Material and Store Management PDF

Material and Store Management
This book is a part of the course by MITSDE, Pune.

This book contains the course content for Material and Store Management.
MITSDE, Pune
First Edition 2011
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alter the content whenever the need arises, and to vary it at any time without prior notice.
Index
Content................................................................................................................................................................... II
List of Figures........................................................................................................................................................ V
List of Tables.........................................................................................................................................................VI
Abbreviations.......................................................................................................................................................VII
Applications.......................................................................................................................................................... 80
Bibliography......................................................................................................................................................... 83
Self Assessment Answers...................................................................................................................................... 85
Book at a Glance
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Contents
Chapter I........................................................................................................................................................ 1
Material Management.................................................................................................................................. 1
Aim................................................................................................................................................................. 1
Objectives....................................................................................................................................................... 1
Learning outcome........................................................................................................................................... 1
1.1 Introduction to Material Management...................................................................................................... 2
1.2 Classification of Inventory........................................................................................................................ 2
1.3 Meaning of Material Management............................................................................................................ 3
1.4 Objectives of Materials Management....................................................................................................... 3
1.5 Motives of Materials Management........................................................................................................... 4
1.6 Scope of Material Management................................................................................................................ 5
1.7 Material Planning...................................................................................................................................... 5
1.8 Technique of Planning Materials.............................................................................................................. 5
1.9 Process of Codification............................................................................................................................. 6
1.10 Standardisation........................................................................................................................................ 7
1.11 Scheduling . ............................................................................................................................................ 7
1.12 Procurement ........................................................................................................................................... 8
1.13 Purchasing . ............................................................................................................................................ 8
1.14 Inspection . ............................................................................................................................................. 9
1.15 Quality Control ...................................................................................................................................... 9
1.16 Packaging . ............................................................................................................................................. 9
1.17 Storage.................................................................................................................................................... 9
1.18 Inventory Control . ................................................................................................................................. 9
1.19 Distribution ............................................................................................................................................ 9
1.20 Disposal ............................................................................................................................................... 10
1.21 Functions of Material Manager............................................................................................................. 10
1.22 Effects of Over Stocking and Under Stocking . ................................................................................... 10
Summary.......................................................................................................................................................11
References.....................................................................................................................................................11
Recommended Reading...............................................................................................................................11
Self Assessment............................................................................................................................................ 12
Chapter II.................................................................................................................................................... 14
Material Cost Management....................................................................................................................... 14
Aim............................................................................................................................................................... 14
Objectives..................................................................................................................................................... 14
Learning outcome......................................................................................................................................... 14
2.1 Introduction to Material Cost Management............................................................................................ 15
2.2 Material Cost........................................................................................................................................... 15
2.3 Economic Order Quantity (EOQ) Models.............................................................................................. 17
2.4 Determination of various Inventory Levels ........................................................................................... 20
2.4.1 Maximum Level . ................................................................................................................... 20
2.4.2 Minimum Level...................................................................................................................... 20
2.4.3 Re-order Level........................................................................................................................ 20
2.4.4 Danger Level........................................................................................................................... 20
2.4.5 Calculation of Various Levels . .............................................................................................. 20
2.5 ABC Analysis . ....................................................................................................................................... 23
2.6 XYZ Analysis ........................................................................................................................................ 25
Summary...................................................................................................................................................... 27
References.................................................................................................................................................... 27
Recommended Reading.............................................................................................................................. 27
Self Assessment............................................................................................................................................ 28
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Chapter III................................................................................................................................................... 30
Inventory Models........................................................................................................................................ 30
Aim............................................................................................................................................................... 30
Objectives..................................................................................................................................................... 30
3.1 Introduction to Inventory Models........................................................................................................... 31
3.2 Models for Accepting/Rejecting Discounts on Purchases...................................................................... 31
3.3 Fixed Order vs. Fixed Interval System................................................................................................... 35
3.3.1 Cyclical Ordering or Fixed Period System (Time Based) ..................................................... 35
3.4 Material Requirement Planning (MRP) ................................................................................................. 38
3.4.1 Applicability of the MRP System........................................................................................... 39
3.4.2 Inputs for MRP ...................................................................................................................... 39
3.4.3 MRP Process........................................................................................................................... 39
3.4.4 Outputs of MRP ..................................................................................................................... 39
3.4.5 Benefits of MRP .................................................................................................................... 40
3.5 Inventory Turnover ................................................................................................................................ 40
3.5.1 Interpretation of Inventory Turnover...................................................................................... 41
Summary...................................................................................................................................................... 42
References.................................................................................................................................................... 42
Self Assessment............................................................................................................................................ 43
Chapter IV................................................................................................................................................... 45
Purchase Management............................................................................................................................... 45
Aim............................................................................................................................................................... 45
Objectives..................................................................................................................................................... 45
4.1 Introduction to Purchase Management................................................................................................... 46
4.1.1 Objectives of Material Management....................................................................................... 46
4.2 Functions of Purchase Department......................................................................................................... 46
4.2.1 Purchasing Function vs. Purchase Department ..................................................................... 47
4.2.2 Procurement vs. Purchasing . ................................................................................................. 48
4.2.3 Objectives of Purchasing........................................................................................................ 48
4.3 Purchase Requisition............................................................................................................................... 48
4.3.1 Types of Purchase Requisitions.............................................................................................. 48
4.4 Purchase Procedure . .............................................................................................................................. 49
4.5 Types of Purchasing ............................................................................................................................... 49
4.5.1 Forward Buying ..................................................................................................................... 49
4.5.2 Tender Buying......................................................................................................................... 50
4.5.3 Systems Contract ................................................................................................................... 51
4.5.4 Speculative Buying ................................................................................................................ 52
4.5.5 Rate Contracts . ...................................................................................................................... 52
4.5.6 Reciprocity in Buying . .......................................................................................................... 52
4.5.7 Zero Stock Buying ................................................................................................................. 53
4.5.8 Blanket Orders ....................................................................................................................... 53
4.6 Vendor Management .............................................................................................................................. 53
4.7 Inspection of Materials........................................................................................................................... 54
4.7.1 Pre Dispatch Inspection.......................................................................................................... 55
4.7.2 Stage Inspection / Final Inspection......................................................................................... 55
4.7.3 Document Inspection.............................................................................................................. 55
4.7.4 Stores/Receipt Inspection....................................................................................................... 55
4.7.5 Third Party Inspection............................................................................................................ 56
Summary...................................................................................................................................................... 58
References.................................................................................................................................................... 58
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Self Assessment............................................................................................................................................ 60
Chapter V..................................................................................................................................................... 62
Stores Management.................................................................................................................................... 62
Aim............................................................................................................................................................... 62
Objectives..................................................................................................................................................... 62
5.1 Introduction to Stores Management........................................................................................................ 63
5.1.1 Motive to Hold Inventory....................................................................................................... 63
5.2 Functions of Stores Department ............................................................................................................ 63
5.2.1 Receipt of Material................................................................................................................. 63
5.2.2 Issue of Material..................................................................................................................... 64
5.2.3 Return of Material................................................................................................................... 65
5.2.4 Transfer of Materials............................................................................................................... 66
5.2.5 Proper Storage Function ........................................................................................................ 66
5.3 Valuation of Material ............................................................................................................................. 68
5.4 Valuation of Receipts.............................................................................................................................. 68
5.5 Valuation of Issues.................................................................................................................................. 69
5.5.1 First In First Out (FIFO) Method . ......................................................................................... 70
5.5.2 Last In First out (LIFO) Method . .......................................................................................... 71
5.5.3 Highest In First Out (HIFO) Method...................................................................................... 71
5.5.4 Average Rate Method ............................................................................................................ 72
5.5.4.1 Simple Average (SAR) Method .............................................................................. 73
5.5.4.2 Weighted Average Rate (WAR) Method.................................................................. 73
5.5.5 Market Rate............................................................................................................................. 74
5.6 Valuation of Returns .............................................................................................................................. 75
Summary...................................................................................................................................................... 77
References.................................................................................................................................................... 77
Self Assessment............................................................................................................................................ 78
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List of Figures
Fig. 1.1 Inventory classification...................................................................................................................... 2
Fig. 2.1 Process from procurement to realization of money......................................................................... 17
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List of Tables
Table 1.1 List of classification of inventories................................................................................................. 7
Table 3.1 Model developed for accepting/rejecting discounts on purchases in excel spread sheet.............. 32
Table 4.1 Purchasing function vs. purchase department............................................................................... 47
Table 4.2 Matrix of price and quality of the tenders..................................................................................... 50
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Abbreviations
BOM - Bill of Materials
DGS & D - Directorate General of Supply & Disposal
DIL - Desired Inventory Level
EDI - Electronic Data Interchange
EOQ - Economic Order Quantities
ERP - Enterprise Resource Planning
FIFO - First In First Out
GC - Guarantee Certificate
GRN - Goods Returned Note
GRR - Goods Received Report
HIFO - Highest In First Out
IR - Inspection Request
IRF - Inventory Record File
IT - Information Technology
LIFO - Last In First Out
LTE - Limited Tender Enquiry
Mfg. TC - Manufacturing Certificate
MPS - Master Production Schedule
MRO - Maintenance, Repair and Operating Inventories
MRP - Materials Requirement Planning
MTC - Material Test Certificate
PO - Purchase Order
PO - Purchase Order
QA - Quality Assurance
ROI - Return on Investment
ROL - Re-Order Level
SAR - Simple Average Rate
STE - Single Tender Enquiry
VDC - Vendor Development Cell
WAR - Weighted Average Rate
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Chapter I
Material Management
Aim
The aim of this chapter is to:
• introduce the students to material management
• explain the scope of material management
• elucidate the various motives of inventory
Objectives
The objectives of this chapter are to:
• discuss the classification of inventory
• recognise the key objectives of material management
• enlist the functions of material manager
Learning outcome
At the end of this chapter, students will be able to:
• understand the materials requirement planning technique (MRP)
• know about the process of purchasing
• know the effects of overstocking and under stocking
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1.1 Introduction to Material Management

