UNITIV (PART D) MATERIALS MANAGEMENT

UNIT STRUCTURE 4.0 Introduction 4.1 Learning Objectives 4.2 Types of Materials and their classification 4.3 Definition of Materials Management 4.4 Objectives of Materials Management in an organisation 4.4.1 Advantages of Material Management 4.5 Material Planning and Control. 4.5.1 Techniques of Material Planning 4.6 Purchasing 4.6.1 Objectives of Purchasing 4.6.2 Duties and Tasks of "Purchase Manager" 4.6.3 Types of Purchasing 4.7 Determination of economic ordering quantity. 4.8 ABC Analysis Selective Inventory Control 4.9 Self Assessment Questions 4.0 Introduction Materials Management is simply the process by which an organization is supplied with the goods and services that it needs to achieve its objectives of buying, storage and movement of materials. Materials Management is related to planning, procuring, storing and providing the appropriate material of right quality, right quantity at right place in right time so as to co-ordinate and schedule the production activity in an integrative way for an industrial undertaking. Most industries buy materials, transport them in to the plant, change the materials in to parts, assemble parts in to finished products, sell and transport the product to the customer. All these activities of purchase of materials, flow of materials, manufacture them in to the product, supply and sell the product at the market requires various types of materials to manage and control their storage, flow and supply at various places. It is only possible by efficient materials management. The basic objectives of material management in an organisation are: To obtain materials at the minimum price, however, this minimum price must not compromise on the quality of goods and the continuity of supply. To minimise the inventory of an organisation without sacrificing the timely availability of materials. This frees up working capital of an organisation for other useful organisation purposes.Thus, the bottom line of any material management system is the minimisation of material procurement, storage and handling costs, without compromising quality and availability of materials. Material management procedures are strategically placed within an organisation.They have different meanings for different people. Some of the material management procedures may give more weightage to purchasing, while others may attach a lot of importance to inventory control. A good material management process may have a strong backing of quality management and quality assurances of material purchasing and handling. This combination
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has a great impact on profitability and productivity as this may reduce the rejection rates of materials, thus, bringing down the overall cost of production in a well managed system. It is sometimes stated that it is the control of quality from the procurement to final distribution of the product that improves productivity and corporate image. A strong logistics system that can create a steady flow or continuum of materials flow into the production pipeline is the need of the hour. It is also claimed that An Overview question is how good this continuum is? And how are the quality control processes associated and linked to this continuum in an organization?

4.1 Learning Objectives After completing this unit the student will be able to understand The Types and Classification of materials, Definition , Objectives and importance of Materials Management in Industry Materials planning and Control Objectives of Purchasing Duties of purchase manager. Determination of economic ordering quantities. Types of materials purchase. 4.2 Types of Materials and their Classification The various types of materials to be managed are: (i) Purchased materials: They are raw materials, components, spare parts, oils, grease ,cotton waste, consumables and tools. (ii) Work in process (WIP) materials: These are semi-finished and finished parts and components lying on the shop floor. (iii) Finished goods: These are the final products either waiting to be assembled in the assembly lines or in stores which are stocked for final delivery waiting to sell. Dobler and Burt (2009) classify manufacturing materials into five categories. These categories are: Raw materials- materials that the company converts into processed parts. This might include parts specifically produced for the company and parts bought directly off the shelf (i.e. bolts, nuts). Purchased parts- parts that the company buys from outside sources (i.e. rubber parts, plastic parts). Manufactured parts- parts built by the company (i.e. tower case for a computer). Work in process- these are semi-finished products found at various stages in the production process (i.e. assembled motherboard). MRO supplies- maintenance, repairing, and operating supplies used in the manufacturing process but are not part of the final products (i.e. soap, lubricating oil). Chandler (2001) states that construction materials can be classified into different categories depending on their fabrication and in the way that they can be handled on site. He classifies the materials into five categories. These categories are Bulk materials- these are materials that are delivered in mass and are deposited in a container. Bagged materials- these are materials delivered in bags for ease of handling and controlled use. Palleted materials- these are bagged materials that are placed in pallets for delivery.
