in handling them.
g) The stores arrangement should be minimize the material deterioration (reduce the
quality) and close watch is necessary for controlling the pilferage and missing of
materials.
h) Other factors which merit attention include procession of toilets, routine
maintenance equipments, safe electrical wings etc.
i) Finally, the care should be given to the problems of ant, flies and other insects.

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Chapter Six
Materials Handling
Definition & scope
Materials handling in industries accounts for nearly 40 % of the cost of production. It is obvious
that no value is added to the end- product through material handling. However, poor material
handling may result in delays in production and leading to idling of equipment. Nearly 50% of
the production cycle time in many industries is spent on handling of materials.

Definition of materials handling

Materials handling can be defined as “the function dealing with the preparation, placing and
positioning of materials to facilitate their movement or storage”.
Thus, the function includes every consideration of the product except the actual processing
operation. In many cases, the handling is also included as an integral part of the process.
Through scientific material handling, there is considerable reduction in the cost as well as in the
production cycle time can be achieved.
6.2 Benefits of proper material handling
The following are the benefits and guidelines are invaluable in the design and cost reduction of
the material handling systems. As material handling add no value but increases the production
cycle time, eliminate handling wherever possible. Ideally there should be any handling at all.

 From the method study, there is possible for elimination of wasteful movements.
 Ensure proper coordination through judicious selection of equipments and training of
workmen.
 Proper material handling system will reduce the usage of extra tools / equipments.
 Install a regular preventive maintenance programme for material handling equipments so
that downtime is minimized.
 It is possible for fully utilization of men, machinery, materials and other factors of
production.
 It is possible to reduce power and fuel from proper material handling equipments.
 There is a possible for more production and improve productivity.
 It is necessary to reduce the accidents while moving of machinery and equipments.

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 Location of stores should be as close as possible to the plant which uses the materials;
this avoids handling and minimizes investment in material handling system.
 Application of O.R. techniques such as queuing theory can be very effective in optimal
utilization of material handling equipment‟s.
6.3. Influencing factors & control
Handling cannot be viewed in isolation. Many factors like the following can be influencing the
material handling systems.
 Plant layout
 Processing system.
 Nature of raw materials.
 Types of finished products.
Therefore, an integrated approach will have to be taken in the case of the material handling. It
must be appreciated that materials handling operations encompass suppliers, stores, inspection,
manufacturing, packaging, warehousing, and transport to the customer. The objective of material
handling is therefore must be obtained maximum overall effectiveness in material handling.
Many decisions have a significant effect on the effectiveness of the material handling system.
We will discuss some of the important decisions.
Layout decisions are normally taken on technological considerations. Such decisions are taken in
consultation with material management and materials handling equipment departments such a
consultative process could result savings in terms of reduction in handling costs, reduction in
investment on handling equipment and a reduction in the production cycle time. In such a
consultative process, movement of materials could be studied right at the outset from the receipt
of raw materials stage to that of the dispatch of finished goods to warehouses. Many
organizations have used industrial engineering techniques such as flow process charts, and string
diagrams to design effective integrated material handling systems. When layout and handling are
designed in an integrated manner, valuable insights can be developed on the selection of
handling equipments, number of equipments and maximum utilization of floor space.
In the two basic layouts viz, product layout and process layout, it has been found that material
handling is kept at a minimum in the case of product layout. This is because product layout is
designed as per the sequence of operations leading to smooth flow of materials. Also, machines
are as located as to minimize the handling between successive processes. However, process

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layout result in lower investment in capital equipment and better utilization. The layouts can be
worked out to suit specific requirement with many compromises. A good layout should be such
that there is no congestion of materials and in process inventory. Transportation lines and
bottlenecks must be minimal.
6.4. Evaluation of materials handling
The effectiveness of the material handling system can be measured in terms of the ratio of the
time spent in the handling to the total time spent in production. It will cover the time element.
The expenses incurred per unit weight handled can measure the cost effectiveness. It can be
safely said that very few organizations try to collate the expenses and time in this manner so as to
objectively view the performance and to take remedial measures. Some of the other indices,
which can be used for evaluating the performance of handling systems, are listed below:

Equipment utilization ratio is an important indicator for judging the materials handling system.
This ratio can be computed and compared with similar firms or in the same firm over a period of
time.
In order to know the total effort needed for moving materials. It may be necessary to compute
materials handling labor ratio (MHL). This ratio is defined as under:
Personnel assigned to material handling
MHL = _________________________________
Total operating work force

In order to ascertain whether the handling system delivers materials to work center with
maximum efficiency, it is desirable to compute Direct Labor Handling Lost Ratio. This ratio is
Materials handling time lost by direct labor
DLHL = _______________________________________
Total direct labor time

The movement‟s operations ratio which is calculated after dividing total number of moves by
total number of productive operations indicates whether the workers are going through too many
motions because of poor routing. It should however be emphasized that the efficiency of
materials handling mainly depends upon the following factors:

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 Efficiency of handling methods employed for handling a unit weight through a unit
distance.
 Efficiency of the layout, which determines the distance through which the materials have
to be handled.
 Utilization of the handling facilities.
 Efficiency if the speed of handling.
In conclusion, it can be said that an effective material handling system depends upon tailoring
the layout and equipments to suit specific requirements. When a large volume has to be moved
from a limited number of destinations then fixed path equipments like rollers, belt conveyors and
gantry cranes are preferred. For increased flexibility, varied path equipments are preferred. In
practice, as we have seen in this chapter, specific requirements will have to be the guiding factor.

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