Every organization depends on materials and services from other organizations to varying extents. These materials
and services are obtained through exchange of money. Various materials are used as inputs such as raw materials,
consumables & spares. These are required to be purchased and made available to the shops/users as and when
needed to ensure uninterrupted production. Efficient management of input materials is of paramount importance
in a business organization for maximizing materials productivity, which ultimately adds to the profitability of the
organization.
Material cost is probably the most important element of cost. In the case of certain industries like cement, sugar,
chemicals, iron and steel etc., the materials cost forms a very significant portion of the overall cost of production.
1.2 Classification of Inventory

The term material refers to all commodities which are consumed in the production process. The materials which
can be consumed in the production process can be basically classified as;
• Direct Materials
• Indirect Materials
Material is generally called raw material. Inventory is a name collectively given to raw material; work in process
and finished goods. Even though Material and Inventory are used as synonyms, material usually means raw material
and inventory means raw material along with work in process plus finished goods.
Fig. 1.1 Inventory classification
Raw Material is first subjected to a manufacturing process before it becomes finished goods. Raw material is also
present with work in process and finished goods. It is a continuous process.
Inventory classification
Inventory includes idle resources that have future economic value. It indicates that it may be available in different
forms depending upon the production cycle stage it is in. Classification of inventory is done on this basis and thus,
the different classifications of inventory are as follows:
• Raw materials: Raw materials are input goods intended for combination and/or conversion through the
manufacturing process into semi-finished or finished goods. They change their form and become part of the
finished product.
• Components and parts: Just as raw materials are converted to finished goods in a manufacturing operation,
components and parts are assembled into finished goods in an assembly operation.
• Maintenance, repair and operating inventories (MRO): These include parts, supplies and materials used in
or consumed by routine maintenance and repair of operating equipment, or in support of operations.
• Work-in-process goods: These include goods in the process of manufacturing and only partially completed.
They are usually measured for accounting purposes in between significant conversion phases. In-process
inventories provide the flexibility necessary to deal with variations in demand between different phases of
manufacturing.
• Finished goods: These represent the completed conversion of raw materials into the final product. They are
goods ready for sale and shipment.
• Resale goods: These are goods acquired for resale. Such goods may be purchased by a wholesaler for resale to
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distributors, or by distributors for resale to consumers, etc.
• Capital goods: These are items (such as, equipment) that are not used or consumed during a single operating
period, but have extended useful lives and must be utilized over multiple operating periods. Tax laws require
that such an item be capitalized, and a predetermined percentage of its cost be recognized as an expense, each
operating period, over a predetermined time frame, according to equipment classes.
• Construction materials: These are raw materials and components for construction projects such as a building,
bridge, etc.
• Hard goods/soft goods: What one identifies as hard goods and soft goods will vary depending on the industry
involved. For example, in data processing, hard goods include apparatus such as, computers and terminals,
while soft goods include software, data storage media and the like.
• Fuel and lubricants: Fuel and lubricants are used for the oiling purpose for the equipment used in the process
which again varies with the type of industry.
• Stationery goods: It includes writing material like, paper, pen, ink etc., which are used by the people involved
in the process.
• Primary packing material: Packing material like, plastic, paper etc. are used to pack the finished goods for
sale.
1.3 Meaning of Material Management

Materials management can be defined as "an integrated management approach to planning, acquiring, processing and
distributing production materials from the raw material state to the finished product state." Materials management
is a key business function that is responsible for the coordination of planning, sourcing, purchasing, moving,
storing and controlling materials in an optimum manner, so as to provide pre-determined service to the customer
at a minimum cost.
Materials management has such sub-fields as:

• inventory management
• value analysis
• receiving
• stores and management of the obsolete
• slow moving and non moving materials
Materials management is the branch of logistics that deals with tangible components of a supply chain. It covers the
acquisition of spare parts and replacements, quality control of purchasing and ordering such parts, and the standards
involved in ordering, shipping, and warehousing the said parts. The physical arrangement of materials/spare parts
is called materials management.
Planning and control of the functions supporting the complete cycle (flow) of materials, and the associated flow of
information is called materials management. Materials management is concerned with the control of materials in
such a manner which ensures maximum return on working capital. Materials management is concerned with the
location and purchase of materials needed, their storage and movement. It also arranges to keep an account of them.
It is also responsible for planning their movement through manufacturing processes, store rooms and distribution
channels.
Materials management provides an integrated systems approach to the coordination of the materials activities and the
control of total material costs. The materials management function ranges from receiving the material requisitions
from user department to placement of purchase orders and then, on the other hand, receiving the materials from
vendors and making it available to the users departments.
1.4 Objectives of Materials Management

The fundamental objectives of the materials management function are acquisition of materials and services:
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• of the right quality

• in the right quantity
• at the right time
• from the right source
• at the right time
The key objectives of material management are as follows:

• Buying at the lowest price, consistent with the desired quality and service
• Maintaining a high inventory turnover, by reducing excess storage, carrying costs and inventory losses occurring
due to deteriorations, obsolescence and pilferage
• Maintaining continuity of supply, preventing interruption of the flow of materials and services to users
• Maintaining the specified material quality level and a consistency of quality. This permits efficient and effective
operation
• Developing reliable alternate sources of supply to promote a competitive atmosphere in performance and
pricing
• Minimizing the overall cost of acquisition by improving the efficiency of operations and procedures
• Hiring, developing, motivating and training personnel and providing a reservoir of talent
• Developing and maintaining good supplier relationships in order to create a supplier attitude and desire furnish
the organisation with new ideas, products, and better prices and service
• Achieving a high degree of cooperation and coordination with user departments
• Maintaining good records and controls that provides an audit trail and ensures efficiency and honesty
• Participating in 'Make or Buy' decisions
1.5 Motives of Materials Management

A company may hold the inventory with the various motives as stated below:
Transaction Motive
The company may be required to hold the inventories in order to facilitate the smooth and uninterrupted production
and sales operations. It may not be possible for the company to procure raw material whenever necessary. There
may be a time lag between the demand for the material and its supply. Hence, it is needed to hold the raw material
inventory. Similarly, it may not be possible to produce the goods immediately after they are demanded by the
customers. Hence, it is needed to hold the finished goods inventory. The need to hold work in progress may arise
due to production cycle.
Precautionary Motive
In addition to the requirement to hold the inventories for routine transactions, the company may like to hold them
to guard against the risk of unpredictable changes in demand and supply forces. For example, the supply of raw
material may get delayed due to the factors like strike, transport, disruption, short supply, lengthy processes involved
in import of the raw materials etc.
Hence the company should maintain sufficient level of inventories to take care of such situations. Similarly, the
demand for finished goods may suddenly increase (especially in case of seasonal types of products) and if the
company is unable to supply them, it may indicate gain for the competitions. Hence, the company will like to
maintain sufficient stock of finished goods.
Speculative Motive
The company may like to purchase and stock the inventory in the quantity which is more than needed for production
and sales purpose. This may be with the intention to get the advantages in terms of quantity discounts connected
with bulk purchasing or anticipated price rise.
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1.6 Scope of Material Management
The scope of material management includes the following aspects:
• Material planning
• Cataloguing or coding the materials
• Standardisation
• Scheduling
• Procurement
• Inspection
• Quality control
• Packaging
• Storage
• Inventory control
• Distribution
• Disposal
1.7 Material Planning

Material management involves the process of planning to get the materials. It is the starting point for the whole
material management function. Material planning is a scientific way of determining the requirements starting with
raw materials, consumables, spare parts and all other materials that are required to meet the given production plan
for a certain period. Material planning is derived from overall organisational planning and hence, it is always a sub-
plan of the broad organisational plan. What it does is forecast and initiate the procurement of materials.
Factors affecting Material planning

The factors affecting Material planning are:
• Macro factors: Global factors such as price trends, business cycles, government’s import and export policies
etc are called macro factors. Credit policy of the government is a critical factor as banks follow these guidelines
only while extending financial support to a business entity.
• Micro factors: These are essentially the factors existing within the organisation such as corporate policy
on inventory holding, production plan, investments etc. For any organisation, factors such as lead time of
procurement, acceptable inventory levels, working capital, seasonality, delegation of power are micro factors
1.8 Technique of Planning Materials

Materials Requirement Planning (MRP)
Materials requirement planning considers the annual production plan of the manufacturing concern. Once a firm
determines its annual production plan, the over all material requirement to meet the given production plan is worked
out. It is a detailed analysis encompassing the materials and quantities available for use, materials with quantities
not available and hence, needing procurement, the actual lead time of procurement etc.
It is always possible to have a situation where some parts of an assembly are available and some others are not
available. The Bill of Materials (BOM) is prepared. It quantifies all the materials (components) needed for various
assemblies as per the production plan. BOM is thus a list displaying the code, nomenclature of an item, its unit
and quantity, location of use and also the estimated price of each component. An explosion chart is a series of bills
of materials grouped together in a matrix form so that combining the requirements for different components can
be made. Once the BOM is ready, the same is handed over to the Purchasing wing which initiates the purchasing
activities. MRP, thus, keeps in view the lead time also. Using computers, preparation of BOM through explosion
of lists is quite easy and smooth.
Materials required for any operation are based on the sales forecasts and production plans. Planning and control is
done for the materials taking into account the materials not available for the operation and those in hand or in the
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pipe line. This involves estimating the individual requirements of parts, preparing materials budget, forecasting the
levels of inventories, scheduling the orders and monitoring the performance, in relation to production and sales.
Cataloguing or coding the materials