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 Packaged materials- these are materials that are packaged together to prevent damage during transportation and deterioration when they are stored. Loose materials- these are materials that are partially fabricated and that should be handled individually. 4.3 Definition of Materials Management The International Federation of Purchasing and Materials Management accept the definition of materials management given below. According to it, materials management is a total concept having its definite organization to plan and control all types of materials, its supply, and its flow from raw stage to finished stage so as to deliver the product to customer as per his requirements in time. This involves materials planning, purchasing, receiving,storing, inventory control, scheduling, production, physical distribution and marketing. It also controls the materials handling and its traffic. The materials manager has to manage all these functions with proper authority and responsibility in the material management department. 4.4 OBJECTIVES OF MATERIALS MANAGEMENT IN AN ORGANIZATION Materials Management has several core objectives and many secondary objectives. The core objectives of material management are: Proper, cost effective material procurement. Proper storage of materials so as to minimize wastages and material hold ups. Making available the material TIMELY. A good material management system will keep up to data records of all the information generated in it, preferably using a computer-based system. In addition to these primary objectives a materials management system indirectly fulfills many secondary objectives also. These secondary objectives are normally related to the functions of a material management system. Some of these secondary objectives are: Identifying new or better sources of supply Development and sustenance of relationships with the vendors Creating a standardized quality of the products Performing the value analysis of inventory. This can be related to the cost of materials. Creating a smooth flow of materials and information among the various sections of materials management system. The material management system works under the broad basic objectives of an organization that is maximum profit with sustained growth and research, satisfied customers and staff of the organization. The material management supports this objective by providing support through: Continuity of supply by maintaining a uniform flow of materials, Reducing the costs of materials purchased and handling by using scientific techniques and electronic tools. The use of scientific tools and techniques for materials and information management, Minimizing holdups of working capital and performing effective inventory control, Releasing working capital by ensuring effective control over inventories, Providing high quality at the lowest price, and Development of better relationships with customers and suppliers 4.4.1 Advantages of Materials Management Material management has created a niche in many organizations, which have implemented the integrated materials management. These organizations usually enjoy the following advantages: Better accountability on part of materials as well as other departments as no one can shift blame to others.
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 As materials management is handled by single authority, it can result in better coordination, as it becomes the central point for any material related problems. Materials management department makes sure that better quality material is supplied timely to the requesting departments. This can result in better performance of the organization. A materials management system is typically controlled through an information system, thus, can help in taking decisions related to material in the organization. One indirect advantage of material management is that good quality material develops the ethical and moral standard in an organization. However, please note there is no study on this issue. 4.5 MATERIAL PLANNING AND CONTROL Material planning is a scientific technique of determining in advance the requirements of raw materials, ancillary parts and components, spares etc. as directed by the production programme.It is a sub-system in the overall planning activity. There are many factors, which influence the activity of material planning. These factors can be classified as macro and micro systems. 1. Macro factors: Some of the micro factors which affect material planning, are price trends, business cycles Govt. import policy etc. 2. Micro factors: Some of the micro factors that affect material planning are plant capacity utilization, rejection rates, lead times, inventory levels, working capital, delegation of powers and communication.

4.5.1 Techniques of Material Planning One of the techniques of material planning is bill of material explosion. Material planning through bill of material explosion is shown below in Fig. 4.2.The basis for material planning is the forecast demand for the end products. Forecasting techniques such as weighted average method, exponential smoothening and time series models are used for the same. Once the demand forecast is made, it is possible go through the exercise of material planning. Bill of
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materials is a document which shows list of materials required, unit consumption location code for a given product. An explosive chart is a series of bill of material grouped in a matrix form so that combined requirements for different components can be done requirements of various materials arearrives at from the demand forecast, using bill of materials, through explosion charts. Thus material requirement plan will lead to be the development of delivery schedule of the materials and purchasingof those material requirements.