For easy procurement, storage, retrieval and the distribution of the inventories, it is essential to classify them into
different categories. This classification can be done through codification or cataloguing. Codification or cataloguing
is basically an identification system for each item of the inventory.
There are three broad approaches to developing a suitable identification system. These are:
• Arbitrary approach
• Symbolic approach
• Use of drawing numbers
Arbitrary approach
As and when an item is received by stores in its receiving bay, a running and unique serial number is assigned to it.
This number becomes the code of the item for subsequent use at different stages. It does not help in the scientific
management of inventory. Arbitrary approach is useful only where perhaps items are non-repetitive and the inventory
management need not be scientific.
Symbolic approach
It assigns code in such a manner that the same item number is not allotted to two different materials. The code is
designed such that it can be used to tell many things about an item of material.
The system uses either a numeric codification system or an alphanumeric system. Under the numeric system, a set of
numeric code (length pre-decided) is assigned to each item where different parts of the code describe different aspects
of an item: class, subclass, unique running number of that item, location of the storage suppliers’ code etc.
Example:
2 145 098 344
Class Subclass Running number Location code
Thus, the code of this item shall be a 10 digit code, 2145098344 and it shall always remain so for this item. It
shall then be easy to communicate about this item among the concerned agencies. Similarly, there can be a code
using alpha numeric value like AA223B234 with different alpha and numerical value describing some pre-decided
meaning. It is also called mnemonic system. Since this code has certain logic, it is also called intelligent code and
this system is widely used everywhere.
Use of drawing numbers

Many firms use drawing numbers as codes to identify an item. Since the drawing number for a firm remains unique,
assigning a code on this basis assumes a unique code for that item and hence, confirms the requirement of a unique
identification for the item.
1.9 Process of Codification

• Decide if the firm wants to go for arbitrary system, symbolic system or engineering drawing system
• List the inventory items
• Define the class of items
• Define the sub class under each class
• Depending upon the number of classes, their subclasses and probable number of items under each sub class
decide the length of codes which shall remain fixed for all the inventory items (10 digit, alphanumeric etc.)
• Start assigning codes as per the detailed list of inventory
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An illustrative list of classification of inventories:
Abrasives Bearings Belt and beltings

Bolts, nuts & washers Brooms & brushes Building materials
Cans & containers Chemicals & reagents Cloth, leather & rubber
Electrical Gases Glassware
Oil & lubricants Pipe & pipe fittings Raw materials
Rolls Refractory Stationery
Safety items Tools & tackles Photographic items
Table 1.1 List of classification of inventories
Codification is usually done by a team consisting of representatives drawn from stores, user department and industrial
engineering department. The major responsibility lies with the stores department.
Codification identifies an item. Also it acts as a communicating medium for an item among the different users of
that item in whatever way such as stores, user department, planning department, finance, purchasing etc. As soon
as the item is received in the stores (if the item is a new one), it is codified. Once codified, the same code is used in
the cycle of procurement, throughout and for ever.
1.10 Standardisation
Standardisation means “formulation, publication and implementation of guidelines, rules and specifications for
common and repeated use, aimed at achieving optimum degree of order or uniformity in a given context, discipline,
or field”. Publication means communication of a message, statement, or text through any means such as audio,
video, print, electronically as an e-book or on the web.
Specification means exact statement of the particular needs to be satisfied or essential characteristics that a customer
requires in goods, material, method, process, service, system, or work and which a vendor must deliver. Specifications
are written usually in a manner that enables both parties (and/or an independent certifier) to measure the degree of
conformity
Specifications are divided generally into two main categories:

• Performance specifications: conform to known customer requirements such as keeping a room’s temperature
within a specified range.
• Technical specifications: express the level of performance of the individual units, and are subdivided into the
following:
Individual unit specifications which state boundaries (parameters) of the unit’s performance consisting of a
nominal (desired or mandated) value and tolerance (allowable departure from the nominal value)
Acceptable quality level which states limits that are to be satisfied by most of the units, but a certain
percentage of the units is allowed to exceed those limits, and
Distribution specifications which define an acceptable statistical distribution (in terms of mean deviation
and standard deviation) for each unit, and are used by a producer to monitor its production processes
1.11 Scheduling
Scheduling means “assigning an appropriate number of workers to the jobs during each day of work and determining
when an activity should start or end”. Schedule depends on the following:
• duration
• predecessor activity (or activities)
• predecessor relationships
• resource availability
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• target completion date of the project
1.12 Procurement
Procurement means acquisition. It includes the complete process of obtaining goods and services from preparation
and processing of a requisition to receipt and approval of the invoice for payment. It is also called sourcing.
Procurement involves the following activities:

• purchase planning
• standards determination
• specifications development
• supplier research and selection
• value analysis
• financing
• price negotiation
• making the purchase
• supply contract administration
• inventory control and stores, and
• disposals and other related functions
1.13 Purchasing
Basically, the job of a materials manager is to provide to the user departments, right material at the right time in
right quantity of right quality at right price, from the right source. To meet these objectives, the activities undertaken
include selection of sources of supply, finalisation of the terms of purchase, placement of purchase orders, follow
up, maintenance of relations with vendors, approval of payments to vendors, evaluating, rating and developing
vendors.
Before deciding the quantity to be purchased, the following factors should be taken into consideration:
• Quantity already ordered
• Quantity reserved - It may happen that a particular quantity, though in hand, might have been reserved for a
particular job which is not available for other purposes. In such cases, this quantity is such, as if it is not in
stock
• Funds availability - Amounts which are kept aside for drawing up purchase budget should be considered
Normally, the process of purchasing the materials involves the following stages:
• Requisitioning: At this stage, the purchasing officer should receive an accurate description of the goods or
service required. The requisition form by which a member of staff notifies purchasing officer of a need for goods
or services should be simple, but clear. The more accurate and detailed the requisition form is, the more are the
chances that the purchase will meet the expectations.
• Financial approval: Here, the purchasing officer must be given the approval from a responsible person. It
should be done before the purchasing commitment is made, and the purchasing system should ensure that this
is done at the right time and by the right person.
• Market assessment: The purchasing officer receives an approved requisition and starts market research in this
stage. He should check that the item is not already in stock, that there is a competitive market for the item, if
there is a list of “approved suppliers” for the item, if a lower price can be negotiated, and so on.
• Purchase decision: During purchase decision stage, after the purchasing officer completed the market assessment
and determined the method of purchase, he decides on the supplier or suppliers. To avoid internal customer
complaints or audit reproof, the decision must be well documented to provide clear reasons as to why a particular
supplier has been chosen.
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• Ordering: At the ordering stage, the main instrument purchasing officer works with is an order form. The order
form is an official, numbered document which details the purchase requirements and authorizes the supplier to
deliver the goods or services to the company. Also, it can fulfil other important functions.
• Delivery: At the delivery stage, the purchasing officer controls the method, terms and time of delivery established
while ordering. In case there is a competitive transport market, wise freighting decisions can lead to considerable
cost savings.
• Receipting and accounting: At this stage, the purchasing officer should check whether the quality and quantity
of delivered goods or services are relevant to ones in the purchase order. Usually, suppliers are not paid until
the goods are checked; however, this procedure should be taken up without unnecessary delays to ensure that
payment terms are met.
• Payment: At the payment stage, the purchasing officer makes sure that the payments are made on the dates
they are due, because maintaining good supplier relations is very important. Also, he should control the terms of
payment in case, they include previously negotiated discounts, progress payments or postponement of payment
during warranty period.
1.14 Inspection
Inspection involves critical appraisal involving examination, measurement, testing, gauging, and comparison of
materials or items. An inspection determines if the material or item is in proper quantity and condition, and if it
conforms to the applicable or specified requirements.
Inspection is generally divided into three categories:

• Receiving inspection,
• In-process inspection, and
• Final inspection.
1.15 Quality Control

A subset of the quality assurance (QA) process, it comprises of activities employed in detection and measurement of
the variability in the characteristics of output attributable to the production system, and includes corrective responses.
In quality control, the role of inspection is to verify and validate the variance data.
1.16 Packaging
Packaging includes processes (such as cleaning, drying, and preserving) and materials (such as glass, metal, paper
or paperboard, plastic) employed to contain, handle, protect, and/or transport an article. The role of packaging is
expanding and may include functions such as to attract attention, assist in promotion, provide machine identification
(barcodes, etc.), impart essential or additional information, and help in utilization.
1.17 Storage
Storage means non-transitory, semi-permanent containment, holding or placement of goods or materials, usually
with the intention of retrieving them at a later time. It does not include the interim accumulation of a limited amount
during processing, maintenance, or repair.
1.18 Inventory Control

Inventory control covers aspects such as setting inventory levels, doing various analyses such as ABC, XYZ etc,
fixing economic order quantities (EOQ), setting safety stock levels, lead time analysis and reporting.
1.19 Distribution
Distribution means movement of goods and services from the source through the distribution channel, right up to
the final customer, consumer, or user.
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1.20 Disposal
Disposal means final placement or riddance of wastes, excess, scrap, etc., under proper process and authority with
(unlike in storage) no intention to retrieve. Disposal may be accomplished by abandonment, destruction, internment,
incineration, donation, sale, etc.
1.21 Functions of Material Manager

The functions of a material manager are as under:
• materials planning and control
• purchasing
• management of stores
• inventory control
• use of information technology for efficient material management
1.22 Effects of Over Stocking and Under Stocking

The objective of material is to maintain optimum stock. The principle which should be kept in mind is that there
should not be any over stocking or under stocking of materials, as both these situations involve costs.
Overstocking will result into the following consequences:

• blocking of working capital, resulting in escalating cost of capital investment
• risk of deterioration of quality and obsolescence resulting in the material being unfit for use
• more storage facilities, resulting in higher rental cost
• additional insurance cost
• more material handling and up-keeping
• risk of breakage/pilferage etc.
• price of raw material may go down in future
• in a nut-shell, carrying cost goes up
• however, ordering cost goes down
Understocking will result into the following consequences:

• production hold-ups, resulting into disturbed delivery schedules
• frantic eleventh hour purchases which may result in unfavourable prices and quality
• payment for idle time to workers
• increase in the number of orders which will result in more transportation cost
• in nut shell ordering cost goes up
• however carrying cost goes down
Overstocking or understocking of materials results in losses, hence a manufacturer should go for optimum stock.
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Summary
• The term material refers to all commodities which are consumed in the production process. The materials
which can be consumed in the production process can be basically classified as direct materials and indirect
materials.
• Material is generally called as raw material. Inventory is a name collectively given to raw material; work in
process and finished goods.
• Inventory includes idle resources that have future economic value. It indicates that it may be available in different
forms depending upon the production cycle stage it is in.
• Materials management can be defined as “an integrated management approach to planning, acquiring, processing
and distributing production materials from the raw material state to the finished product state”.
• The fundamental objectives of the materials management function are - acquisition of materials and services:
of the right quality, in the right quantity, at the right time, from the right source, and at the right time.
• A company may hold the inventory with the various motives such as: transaction motive, precautionary motive,
and speculative motive.
• Material planning is a scientific way of determining the requirements starting with raw materials, consumables,
spare parts and all other materials that are required to meet the given production plan for a certain period.
• Materials requirement planning (MRP) considers the annual production plan of the manufacturing concern.
• Codification or cataloguing is basically an identification system for each item of the inventory. There are three
broad approaches to developing a suitable identification system: arbitrary, symbolic, and use of drawing numbers
approach.
• Standardisation means the formulation, publication, and implementation of guidelines, rules, and specifications
for common and repeated use, aimed at achieving optimum degree of order or uniformity in a given context,
discipline, or field.
• Scheduling means assigning an appropriate number of workers to the jobs during each day of work and
determining when an activity should start or end.
References
• Purchasing Process Structure [Online] (Updated on 16th March 2011) Available at <http://www.
taskmanagementsoft.com/solutions/departments/purchasing-management-process.php> [Accessed on 8th April,
2011]
• Materials Management [Online] (Updated on 16th March, 2011) Available at <http://www.productivity.in/
knowledgebase/Material%20Management/Scope%20and%20functons%20of%20materals%20management.
pdf> [Last accessed on 16th March 2011]
• Inventory Management [Online] (Updated on 16th March, 2011). Available at <http://www.google.co.in/url?s
a=t&source=web&cd=9&ved=0CFsQFjAI&url=http%3A%2F%2Fwww.sonoma.edu%2Fusers%2Fa%2Fatk
int%2Fbus316%2FCH161Inv1.ppt&rct=j&q=abc%20analysis%20in%20inventory%20management&ei=F_q
CTZZL051xk9GYgQM&usg=AFQjCNFBT55mNjbTlI5lhJEllb5RM6Oj_A&sig2=dAkAeZ1GtvaJNczCxpJ
Lqg&cad=rja> [Last accessed on 16th March 2011]
Recommended Reading
• Muller, M., 2003. Essentials of Inventory Management. AMACOM
• Piasecki, David J., 2009. Inventory Management Explained: A focus on Forecasting, Lot Sizing, Safety Stock,
and Ordering Systems. 1st ed., Ops publishing.
• Piasecki, Edward A., 1998. Inventory Management and Production Planning and Scheduling. 3rd ed., Wiley.
11/MITSDE
Self Assessment
1. Which of the following is defined as “assigning an appropriate number of workers to the jobs during each day
of work and determining when an activity should start or end”?
a. Procurement
b. Scheduling
c. Planning
d. Disposal
2. ________________provides an integrated systems approach to the coordination of the materials activities and
the control of total material costs.
a. Material management
b. Planning and control
c. Cost management
d. Scheduling
3. Inventory is a name collectively given to raw material; work in process and __________.
a. services
b. equipments
c. resources
d. finished goods
4. Which of the following statement is false?

a. Over stocking or under stocking of materials results in losses, hence a manufacturer should go for optimum
stock.
b. Specifications are written usually in a manner that enables both parties (and/ or an independent certifier) to
measure the degree of conformity.
c. Codification is usually done by a team consisting of representatives drawn from stores, user department and
industrial engineering department
d. The code is designed such that it can be used to tell one thing about an item of material.
5. In quality control, the role of inspection is to verify and validate the ________data.
a. system
b. optimum
c. variance
d. material
6. ________ is first subjected to a manufacturing process before it becomes finished goods.

a. Procurement
b. Planning
c. Raw material
d. Purchasing
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7. What do the idle resources have in an inventory?
a. Future economic value
b. Future purchasing value
c. Future profit value
d. Future manufacturing value
8. The materials which can be consumed in the production process can be basically classified as:
a. raw material and finished material
b. direct material and indirect material
c. minimum material and maximum material
d. spare material and optimum material
9. Which of the following statements is true?

a. In-process inventories provide the flexibility necessary to deal with variations in demand between different
phases of manufacturing.
b. What one identifies as hard goods and soft goods will remain same with every industry.
c. Materials management is the branch of statistics that deals with the tangible components of a supply
chain.
d. Material management is not concerned with the location and purchase of materials needed, their storage
and movement.

10. There are three broad approaches to developing a suitable identification system:
a. arbitrary, symbolic and use of drawing numbers approach
b. arbitrary, random and use of drawing numbers approach
c. arbitrary, supply and use of drawing numbers approach
d. arbitrary, symbolic and use of prime numbers approach
13/MITSDE
Chapter II
Material Cost Management
Aim
• introduce the concept of economic order quantity
• explain the material cost management
• elucidate the various inventory levels
Objectives
• discuss material cost
• recognise the drawbacks of economic order quantity model (EOQ)
• understand the ABC analysis
Learning outcome
• assimilate the XYZ analysis
• learm about AX control
• identify the advantages of ABC analysis
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2.1 Introduction to Material Cost Management
The object of inventory control is to reduce the investment in the inventory without affecting the efficiency in the
area of production and sales. If a sufficient stock of raw material is not available, the production activity is likely
to be interrupted. If sufficient stock of finished goods is not available, it may not be possible for the organisation to
serve the customers properly and they may shift to the competitors. The objective of inventory control is to avoid the
situation of over stocking as well as under stocking. The level of inventories should be maintained at the optimum
level. Excess stock results in higher carrying cost and less stock results in excess ordering cost. In case of a typical
manufacturing type of operation, the activity may consist of conversion of raw material in the form of finished
goods with the help of labour and other services and selling the finished goods in the market to earn the profits.
Though inventory is an idle resource, it is almost essential to keep some inventory in order to promote smooth and
efficient running of business.
For example: Consider the case – an enterprise that does not have any inventory. Clearly, as soon as the enterprise
receives a sales order, it will have to order for raw materials to complete the order. This will keep the customers
waiting. It is quite possible that sales may be lost. Also the enterprise may have to pay high price for some other
reasons. On the other hand, inventory may promote sales by reducing customers waiting time.
It is essential to maintain the inventories in order to enhance the stability of production and employment levels.
Consider the case of seasonal items. Any fluctuation in demand can be met if possible, by either changing that part
of production or with inventories. If the fluctuation is not followed by changing the rate of production, one has to
take into account the following costs.
Cost of increasing production and employment level, involves the following:

• employment and training
• additional staff and service activities
• added shifts
• overtime costs
Cost of decreasing production and employment level, involves the following:

• employee compensation
• other employee costs
• staff, clerical and service activities
• total time costs
The functions of inventories are to:

• protect against unpredictable variations (fluctuations) in demand and supply
• take advantage of the price discounts by bulk purchases
• take the advantage of batches and longer production run
• provide flexibility to allow changes in production plans in view of change in demands, etc.
• facilitate intermittent production
2.2 Material Cost

Material cost is the cost of commodities and materials used by the organization. It can be direct or indirect.
• Direct Material is indicative of material which can be identified with the individual product and which becomes
an integral part of the finished goods. It basically consists of all raw materials, either purchased from outside
or manufactured in-house.
• Indirect Material indicates that material which cannot be identified with the individual product. This material
assists the manufacturing process and does not become an integral part of finished goods. The examples of
indirect material may be consumable stores, cotton waste, oils and lubricants, stationery material, primary
15/MITSDE
packing material etc.
Material cost is categorized as variable cost. The cost increases with the increase in the level of production activity
and vice versa. The heart of inventory analysis resides in the identification of relevant costs. Some of the important
costs that apply to inventory situation are as follows:
• Ordering or set up costs: These are the costs associated with ordering or manufacturing goods through purchasing
or manufacturing and are known as set up costs or cost of ordering. Set up costs are generally assumed to be
independent of the quantity ordered or produced.
• Purchase cost or production cost (Material cost): When large production runs are in process, these results in
reduction of production cost per unit. Often, discounts are offered for the purchase of large quantities. In other
words, often the unit cost of an item depends on the quantity procured or produced.
• Inventory holding cost or carrying cost: The cost associated with carrying or holding the goods in stock are
known as carrying or holding costs. These costs arise due to the storage costs, property taxes on the items in
inventory, interest on the invested capital (interest on value of the inventory items, spillage of the inventory
items, depreciation of the inventory items, transportation and handling of the items in inventory, etc).
• Shortage or stock out costs: The costs that are incurred as a result of running out of stock are known as stock out
or shortage costs. As a result of shortages, sales or goodwill may be lost. If the unfulfilled demand for the items
can be satisfied at a later date (back order case). In this case, the cost of back orders are assumed to vary directly
with the shortage quantity (in rupee value) and the delaying time. However, if the unfulfilled demand is lost
(lost-sales case), in this case, the cost of shortages are assumed to vary directly with the shortage quantity.
Example: For calculating material cost-
The following is the information about a manufacturing unit, M/s Vishal Industries-
Elements of cost Amount per unit

Raw material 80
Direct labour 30
Overheads 60
Total cost 170
Profit 30
Selling Price 200
The following further particulars are available:

• Raw materials are in stock for one month
• Materials are in process for an average of half month
• Finished Goods are in stock for an average of one month
• Credit allowed to customers is two months
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You are requested to prepare a statement showing the material cost needed to manufacture 1, 20,000 units per
annum.
Solution:
Estimates of Raw Material Cost Rs.
Amount of
S. Current Period of No of Units for which working
material cost
No. Assets holding capital required
1 Raw Material 1 Month 10,000 8,00,000
2 Work in Process 0.5 month 5,000 4,00,000
3 Finished Goods 1 Month 10,000 8,00,000
4 Debtors 2 Months 10,000 16,00,000
Total 36,00,000
Working notes
S. No of units for which Amount of
Category Period of holding
No. working capital required Material cost
1 Raw material 1 Month 10,000 8,00,000
2 Work in Process 0.5 Month 5,000 4,00,000
3 Finished Goods 1 Month 10,000 8,00,000
4 Debtors 2 Months 10,000 16,00,000
Total 36,00,000
Cash
Raw Material
Debtors
Work in
Process
Finished
Goods
Fig. 2.1 Process from procurement to realization of money
Note: We have not considered the labour cost and other cost, since it is outside the purview of material cost. From
the above example, it is clear that the cost of raw material is present in raw material stage, work in process stage,
finished good stage and debtors. Raw material is like a life blood of the industry which flows through out the process
from procurement stage to realization money from debtors. The following diagram will illustrate this.
2.3 Economic Order Quantity (EOQ) Models