4.6 PURCHASING

Purchasing is an important function of materials management. In any industry purchase means buying of equipments, materials, tools, parts etc. required for industry. The importance of the purchase function varies with nature and size of industry. In small industry, this function is performed by works manager and in large manufacturing concern; this function is done by a separate department. The moment a buyer places an order he commits a substantial portion of the finance of the corporation which affects the working capital and cash flow position. He is a highly responsible person who meets various salesmen and thus can be considered to have been contributing to the public relations efforts of the company. Thus, the buyer can make or mar the companys image by his excellent or poor relations with the vendors
4.6.1 Objectives of Purchasing

The basic objective of the purchasing function is to ensure continuity of supply of raw materials, sub-contracted items and spare parts and to reduce the ultimate cost of the finished goods. In other words, the objective is not only to procure the raw materials at the lowest price but to reduce the cost of the final product. The objectives of the purchasing department can be outlined as under: 1. To make available the materials, suppliers and equipments at the minimum possible costs:These are the inputs in the manufacturing operations. The minimization of the input cost increases the productivity and resultantly the profitability of the operations. 2. To ensure the continuous flow of production through continuous supply of raw materials, components, tools etc. with repair and maintenance service. 3. To increase the asset turnover: The investment in the inventories should be kept minimum in relation to the volume of sales. This will increase the turnover of the assets and thus the profitability of the company. 4. To develop an alternative source of supply: Exploration of alternative sources ofsupply of materials increases the bargaining ability of the buyer, minimisation of cost of materials and increases the ability to meet the emergencies. 5. To establish and maintain the good relations with the suppliers: Maintenance of good relations with the supplier helps in evolving a favourable image in the business circles. Such relations are beneficial to the buyer in terms of changing the reasonable price, preferential allocation of material in case of material shortages, etc. 6. To achieve maximum integration with other department of the company: The purchase function is related with production department for specifications and flow of material, engineering department for the purchase of tools, equipments andmachines, marketing department for the forecasts of sales and its impact on procurement of materials, financial department for the purpose of maintaining levels of materials and estimating the working capital required, personnel department for the purpose of manning and developing the personnel of purchase department and maintaining good vendor relationship.

7. To train and develop the personnel: Purchasing department is manned with varied types of personnel. The company should try to build the imaginative employee force through training and development. 8. Efficient record keeping and management reporting: Paper processing is inherent in the purchase function. Such paper processing should be standardised so that record keeping can be facilitated. Periodic reporting to the management about the purchase activities justifies the independent existence of the department. 4.6.2 Duties and Tasks for: "Purchasing Manager" 1) Maintain records of goods ordered and received. 2) Locate vendors of materials, equipment or supplies, and interview them in order to determine product availability and terms of sales. 3) Prepare and process requisitions and purchase orders for supplies and equipment. 4) Control purchasing department budgets. 5) Interview and hire staff, and oversee staff training. 6) Review purchase order claims and contracts for conformance to company policy. picture of business person in suit 7) Analyze market and delivery systems in order to assess present and future material availability. 8) Develop and implement purchasing and contract management instructions, policies, and procedures. 9) Participate in the development of specifications for equipment, products or substitute materials. 10) Resolve vendor or contractor grievances, and claims against suppliers. 11) Represent companies in negotiating contracts and formulating policies with suppliers. 12) Review, evaluate, and approve specifications for issuing and awarding bids. 13) Direct and coordinate activities of personnel engaged in buying, selling, and distributing materials, equipment, machinery, and supplies. 14) Prepare bid awards requiring board approval. 15) Prepare reports regarding market conditions and merchandise costs. 16) Administer on-line purchasing systems. 17) Arrange for disposal of surplus materials. 4.6.3 Types of Purchasing Considering the nature of business an organisation has there could be different approaches and hence Purchasing can be any of these types:
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1.Forward Buying 2.Tender Buying 3.Speculative Buying 4. Systems Contracting 5. Rate Contract 6. Reciprocity 7. Zero Stock buying 8. Blanket Order 1 Forward Buying Forward Buying as the name suggests is the system under which buying is done with longer term in perspective. It is not meant for meeting the present consumption requirement. It is rather a commitment on part of both the buyer and the seller , normally for a period of one year. Depending upon the availability of the item, the financial policies, the economic order quantity, the quantitative discounts, and the staggered delivery, the future commitment is decided. A few organisations do hedge, particularly in the commodity market by selling or buying contracts. Forward buying helps a firm in booking capacity of a supplier and thus often results into a safeguard against a competitor acquiring his capacity. It is usually done for Raw materials but is not limited to it. Now a days , with competition becoming globalised such an arrangement is a win-win situation for both , the buyer and the supplier. 2. Tender Buying With competition growing as ever , Information technology replacing the arduous manual mode of purchasing and transparency in dealings more required than ever, many professionally managed firms have started looking for more sources of supplies, beyond their normal boundaries. Not that Tender buying did not exist earlier. Rather, it has always been considered the only way of buying materials / services in the government and quasi government procurements. What is Tender buying ? As the word suggests , Tender buying is selecting a supply source (supplier) out of many sources available. That is, many tenderers are invited to participate in the tendering process and then one or more than one tender is selected for order placement. Such tenders are also called the Accepted tender/s (A/Ts). The main focus through tender buying is on competition of price and quality. Usually, the best quality (T1 or Q1) is selected after assessment of the technical offers and then the lowest offered price (L1) tender is selected for order placement.

Process of tender buying : A typical purchase function starts with the raising of a requisition (Indent / Material Procurement Requisition) for an item which is required for a stated purpose. This requisition is then converted into an enquiry form which is issued to the probable vendors who are asked to respond within a given date and time (called Tender opening date) as mentioned in the enquiry issued to them. The interested vendors respond to the tender enquiry by giving their tenders. Tenders thus received are opened on the Tender opening date at the fixed time. The tenders are then subjected to evaluation with respect to a tenderer's capability, Financial as well as Technical and other criteria as laid down in the tender enquiry. This step also witnesses series of discussions, clarifications and negotiation with the tenderers. Some tenders can be rejected at this stage as they might not meet the requirement of the purchaser. Finally, the tenders which are found suitable are subjected to price comparision and usually the tenderer offering the lowest price (L1) is selected for placement of order. The process explained above shows a great deal of variations depending upon a company's procurement policy. In some places, the best quality offering tenders are accepted for subsequent price comparision whereas in some other place all the tenderers who meet the minimum requirement are considered accepted for price comparision and order placement. Similarly, in some places the order is placed only on L1 (lowest offered price) whereas in some other places it may not be rigidly followed so. Types of Tenders : Since the tenders are sent to the probable vendors , knowledge of vendors for the item in question is a necessity. It's based on this concept that the types or mode of tendering is decided against a particular purchase requisition. Most commonly used Types of tendering / tender buying are as below : 1) Global Tender : As the name suggests a global tender is floated with a view to elicit offers / response from any vendor situated anywhere in the world. The need for a global tender arises when the purchaser either does not know about the vendors for a particular item in question or when he thinks that a wider choice of vendor is possible through it, irrespective of his nation's boundaries. A few clear reasons are : Lack of information on vendors Only a few vendors known When there are chances of cartel formation among known vendors Anticipation that more response may come What is of importance in this popular mode is the way a global tender is floated. With internet becoming the most powerful tool transcending the national boundaries ,a wide range of applications are now possible. There are tender portals ( www.tendertiger.com , www.indiatenders.com etc.) on which one can upload the whole tender enquiry and then ask the interested vendors to make offers. Besides,this increasingly popular way of inviting tenders , listing the tender in international trade journals, leading world newspapers etc. are other ways of putting up a global tender enquiry. The idea is to give wide publicity of the tender, worldwide and circumstances permitting ,to place the order on a foreign supplier too.
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2) Open Tender : An Open tender too like a Global tender tends to invite tender from any interested vendor. The basic difference assumed between an open tender and a global tender enquiry is essentially the range of its applicability. While a global tender gets the worldwide publicity, an open tender is limited only within a country. Otherwise, the concept remains the same as it also seeks to elicit better or wider response. Since the Open tender enquiry is limited within the country itself , besides the internet mode , the enquiry is also printed in the national dailies, internal trade bulletins etc for ensuring its wide publicity, within the country. Any vendor who meets the tender requirements can make an offer. Now a days, since e-procurement is replacing the old manual mode of working , one of the most commonly used mode for Open tendering is uploading the tender on the internet. What is of interest now is the narrowing down of differences between the global tender and an open tender. Any content published on the internet is expected to be available to anybody located anywhere in the world unless due to some mechanism such as firewall etc the reach of internet is restricted. 3) Limited Tender : When the issue of tender enquiry is limited only to a selected few vendors ,it is called Limited Tender Enquiry (LTE). LTE is issued when the capabilities of the vendors is well known to the purchaser. It is considered better than Global and Open tender modes as there is always an element of uncertainty in those two modes with respect to the capabilities of the vendors. For issuing LTE ,a purchaser maintains a list of approved /registered vendors whose capabilities are checked periodically. 4) Single Tender Enquiry : An STE is issued only when either the item is proprietory in nature, that is only one supplier produces that item or where there may be more vendors but due to certain exigencies it is not possible to devote time on evaluating the vendors' offers / one supplier can ,for sure , fulfill the needs. Which mode to use and when depends on many factors as well a company's procurement policy. For example, for a small value purchase , if the policy does not prohibit, Single tender enquiry or Limited tender enquiry is considered ideal. These are also ideal for high value and frequently bought items. On the other hand, for high value and non frequently bought items / systems , Open / Global tenders are suited. In many government organisations, whose procurements are also called public procurements for the reason that they spend public money for the public cause ,all the tenders are to be invited only through Open / Global tenders. 3. Speculative Buying When purchasing is done purely from the point of view of taking advantage of a speculated
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rise in price of the commodity it is called Speculative buying. The intent is not to buy for the internal consumption but to resell the commodity at a later date when the prices have gone up and to make a profit by selling. The items may be those that are needed for internal consumption but the quantity shall be much more than the requirement so as to take advantage of the coming price rise. 4. Systems Contracting Systems contract ,as the term suggest, is a contract of system of buyer with that of the seller. It is a release system in which items, usually, commonly available off-the-shelf, are identified and pre-priced in anticipation of certain usage. Delivery releases are made against existing orders placed by purchase. This is a procedure intended to help the buyer and the seller to reduce administrative expenses and at the same time to ensure proper controls. The system authorises the designated persons of the buyer to place orders directly to the supplier with the specific materials during a given contract period. The contract is thus finalised only after it is ensured that an attempt has been made to integrate as many buyer-seller materials management functions as possible. In this system the original indent, duly approved by competent authorities, is shipped back with the items and avoiding the usual documents like purchase orders, materials requisitions, expediting letters and acknowledgements, goods in transit report, etc. The contract is simple, covering only delivery period, price and invoicing procedure. Systems contracting is particularly useful for items with low unit price and high consumption profile and thus relieves the buyers of the routine work. While Systems contract has certain features in common with other purchasing agreements , it is this integration of buyer-seller operations that clearly distinguishes it from other types of contracts. 