Economic Order Quantity (EOQ) models are the most basic models of inventory management. EOQ model is
essentially a trade-off between various relevant costs and derive an order quantity and time for placing an order in
such a way that the total costs are minimized.
Economic lot size or economic order quantity model assumptions are:

• The rate of demand for the item is deterministic and is constant D units per annum, independent of time
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• Production rate is infinite, i.e. production is instantaneous

• Shortages are not allowed
• Lead time is zero or constant independent of demand and the quantity ordered
• The entire quantity is delivered as a single package (or production in a single run)
Objective of the EOQ

The prime objective of EO is to minimise the average annual variable cost. Economic Order Quantity (EOQ) indicates
that quantity, which is fixed in such a way that the total variable cost of managing the inventory, can be minimised.
Such cost basically consists of two parts:
• First, ordering cost (which in turn consists of the costs associated with the administrative efforts connected with
preparation of purchase requisitions, purchase enquiries, transportation cost and handling of more number of
bills and receipts)
• Second, carrying cost i.e., the cost of carrying or holding the inventory (which in turn consists of the cost like
godown rent, handling and upkeep expenses, insurance, opportunity cost of capital blocked i.e., interest etc.)
There is a reverse relationship between these two types of costs i.e.,

If the purchase quantity increases, ordering cost may get reduced but the carrying cost increases and vice
versa.
A balance is to be struck between these two factors and it is possible at Economic Order Quantity (EOQ), where
the total variable cost of managing the inventory is the least.
The following is the formula for calculating Economic Order Quantity:

EOQ = √ (2 A O)/C
Where,
Q = Economic Order Quantity
A = Annual Requirement in Units
O = Cost of Placing an Order
C = Cost of Carrying One Unit per Year
Example: A manufacturer uses 4,000 units of a component every year and he buys them entirely from outside
supplier. The order placing and receiving cost is Rs. 100 per order and annual carrying cost is Rs. 10%. Unit cost
of raw material is Rs 200/-. Calculate Economic Order Quantity.
Solution: EOQ = √ (2 A O)/C

= √ (2 x 4,000 x 100)/ 10% of 200
= √ (8, 00,000/20)
= √40,000
= 200 units
Annual Requirement: 4,000

Ordering cost per order: 100
Carrying Cost: 10%
Price per unit: 200
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Lot size No. of orders Ordering cost Carrying cost Total cost
1 2 3 4 5
2=4000/col. 1 3=100xcol.2 4=col.1x100x0.10/2 5=3+4
50 80 8,000 500 8,500
100 40 4,000 1,000 5,000
150 27 2,667 1,500 4,167
200 20 2,000 2,00 4,000
250 16 1,600 2,500 4,100
500 8 800 5,000 5,800
1000 4 400 10,000 10,400
2000 2 200 20,000 20,200
Number of Orders = Annual Requirement/Size of the order

= 4,000/200
= 20
Ordering Cost = Number of Orders x Ordering Cost per order
= 20 x 100
= Rs. 2,000
Carrying Cost = Carrying Cost% x Size of the Order x Price per Unit /2
= 10/100 x 200 x 200/2
= Rs. 2, 000
Total Cost = Ordering Cost + Carrying Cost
= Rs. 2, 000 + Rs. 2, 000
= Rs. 4, 000
It can be observed from the above table that the order size of 200 units proves to be the most economic one, in terms
of minimum total cost. If the purchases are made in any other way, the same may not necessarily result in minimial
total cost. From the above table, we can find that for the order size of 200 units, the total cost is lowest i.e. Rs. 4,
000/- . We can also observe that as the size of the order increases, the number of orders decreases and hence, the
ordering cost decreases but the carrying cost increases. Thus, the ordering cost is inversely proportion to the size
of the order and the carrying cost is directly proportion to the size of the order.
Drawback of EOQ model

In the above modal, various parameters are used such as demand, inventory carrying charges, ordering cost. These
parameters are estimated and though they are assumed to be known, in real life what we have is an estimated value
which may be different than real value for various reasons.
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2.4 Determination of various Inventory Levels

Fixation of various inventory levels facilitates the initiating of proper action in respect of the movement of various
materials in time so that the various materials may be controlled in a proper way. However, the following points
should be remembered.
• Only the fixation of inventory levels does not facilitate the inventory control. There has to be a constant watch
on the actual stock level of various kinds of materials so that proper action can be taken in time.
• The various levels fixed are not fixed on a permanent basis and are subject to revision regularly.
The various levels which can be fixed are as below:

Maximum Level
Minimum Level
Re-order Level
Danger Level
2.4.1 Maximum Level

It indicates the level above which the actual stock should not exceed. If it exceeds, it may involve unnecessary
blocking of funds in inventory. While fixing this level, following factors are considered:
• maximum usage
• lead time
• storage facilities available, cost of storage, and insurance etc..
• prices for the material
• availability of funds
• nature of the material
• government regulations in respect of import of goods
• economic order quantity
2.4.2 Minimum Level

It indicates the level below which the actual stock should not reduce. If it reduces, it may involve the risk of non-
availability of material whenever it is required. While fixing this level, the following factors are considered:
• lead time
• rate of consumption
2.4.3 Re-order Level

It indicates that level of material stock at which it is necessarily to take the steps for procurement of further lots of
material. This is the level falling in between the two extremes of maximum level and minimum level and is fixed in
such a way that the requirements of production are met properly till the new lot of material is received.
2.4.4 Danger Level

This is the level fixed below minimum level. If the stock reaches this level, it indicates the need to take urgent
action in respect of getting supply. At this stage, the company may not be able to make the purchases in a systematic
manner, but may have to make rush purchases which may involve higher costs of purchases.
2.4.5 Calculation of Various Levels

The various levels can be decided by using the following mathematical expressions.
Re-order Level = Maximum Lead Time x Maximum Usage
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Maximum Level = Reorder Level + Reorder Quantity - (Minimum Usage x Minimum Lead Time)
Minimum Level = Reorder Level - (Normal Usage x Normal Lead Time)
Average Level = (Maximum Level + Minimum Level)/2
Danger Level = Normal Usage x Lead-time for emergency purchases
Note: It should be noted that the expression of the reorder quantity in the calculation of maximum level indicates
economic order quantity.
Illustration 1
Normal usage 50 units per week
Minimum usage 20 units per week
Maximum usage 80 units per week
Reorder quality 500 units
Reorder period 5 to 7 weeks
Compute from the above:

1. Re-order level
2. Minimum level
3. Maximum level
4. Average stock level
Solution
Reorder Level = Maximum Lead time x Maximum Usage 7 weeks x 80 units
= 560 units
Minimum Level = Reorder Level – (Normal Usage x Normal Lead-time)
= 500 units – (50 units X 6 weeks)
= 200 units.
Maximum Level = Reorder Level+Reorder Quantity - (Minimum Usage x Minimum Lead time)
= 560 units + 500 units – (20 units x 5 weeks)
= 960 units.
Average Stock Level = (Minimum Level + Maximum Level)/2
= (200 units + 960 units)/2
= 580 units
Illustration 2
Swarupa Industries manufactures a special product ‘Vick’. The following particulars are collected for the year
1986.
• Monthly demand of 'Vick' - 1000 units
• Cost of placing an Order - Rs. 100
• Annual carrying cost per unit - Rs. 15
• Normal Usage 50 units per week
• Minimum Usage 25 units per week
• Maximum Usage 75 units per week
• Re-order period 4 to 6 weeks
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Compute the following:

1. Re-order Quantity
2. Re-order Level
3. Minimum Level
4. Maximum Level
5. Average Stock Level
Solution
Reorder Quantity;
EOQ = √(2 A O)/C
= √(2 X 12,000 X 100)/ 15
= √(24,00,000/15)
= √1,60,000
= 400 units
Reorder Level = Maximum Lead Time x Maximum Usage
= 6 weeks x 75 units
= 450 units
Minimum Level = Reorder Level - (Normal Usage x Normal Lead time)
= 450 units – (50 units x 5 weeks)
= 200 units
Maximum Level = Reorder Level + Reorder Quantity – (Minimum Usage x Minimum Lead-time)
= 450 units + 400 units – (25 units x 4 Weeks)
= 750 units.
Average Stock Level = (Minimum Level + Minimum Level)/2
= (200 units + 750 units)/2
= 475 units
There may be one more way in which the various inventory levels may be fixed and for this determination of the
safety stock (also called as minimum stock or buffer stock) is essential. Safety stock is that level of stock below
which the actual should not be allowed to fall. The safety stock may be calculated as;
Maximum Usage x Maximum Lead-time) - (Normal Usage X Normal Lead-time)
According to this method, the various inventory levels as discussed above may be fixed as below.
• Minimum Level = Safety stock
• Maximum Level = Safety Stock + EOQ
• Reorder Level = Safety Stock + (Normal Usage x Normal Lead-time)
• Average Stock Level = (Minimum Level + Minimum Level)/2
= (Safety Stock + Safety stock + EOQ)/2
Illustration 3
Calculate the various levels from the information given hereunder:
1. Total cost of purchasing relating to the order Rs. 20
2. Number of units to be purchased during the year 5,000
3. Purchase price per unit including transportation costs Rs. 50
4. Annual cost of storage of one unit Rs. 5
• Lead time:
Average ... 10 days
Maximum... 15 days
Minimum... 6 days
Maximum for emergency purchases... 4 days
• Rate of consumption:
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Average... 15 units per day
maximum... 20 units per day
Solution:
Working Notes:
• Calculation of Safety Stock
= (Maximum Usage x Maximum Lead-time) (Normal Usage x Normal Lead-time)
= (20 units x 15 days) – (15 days x 10 days)
= 300 units - 150 units = 150 units
• Calculation of EOQ
EOQ = √(2 A O)/C
= √(2 X 5,000 X 20)/ 5
= √40,000
= 200 units
Reordering Level
= Safety Stock + (Normal Usage x Normal Lead-time)
= 150 units + (15 units X 10 days)
= 150 units + 150 units
= 300 units.
Maximum Level = Safety Stock + EOQ