5. Rate Contracts Rate contracts are mutual agreements between the buyer and the seller to operate a set of chosen items, during a given period of time, for a fixed price or price variation. Under this system the rates are fixed and at times even the quantity of the selected items. As and when the need arises the buyer issues a Purchase order directly on the basis of the rate chart available on the supplier who in turn supplies the items. The system of rate contract is prevalent in public sector organistions and government departments. It is common for the suppliers to advertise that they are on rate contract with the DGS & D (Directorate General of Supply & Disposal), for the specific period for the given items. After negotiation, the seller and the buyer agree to the rates of items. Application of rate contract helps organisations cut down the internal administrative lead time as individual firms need not go through the central purchasing departments and can place orders directly with the suppliers. However, suppliers always demand higher prices for prompt delivery, as rate contracts normally stipulate only the rate and not the schedule on which the item is needed. This difficulty has been avoided by ensuring the delivery of a minimum quantity at the agreed

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rates. This procedure of fixing a minimum quantity is called the running contract and is being practiced by the railways and the DGS&D. As mentioned above, this system of buying helps an organisation reduce its internal as well as the external lead time, reduces administrative work load as the files don't need to go up and down, helps in building Buyer-supplier relationship as the contract period id usually one year and then there is always a chance of the same players doing the next contract. The system works well normally in a situation where the selected items are routinely consumed. However, there is no compulsion that the demand be uniform over the period of time. 6. Reciprocity in Buying In certain business situations a buyer may give preference to a supplier who also happens to be his customer. This relationship is known as reciprocity. It is something like "I buy from you if you buy from me" One of the main questions for which this , otherwise simple way of buying, is always under the scanner of purchasing ethics is its undue ability to restrict competition and fair play. One of the major roles that any purchaser plays for his firm is in cost reduction arena which is attempted by generating competition among the suppliers. This principle gets a jolt through reciprocity in buying. However, when factors such as quality, after sales service, price etc are equal normally a buyer would like to buy from his customer , if for nothing then at least for having a good working relationship. However, the distinct disadvantages of reciprocal buying outweigh the limited and narrow advantage that a firm may derive out of it. Some of the main disadvantages of reciprocity are not being able to follow the well laid criteria of quality, price and service. A purchasing executive should not indulge in reciprocity on his initiative when the terms and conditions are not equal with other suppliers. It is often found that less efficient manufacturers and distributors gain by reciprocity what they are unable to gain by price and quality. Since this tends to discourage competition and might lead to higher prices and fewer suppliers, reciprocity should be practiced on a selective basis. 7. Zero Stock Buying Zero stock buying refers to buying in a manner that the system ensures that the material is delivered by the seller only when it is required and that no prior inventory of the item is maintained by the buyer. As the competition becomes more intense the need for a lean manufacturing system becomes more focussed. Keeping inventory thus is blocking huge money that is idle for the firm. Thus Zero stock buying is more of an inventory safeguard rather than the normal buying. Normally, under this system the firms try to operate on the basis of zero stock and the supplier holds the stock for these firms. Usually, the firms of the buyer and seller are close to each other so that the raw material of one is the finished product of another.

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Alternatively, the system could work well if the seller holds the inventory and if the two parties work in close coordination. However the price per item in this system is slightly higher as the supplier may include the inventory carrying cost in the price. In this system, the buyer need not lock up the capital and so the purchasing routine is reduced. This also significantly reduces obsolescence of inventory, lead time and clerical efforts in paper work. Thus, the seller can devote his marketing efforts to other customers and production scheduling becomes easy. In practice, the buyer is called upon to pay to the supplier only when the material is delivered as per the need.