= 150 units + 200 units
= 350 units
Minimum Level = Safety Stock = 150 units
Danger Level = Normal Usage x Lead-time for emergency purchases

= 15 units x 4 days
= 60 units
Average Stock Level = (EOQ + Safety Stock + Safety Stock)/2

= (200 + 150 + 150)/2
= 250 units
2.5 ABC Analysis

The ABC classification process is “an analysis of a range of objects, such as finished products, items lying in inventory
or customers into three categories”. This method usually categorizes inventory into three classes with each class
having a different management control associated.
• A - Outstandingly important
• B - of average importance
• C - Relatively unimportant as a basis for a control scheme
Each category can and sometimes should be handled in a different way, with more attention being devoted to category
A, less to B and still less to C.
Popularly known as the '80/20' rule, ABC concept is applied to inventory management as rule-of-thumb. It says that
“about 80% of the Rupee value, consumption wise, of an inventory remains in about 20% of the items”. This rule
is frequently used by inventory managers to put their efforts where the benefits are most, in terms of cost reduction
as well as maintaining a smooth availability of stock.
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The ABC concept is derived from the Pareto’s 80/20 rule curve. It is also known as the 80-20 concept. Here, Rupee
value of each individual inventory item is calculated on annual consumption basis. It is a determination of the relative
ratios between the number of items and the value of the items consumed on a repetitive basis.
‘A’ class items are closely monitored because of the value involved (70-80%); High value (A), Low value (C) and
intermediary value (B). ABC Analysis is the basis for material management processes and helps define how stock
is managed. It can form the basis of various activity including leading plans on alternative stocking arrangements
(consignment stock), reorder calculations and can help determine at what intervals, inventory checks are carried out
(for example A class items may be required to be checked more frequently than C class stores.
The ABC classification system is grouping of items according to annual issue value, (in terms of money), in an
attempt to identify the small number of items that will account for most of the issue value and that are the most
important ones to control for effective inventory management. The emphasis is on putting effort where it will have
the effect is most.
All the items of inventories are put in three categories, as mentioned below:
• A Items: These Items are seen to be of high consumption volume. ‘A’ items usually include 10-20% of all
inventory items, and account for 50-60% of the total Rupee consumption volume
• B Items: ‘B’ items are those that are 30-40% of all inventory items, and account for 30-40% of the total
Rupee consumption volume of the inventory. These are important, but not critical, and don’t pose sourcing
difficulties
• C Items: ‘C’ items account for 40-50% of all inventory items, but only 5-10% of the total
ABC classifications allow the inventory manager to assign priorities for inventory control. Strict control needs to
be kept on A and B items, with preferably low safety stock level. Taking a lenient view, the C class items can be
maintained with looser control and with high safety stock level.
The ABC concept puts emphasis on the fact that every item of inventory is critical and has the potential of affecting,
adversely, production, or sales to a customer or operations. The categorization helps in better control on A and B
items. ABC classifications can be used to design cycle counting schemes. For example, A items may be counted 3
times per year, B items 1 to 2 times, and C items only once, or not at all.
Suggested policy guidelines for A , B & C classes of items are given below:
A items (High Cons. Val) B items (Moderate cons. Val.) C item (Low cons. Val)
• Very strict cons. Control • Moderate control • Loose control
• No or very less safety stock • Low safety stock • High safety stock
• Phased delivery (Weekly) • Once in three months • Once in 6 months
• Weekly control report • Monthly control report • Quarterly report
• Maximum follow up • Periodic follow up • Exceptional
• As many sources as possible • Two or more reliable • Two reliable
• Accurate forecasts • Estimates on past data • Rough estimate
• Central purchasing/storage • Combination on past data • Decentralised
• Max. efforts to control LT • Combination purchasing • Min. clerical efforts
• To be handled by Sr. officers • Moderate • Can be delegated
• Middle level
ABC analysis assumes the principle of “Vital Few Trivial Many” while considering the inventory structure of any
organisation and is popularly known as “Always Better Control”. It is an analytical method of inventory control
which aims at concentrating efforts in those areas where attention is required most. It is usually observed that only
a few numbers of items of inventory prove to be more important in terms of amount of investment in inventory or
value of consumption, where as a very large number of items of inventory account for a very meagre amount of
investment in inventory or value of consumption. ABC analysis classifies the various inventory items according to
24/MITSDE
their importance in terms of amount:
• ‘A’ class consists of only a small percentage of a total number of items handled, but is most important in terms
of amount
• ‘B’ Class items include relatively less important items.
• ‘C’ Class items consist of a very large number of items which are less important.
The importance of the various items may be decided on the basis of following factors:
• amount of investment in inventory
• value of material consumption
• critical nature of inventory items
An example of ABC Analysis is given below.
Category No of items Percentage to total number Value in Rs. Percentage to total value
A 150 1.29% 100000 76.92%
B 1500 12.88% 20000 15.38%
C 10000 85.84% 10000 7.69%
Total 11650 100.00% 130000 100.00%
From the above example we can find that the 'A' category items are less in number i.e. 1.29% to total numbers but,
the most important thing is value and they account for 76.92% of the total value. On the other hand, ‘C’ category
items are very high in number since they account for 85.84% to total numbers but, in terms of value they are least
important since they account for 7.69% of the total value. The Material Manager should concentrate on 'A' category
items.
Advantages of ABC Analysis are as under:
• A close and strict control is facilitated on the most important items which constitute major portion of overall
inventory valuation or overall material consumption and due to this the costs associated with inventions may
be reduced.
• The investment in inventory can be regulated in a proper manner and optimum utilization of the available funds
can be assured.
• A strict control on inventory items in this manner helps in maintaining a high inventory turnover ratio. However,
it should be noted that the success of ABC analysis depends mainly upon correct categorisation of inventory
items and hence, should be handled by only experienced and trained personnel.
2.6 XYZ Analysis

XYZ analysis is one of the basic supply chain techniques, often used to determine the inventory valuation inside
a store. It’s also strategic as it intends to enable the Inventory manager in exercising maximum control over the
highest stocked item, in terms of stock value.
This method usually categorizes inventory into three bands with each band having a different management control
associated. Although different criteria may be applied to each category the typical method of scoring an inventory
item is that of annual stock value of said item (Quantity in stock X Price per unit) with the result then ranked and
then scored (X, Y or Z).
Bandings may be specific to the industry but typically follow a 70%, 90%, 100% banding, in that X class items
represent 70% of the stock value (although they may account for 20% number wise), Y class items fall between 70%
and 90% of the annual stock value with Z class the remaining. In practical terms the complex high cost materials
typically fall into the X class items, with the consumable, low cost (and typically fast moving) classed as Z class.
Not all stock is equally valuable and therefore doesn’t require the same management focus. The results of the XYZ
analysis provide information that helps evaluate how each inventory part should be monitored and controlled. X
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class items which are critically important and require close monitoring and tight control – while this may account
for large value these will typically comprise a small percentage of the overall inventory count. Y class is of lower
criticality requiring standard controls and periodic reviews of usage. Z class requires the least controls.
Classification of inventory in terms of XYZ is also quite strategic as it can form the basis of various activity
including leading plans on alternative stocking arrangements (consignment stock), reorder calculations and can help
determine at what intervals inventory checks are carried out. For example X class items may require to be checked
more frequently than Z class stores.
The main difference between the ABC Analysis and XYZ Analysis is that in case of ABC Analysis, the materials are
classified on the basis of value of materials consumed where as in case of XYZ Analysis; the materials are classified
on the basis of value of materials held in the stock.
Inventory plays an important role for any organisation as it blocks the working capital which otherwise would have
earned the organisation some money. While the need for having inventory can’t be denied for any running plant /
machinery, its availability in controlled measures too is highly desirable. Control techniques such as ABC and XYZ
analyses try to ensure the maximum control of materials.
AX control
One of the ways to have still better (tight) control over the inventory with still less commitment of resources is by
determining the AX category of items in a given inventory. Once ABC and XYZ analyses have been done and a
list of A and X classes of items is drawn then AX category is a combination of the two categories. Going by the
definition of A and X separately, AX category of items, normally, display a high consumption (A) as well as a high
stock value (X). Essentially, these items are high value, in terms of overall procurement cost.
Obviously, the measures that need to be taken to keep AX inventory under control is similar to that of A or X items
that are:
• stock less number at any given time
• have tight consumption control
• more sources so that supply doesn’t become a constraint when needed etc.
Based on the ABC and XYZ analysis there is another control mechanism, popularly known as AX control. Materials
falling under A category under ABC analysis and X category under XYZ analysis are included in AX category and
maximum control is exercised on these items.
The combination of ABC analysis and XYZ analysis will give the following alternatives.
X Y Z
A AX AY AZ
B BX BY BZ
C CX CY CZ
AX category the most important items of materials and CZ category the least important category.
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Summary
• The object of inventory control is to reduce the investment in the inventory without affecting the efficiency in
the area of production and sales.
• It is essential to maintain the inventories in order to enhance stability of production and employment levels.
• Cost of increasing production and employment level, involves: employment and training, additional staff and
service activities, added shifts, and overtime costs.
• Cost of decreasing production and employment level, involves: employee compensation, other employee costs,
staff, clerical and service activities, and total time costs.
• Material Cost is the “cost of commodities and materials used by the organization”. It can be direct or indirect.
• Direct Material indicates that material which can be identified with the individual product and which becomes
an integral part of the finished goods.
• Indirect Material indicates that material which cannot be identified with the individual product.
• Ordering or set up costs: These are the costs associated with ordering or manufacturing goods through purchasing
or manufacturing.
• Purchase cost or production cost (Material Cost): When large production runs are in process, these results in
reduction of production cost per unit.
• The cost associated with carrying or holding the goods in stock are known as carrying or holding costs.
• The costs that are incurred as a result of running out of stock are known as stock out or shortage costs.
• Economic Order Quantity (EOQ) models are the most basic models of inventory management. EOQ model is
essentially a trade-off between various relevant costs and derive an order quantity and time for placing an order
in such a way that the total costs are minimized.
• Formula for calculating Economic Order Quantity can be given as - EOQ = √ (2 A O)/C
• Various inventory levels are: maximum, minimum, re-order and danger level.
• The ABC classification process is “an analysis of a range of objects such as, finished products, items lying in
inventory or customers into three categories”.
• XYZ analysis is one of the basic supply chain techniques, often used to determine the inventory valuation
inside a store.
References
• Deepak, 2008. ABC analysis [Online] (Updated 18th March, 2011) Available at <http://www.slideshare.net/
Deepakpati/abc-analysis>. [Accessed on 18th March 2011]
• Inventory Control Models [Online] (Updated 18th March, 2011). Available at <http://www.foundationcoalition.
org/resources/ie/EOQ/EOQ.ppt>. [Accessed on 18th March 2011]
Recommended Reading
• Frazelle, E., 2001. World-Class Warehousing and Material Handling. 1st ed., McGraw-Hill.
• Richards, G., 2011. Warehouse Management: A Complete Guide to Improving Efficiency and Minimizing Costs
in the Modern Warehouse. Kogan Page
• Emmett, S., 2005. Excellence in Warehouse Management: How to Minimise Costs and Maximise Value.
Wiley
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Self Assessment
1. _________material indicates that material which cannot be identified with the individual product.
a. Inventory
b. Direct
c. Indirect
d. Costly
2. The heart of _________analysis resides in the identification of relevant costs.

a. product
b. finished goods
c. raw material
d. inventory
3. The ABC concept is derived from which of the following?

a. Pareto’s 20/80 rule curve
b. Pareto’s 40/20 rule curve
c. Pareto’s 40/80 rule curve
d. Pareto’s 80/20 rule curve
4. What is material cost categorized into?

a. Variable Cost
b. Fixed cost
c. Explicit cost
d. Implicit cost
5. Which of the following statements is false?

a. Inventory plays an important role for any organisation as it blocks the working capital which otherwise
would have earned the organisation some money.
b. All the stock is equally valuable and therefore doesn’t require the same management focus.
c. Safety stock is that level of stock below which the actual should not be allowed to fall.
d. The cost increases with the increase in the level of production activity and vice versa.

a. Inventory is an profitable resource, it is almost essential to keep some inventory in order to promote smooth
and efficient running of business.
b. The objective of inventory control is to avoid the situation of over stocking as well as under stocking.
c. It is not essential maintain the inventories in order to enhance stability of production and employment
levels.
d. The level of inventories should be maintained at the minimum level.
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7. _______Analysis is the basis for material management processes and helps define how stock is managed
a. Profit
b. ABC
c. XYZ
d. Inventory
8. _______costs are generally assumed to be independent of the quantity ordered or produced

a. Ordering
b. Purchasing
c. Carrying
d. Set-up
9. Which of the following is that level of stock below which the actual should not be allowed to fall?
a. Safety
b. Optimum
c. Required
d. Purchase
10. Which of the following is the correct formula for calculating economic order quantity?
a. EOQ = √ (3 A O)/C
b. EOQ = √ (4 A O)/C
c. EOQ = √ (2 C O)/A
d. EOQ = √ (2 A O)/C
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Chapter III
Inventory Models
Aim
• introduce to the concept inventory models
• explain the model of accepting and rejecting discounts on purchases
• elucidate the advantages and disadvantages of the inventory models
Objectives
• discuss concept of material requirement planning (MRP)
• recognise the inputs and outputs of material requirement planning (MRP)
• understand the fixed order and fixed interval system
Learning outcome
At the end of this chapter, the students will be able to:
• understand the concept of inventory turnover
• enlist the benefits of material requirement planning (MRP)
• know the applicability of material requirement planning system
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3.1 Introduction to Inventory Models
Material management is a day to day function. Various decisions regarding right size of the order, right price have to
be taken on an on going basis. These decisions are repetitive in nature. They involve a lot of calculations. Therefore,
it is advisable for the industries to develop certain models especially using information technology. These models
can take care of calculation part and give enough time to the material managers to take the decision. The models
will act as an aid to the managers to compare various offers, discounts prices etc.
Inventory model is “a mathematical equation or formula that helps a firm in determining the economic order quantity,
and the frequency of ordering, to keep goods or services flowing to the customer without interruption or delay”.
3.2 Models for Accepting/Rejecting Discounts on Purchases

Many a times the suppliers of raw material come with an offer of discount on the catalogue price if a certain minimum
quantity is ordered. The manufacturers may be tempted to accept the order thinking that they will make profit by
availing the discount. Accepting or rejecting such decisions should not be impulsive decisions of the purchase
department. They should be conscious decisions based on calculations and quantification of benefits.
If a manufacturer orders a quantity which is more than the economic order quantity (EOQ) the following two things
will happen:
• Reduction in cost due to:
discount on the price of the raw material
reduction in ordering cost, because the number of orders goes down
• Increase in Carrying cost:
If the reduction in cost is more than the increase in carrying cost then only a manufacturer should accept
the discount offer. Other wise he should reject the offer.
If A > B, accept the discount offer.

If A < B, reject the discount offer.
We can develop a model using excel spread sheet which will help us in taking a decision. We have to just feed the
original data. Rest of the calculations and comparisons are done by the computer.
The following is the model developed in excel spread sheet. Those have working knowledge of Excel can easily
understand this format and formulae used.
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Row No.\Column Name A B C

1 Accept/reject a discount model
2 A) Basic information
3 1 Annual requirement units 20,000
4 2 Ordering cost per order 2,000
5 3 Carrying cost 20%
6 4 Price per unit 100
7
8 5 Discount quantity units 5,000
9 6 Discount rate 1%
10
11 B) If EOQ model followed
12 1 EOQ units -SQRT((2*C3*C4)/(C5*C6))
13 2 No. of orders -C3/C12
14 3 No. of orders rounded off -CEILING(C13,1)
15 4 Ordering cost -C4*C14
16 5 Carrying cost -C12/2*C5*C6
17 6 Material cost -C3*C6
18 7 Total Cost in Rupees -C15+C16+C17
19
20 C) If discount offer is accepted
21 1 Discount quantity -C8
22 2 No. of orders -C3/C21
23 3 No. of orders rounded off -CEILING(C22,1)
24 4 Ordering cost -C4*C23
25 5 Carrying cost -C21/2*C5*C6
26 6 Material cost -C3*C6*(1-C9)
27 7 Total cost rupees -C24+C25+C26
28
29 D) Benefit of discount offer =C18-C27
30 E) Decision =IF(C29>0, “Accept”,” Reject”)
Table 3.1 Model developed for accepting/rejecting discounts on purchases in excel spread sheet
Illustration 1
A B C
Accept/reject a discount model
A) Basic information
1 Annual requirement units 20,000
2 Ordering cost per order 2,000
3 Carrying cost 20%
4 Price per unit 100
5 Discount quantity units 5,000
6 Discount rate 1%
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B) If EOQ model followed
1 EOQ units 2,000
2 No. of orders 10
3 No. of orders rounded off 10
4 Ordering cost 20,000
5 Carrying cost 20,000
6 Material cost 2,000,000
7 Total Cost Rupee 2,040,000
C) If discount offer is accepted
1 Discount quantity 5000
2 No. of orders 4
7 Total cost rupees 2,038,000
D) Benefit of discount offer 2000
E) Decision Accept
Illustration 2
A B C
Accept/reject a discount model
1 Annual requirement units 10,000
2 Ordering cost per order 1,000
3 Carrying cost 10%
5 Discount quantity units 4,000

6 Discount rate 1%

1 EOQ units 1,000
2 No. of orders 10
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7 Total Cost Rupee 2,020,000
C) If discount offer is accepted

1 Discount quantity 4000
2 No. of orders 3
7 Total cost rupees 2,023,000
D) Benefit of discount offer -3000

E) Decision Reject
Illustration 3
The Purchase Department of the organisation has received an offer of quantity discounts on its orders of materials
as under:
Price Per Ton Order Size in Tons

1,200 Less than 500
1,180 500 and less than 1000
1,160 1000 and less than 2000
1,140 2000 and less than 3000
1,120 3000 and above
The annual requirement for the material is 5000 tons. The delivery cost per order is Rs.1, 200 and the stock holding
cost is estimated at 20% of material cost per annum. You are required to advice the Purchase department the most
economic purchase level.
Solution :
Lot Price per Purchase No. of or-
Ordering cost Carrying cost Total cost
Size ton price ders
1 2 3 4 5 6 7
4- 5000/
3- 5000Xcol.2 5-1200Xcol.4 6-col.3X20/2 7-col.3+col.5+col.6
col.1
100 1,200 6,000,000 50 60,000 12,000 6,072,000
250 1,200 6,000,000 20 24,000 30,000 6,054,000
500 1,180 5,900,000 10 12,000 59,000 5,971,000
625 1,160 5,900,000 8 9,600 73,750 5,983,350
1000 1,160 5,800,000 5 6,000 116,000 5,922,000
1250 1,160 5,800,000 4 4,800 145,000 5,949,800
2500 1,120 5,600,000 2 2,400 280,000 5,882,400
5000 1,100 5,500,000 1 1,200 550,000 6,051,200
Observations from the above table:

• As the lot size increases the number of order decreases, hence the ordering cost also decreases.
• As the lot size increases the carrying cost increases.
• As the lot size increases the material cost decreases due to discount for higher quantity.
• A lot of size of 500 units is the economic order quantity (EOQ) since the total cost is lowest at this level.
• Even though the discount is highest for an order of 2500 units, this is not economical because, the benefit of
discount plus reduction in ordering cost is less than increase in carrying cost.
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3.3 Fixed Order vs. Fixed Interval System
There are two basic systems of managing or controlling inventory under the independent demand pattern:
• Cyclical ordering or Fixed period system (Time based)
• Order point or Fixed order quantity system (Quantity based)
3.3.1 Cyclical Ordering or Fixed Period System (Time Based)