For example, in India , say the Indian Oil Limited maintains its petrol and diesel refilling stations inside the manufacturing premises of many companies. As and when petrol or diesel is required ,say in a lorry, IOL fills that and a coupon is signed by the driver of the lorry. Buyer makes the payment to IOL against that coupon. Zero stock is becoming popular with the concepts such as Just-in-time approach that is similar to it. However, in situations where the supplier has to transport material from one place to the other with a fair distance in between ,this system needs careful handling as one never knows the road or weather conditions. Normally, the system caters to those items that are not very critical to manufacturing. It best suits the situations where the output of one firm is the input of the other firm with both the firms located nearby 8. Blanket Orders Under the Blanket Order system an agreement is done between the buyer and the supplier to provide a required quantity of specified items, over a period of time, usually for one year, at an agreed price. This system minimises the administrative expenses and is useful for 'C' class items for which rigid controls are not required. Deliveries are made depending upon the buyers needs. The system relieves the buyer from routine work, giving him more time for focusing attention on high value items such as 'A' and part of 'B' class. Blanket Order system requires fewer purchase orders and thus reduces clerical work. It often achieves lower prices through quantity discounts by grouping the requirements. The supplier, under the system, maintains adequate inventory to meet the blanket orders, but he does not incur selling costs, once the negotiations are finalised. 4.7 Economic order quantity and its determination Economic order quantity is the order quantity that minimizes total inventory holding costs and ordering costs. It is one of the oldest classical production scheduling models. The framework used to determine this order quantity is also known as Wilson EOQ Model or Wilson Formula. The model was developed by Ford W. Harris in 1913,[1] but R. H. Wilson, a consultant who applied it extensively, is given credit for his in-depth analysis. EOQ applies only when demand for a product is constant over the year and each new order is delivered in full when inventory reaches zero. There is a fixed cost for each order placed, regardless of the number of units ordered. There is also a cost for each unit held in storage,
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commonly known as holding cost, sometimes expressed as a percentage of the purchase cost of the item. We want to determine the optimal number of units to order so that we minimize the total cost associated with the purchase, delivery and storage of the product. The required parameters to the solution are the total demand for the year, the purchase cost for each item, the fixed cost to place the order and the storage cost for each item per year. Note that the number of times an order is placed will also affect the total cost, though this number can be determined from the other parameters. Underlying assumptions: The ordering cost is constant. The rate of demand is known, and spread evenly throughout the year. The lead time is fixed. The purchase price of the item is constant i.e. no discount is available The replenishment is made instantaneously, the whole batch is delivered at once. Only one product is involved. EOQ is the quantity to order, so that the sum of ordering cost and holding cost is at its minimum. These costs will be equal to one another at the minimized cost point. Variables c = purchase price, unit production cost Q = order quantity Q* = optimal order quantity D = annual demand quantity K = fixed cost per order, setup cost (not per unit, typically cost of ordering and shipping and handling. This is not the cost of goods) h = annual holding cost per unit, also known as carrying cost or storage cost (capital cost, warehouse space, refrigeration, insurance, etc. usually not related to the unit production cost) The Total Cost function The single-item EOQ formula finds the minimum point of the following cost function: Total Cost = purchase cost or production cost + ordering cost + holding cost - Purchase cost: This is the variable cost of goods: purchase unit price annual demand quantity. This is c D - Ordering cost: This is the cost of placing orders: each order has a fixed cost K, and we need to order D/Q times per year. This is K D/Q - Holding cost: the average quantity in stock (between fully replenished and empty) is Q/2, so this cost is h Q/2
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TC = cD + {DK}/{Q}+ {hQ}/{2}. To determine the minimum point of the total cost curve, partially differentiate the total cost with respect to Q (assume all other variables are constant) and set to 0: {0} = -{DK}/{Q2}+{h}/{2} Solving for Q gives Q* (the optimal order quantity): Q*2 ={2DK}/{h}} Therefore: Q* = sqrt{{2DK}/{h}} . Q* is independent of c; it is a function of only K, D, h. Several extensions can be made to the EOQ model, including backordering costs and multiple items. Additionally, the economic order interval can be determined from the EOQ and the economic production quantity model (which determines the optimal production quantity) can be determined in a similar fashion.

Example Suppose annual requirement quantity (D) = 10000 units Cost per order (K) = $2 Cost per unit (c)= $8 Carrying cost percentage (h/c)(percentage of c) = 0.02 Annual carrying cost per unit (h) = Rs.0.16 Economic order quantity = sqrt{{2D*K}/{h}} = sqrt{{2*10000*2}/{8*0.02}} = 500 units Number of orders per year (based on EOQ) = {{10000}/{500}} = 20 Total cost = c*D + K (D/EOQ) + h (EOQ/2) Total cost = 8*10000 + 2 (10000/500) + 0.16 (500/2) = $80080 If we check the total cost for any order quantity other than 500(=EOQ), we will see that the cost is higher. For instance, supposing 600 units per order, then Total cost = 8*10000 + 2 (10000/600) + 0.16 (600/2) = $80081 Similarly, if we choose 300 for the order quantity then Total cost = 8*10000 + 2 (10000/300) + 0.16 (300/2) = $80091 This illustrates that the Economic Order Quantity is always in the best interests of the entity.

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4.8 ABC ANALYSIS-(SELECTIVE INVENTORY CONTROL) In supply chain, ABC analysis is an inventory categorization method which consists in dividing items into three categories, A, B and C: A being the most valuable items, C being the least valuable ones. This method aims to draw managers attention on the critical few (A items) and not on the trivial many (C-items). Prioritization of the management attention Inventory optimization is critical in order to keep costs under control within the supply chain. Yet, in order to get the most from management efforts, it is efficient to focus on items that cost most to the business. The Pareto principle states that 80% of the overall consumption value is based on only 20% of total items. In other words, demand is not evenly distributed between items: top sellers vastly outperform the rest. The ABC approach states that, when reviewing inventory, a company should rate items from A to C, basing its ratings on the following rules: A-items are goods which annual consumption value is the highest. The top 70-80% of the annual consumption value of the company typically accounts for only 10-20% of total inventory items. C-items are, on the contrary, items with the lowest consumption value. The lower 5% of the annual consumption value typically accounts for 50% of total inventory items. B-items are the interclass items, with a medium consumption value. Those 15-25% of annual consumption value typically accounts for 30% of total inventory items. The annual consumption value is calculated with the formula: (Annual demand) x (item cost per unit). Through this categorization, the supply manager can identify inventory hot spots, and separate them from the rest of the items, especially those that are numerous but not that profitable

The graph above illustrates the yearly sales distribution of a US eCommerce in 2011 for all products that have been sold at least one. Products are ranked starting with the highest sales volumes. Out of 17000 references: Top 2500 products (Top 15%) represent 70% of the sales. Next 4000 products (Next 25%) represent 20% of the sales.
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Bottom 10500 products (Bottom 60%) represents 10% of the sales. This example is fairly close to the canonical Pareto situation.Inventory management policies Policies based on ABC analysis leverage the sales imbalance outlined by the Pareto principle. This implies that each item should receive a weighed treatment corresponding to its class: A-items should have tight inventory control, more secured storage areas and better sales forecasts. Reorders should should be frequent, with weekly or even daily reorder. Avoiding stock-outs on A-items is a priority. Reordering C-items is made less frequently. A typically inventory policy for C-items consist of having only 1 unit on hand, and of reordering only when an actual purchase is made. This approach leads to stock-out situation after each purchase which can be an acceptable situation, as the C-items present both low demand and higher risk of excessive inventory costs. For C-items, the question is not so much how many units do we store? but rather do we even keep this item in store? B-items benefit from an intermediate status between A and C. An important aspect of class B is the monitoring of potential evolution toward class A or, in the contrary, toward the class C. Splitting items in A, B and C classes is relatively arbitrary. This grouping only represents a rather straightforward interpretation of the Pareto principle. In practice, sales volume is not the only metric that weighs the importance of an item. Margin but also the impact of a stockout on the business of the client should also influence the inventory strategy. Pareto principle is over a century old and ABC analysis has been around for multiple decades already. Those concepts provide interesting insights in supply chain, but we believe, fail to some extent to embrace a more modern approach where software can automate the bulk of the inventory management. For example, as far demand forecasting is concerned, tools such as Sales cast can indifferently forecast A, B and C items without any extra effort once the historical data is fed into the system .4.9 SELF ASSESSMENT QUESTIONS 1) What are the objectives of Materials management? What are its advantages? 2) What are the activities of materials and information flow in an organization? 3) What is the scope of materials management? 4) Define the various roles of materials management in the context of internal and external interfaces to materials management system. 5) Describe the role and duties of Purchase Manager in performing various functions in an organization? 6) Describe the role of ABC Analysis in prioritation of inventory holding ?

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