• Fixed period based systems (also called cyclical systems), are designed so that each inventory item is reviewed
and reorders are placed after a predetermined time interval (i.e. every two weeks, every thirty days, etc.).
• Orders are placed for each item equal to the difference between current inventory level and a predetermined
maximum. In cyclical systems, time between reorders is constant, but reorder quantity is variable.
• Predetermined maximums are set with a consideration of order lead time.
• It involves scheduled periodic reviews of the stock level of all inventory items. This is given below in detail.
Fixed schedule (calendar) for reviewing a group of items is drawn, fixed Desired Inventory Level (DIL) of each
item or group of items is calculated. In case where stock level of an item is insufficient to sustain the production
operation until the next scheduled review, order is placed to replenish the stock to DIL, maintenance of perpetual
inventory records.
Procedure -
• First, all the inventory items are grouped in certain feasible categories or classes of items such as pipes & pipe
fittings, raw materials, chemicals and reagents, oil and lubricants etc.
• Now, a calendar is drawn for all the classes so that depending upon the number of classes each class is reviewed
for replenishment during certain specified time frame.
• The DIL for each group or individual item is fixed.
• DIL = (Review Period + Lead Time + Safety Stock) x Periodical Demand
Illustration
Review Period = 30 days
Lead Time = 15 days
Safety Stock = 10 days
Daily Demand = 100 units
Desired inventory level (DIL) = (30 +15 +10) x 100 = 5,500
If the actual quantity on hand is 1,400 on the date of reorder, the reorder quantity will be 5,500- 1,400 = 4,100.
Depending upon the review period, a class of items is reviewed with reference to its stock position, production plan,
any dues in quantity against any previous order.
During review and based on the lead time, if the present stock of an item or group of items is not expected to last
the next production plan then action for replenishment is taken by raising the material procurement requisition.
The order quantity = (DIL- (Present stock + dues in)
This system is suitable for the following:

• for materials whose purchases can be planned months in advance
• for materials which exhibit an irregular or seasonal usage pattern
• for items with volatile prices
• for group of items purchased from and shipped together by one supplier
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Disadvantages of the system are as under:

• compels periodic reviews of all items
• not effective to combat stock out situations
• actual ordering quantities may deviate from optimum quantity
• tends to peak the purchasing work load around the review dates
• there is no automatic trigger for reorder before the review time in the event of increased usage, which generally
leads to increased inventory levels as a means of stock out prevention
• system does not permit effective use of economic order quantities
Illustration of disadvantages of fixed period
Change in Change in Change in Change in

annual quantity unit price ordering cost carrying cost
1 Annual requirement units 20,000 12,000 20,000 20,000 20,000
2 Ordering cost per order 2,000 2,000 2,000 1,000 2,000
3 Carrying cost 20% 20% 20% 20% 10%
4 Price per unit 100 100 200 100 100

1 EOQ units 2,000 1,549 1,414 1,414 2,828
2 No. of orders 10 8 14 14 7
3 No. of orders rounded off 10 8 15 15 8
4 Ordering cost 20,000 16,000 30,000 15,000 16,000
5 Carrying cost 20,000 15,492 28,284 14,142 14,142
6 Material cost 2,000,000 1,200,000 4,000,000 2,000,000 2,000,000
7 Total cost rupees 2,040,000 1,231,492 4,058,284 2,029,142 2,030,142
C) If fixed period is
followed
1 Review period days 30 30 30 30 30
2 Lead period days 15 15 15 15 15
3 Safety stock days 10 10 10 10 10
4 Daily demand 67 40 67 67 67
5 DIL 3,667 2,200 3,667 3,667 3,667
9 Ordering cost 24,000 24,000 24,000 12,000 24,000
10 Carrying cost 36,667 22,000 73,333 36,667 18,333
11 Material cost 2,000,000 1,200,000 4,000,000 2,000,000 2,000,000
D) Benefit/loss due to fixed

-20,667 -14,508 -39,049 -19,525 -12,191
period
The above illustration shows that if a fixed period system is followed, there will be loss compared to EOQ model.
Order point or Fixed order quantity system (Quantity based)

Order point system / fixed order quantity system of inventory control is based on the order point and order quantity
factors rather than on the time factor. The inventory policy is drawn after defining the following:
• fixed order point / re-order level (ROL) for each item
• fixed maximum, minimum levels for each item
• fixed quantity to be ordered often called Min-Max systems; these involve both a maximum inventory level and
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a minimum at which reorders are generated
Basically, units of an item are issued until the level of that inventory reaches the predefined reorder point. An order
is then triggered for a predetermined quantity (usually a calculated economic order quantity). In this system, the
order quantity is constant and the time between orders is variable.
The different inventory points (Levels) of stock for an item are:

• Maximum level (Max.), predetermined
• Minimum Level (Safety Stock, SS), predetermined
• Lead time (LT), predetermined
• Monthly demand = D (often based on Moving average method)
• MaxL= (Review period + LT + SS) x D
• Reorder level (ROL) = (LT + SS) x D
• Order Quantity (OQ) = Max – (Present stock + Pipeline dues)
Process: In course of consumption of an inventory item in the form of issue from stores to the users, the stock level
of the item starts depleting through its usage rate D.
As per the above definition, the stock goes up to the maximum level in the first replenishment and then, because of
steady consumption, comes gradually down. In that process, again it touches the Reorder Level (ROL). As soon as
the stock level touches the ROL, fresh replenishment action is initiated. It is presumed that the next lot shall arrive
by the time the present depleting stock touches the safety stock, keeping a stable lead time and a stable usage rate,
D.
Advantages of Fixed order quantity system:

• Each item is procured in the most economical quantity
• An item is attended to only when it needs attention i.e. when its stock has reached the ROL
• Control can be exercised on inventory with reference to maximum & minimum levels.
• Applicability of Order Point system: Item must have a reasonable stable usage
• Lead time should not have radical variation
• Supplier should be able to accept irregularly timed and unscheduled orders
Limitations of the Fixed order quantity system:

• needs continuous monitoring of stock level of each item
• cumbersome to operate for items with unstable usage and lead time
• perpetual inventory records are required
Illustration to highlight disadvantages of the fixed order system
Change in
Change in Change in Change in
A) Basic information annual
unit price ordering cost carrying cost
quantity
1 Annual requirement units 20,000 12,000 20,000 20,000 20,000
2 Ordering cost per order 2,000 2,000 2,000 1,000 2,000
3 Carrying cost 20% 20% 20% 20% 10%
4 Price per unit 100 100 200 100 100
1 EOQ units 2,000 1,549 1,414 1,414 2,828
2 No. of orders 10 8 14 14 7
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4 Ordering cost 20,000 16,000 30,000 15,000 16,000

5 Carrying cost 20,000 15,492 28,284 14,142 14,142
6 Material cost 2,000,000 1,200,000 4,000,000 2,000,000 2,000,000
C) If fixed order is
followed
1 Fixed order quantity 1,000 1,000 1,000 1,000 1,000
2 No. of orders 20 12 20 20 20
3 No of orders rounded off 20 12 20 20 20
4 Ordering cost 40,000 24,000 40,000 20,000 40,000
5 Carrying cost 10,000 10,000 20,000 10,000 5,000
6 Material cost 2,00,000 1,200,000 4,000,000 2,000,000 2,000,000
D) Benefit/loss due to
-10,000 -2,508 -1716 -858 -14,858
fixed order
3.4 Material Requirement Planning (MRP)

Dependent demand occurs when the need for parts, supplies, or materials is dependent upon a predetermined usage
or production schedule. In such cases, a description and quantity of components needed and the exact date of each
need is defined by a production schedule. Required delivery dates for each component will then be offset by lead
time, and orders will be placed accordingly.
Example: If a pen manufacturing company plans to produce 1000 pens in a period, it will need 1000 nibs, 1000
caps, etc., and will need them at the rate they will be installed in the finished pens. Such needs, with consideration
for lead time, are considered in a dependent demand planned order schedule.
Material Requirement Planning is one example of a system specifically designed to manage dependent demand
reorders. Material Requirement Planning (MRP) happens to be the best model of dependent demand pattern of
Inventory. Under it, the requirement of an item is predetermined as it depends upon the actual need of it, triggered
by certain production schedule. Obviously, MRP has two main characteristics, the known requirement and the
known period of requirement (time).
Materials Requirements Planning (MRP) is a set of techniques that takes the master production schedule and other
information from inventory records and product structure records as inputs to determine the requirements and
schedule of timing for each item.
Based on a master production schedule, a material requirements planning system performs the following
functions:
• creates schedules identifying the specific parts and materials required to produce end items
• determines exact numbers needed
• determines the dates when orders for those materials should be released, based on lead times
MRP does not need carrying of any inventory ahead of requirement. It starts with the finalisation of the production
plan in a firm. The production plan then is used by the materials management professionals to explode the 'Bill of
Material' which is a complete detailing of the materials needed including their various components. It is exploded
for the number of units to be produced, to obtain that product’s exact requirement.
Since a given common part is used in many items, sub-assemblies etc, total requirement of that part is summed up
to draw a consolidated requirement. Since this exercise is done for a great number of materials, computers become
very useful for the purpose. After the bill of material is finalised, its taken over by the materials professionals of the
firm who check the availability of any item. A detailed action plan indicating the materials, quantity to be procured
and most importantly the time all of these are required at is prepared. Accordingly, the orders are placed and the
suppliers are asked to match the given delivery period.
In practice, under this system, the production material requirements are calculated on weekly basis. It then generates
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requisitions for each material to be delivered in the required quantity a given number of days prior to the start of
manufacturing operation. Obviously, it puts more pressure on purchasing and production planning rather than on
maintenance of inventory. In MRP system, master production schedule which is updated periodically is the force
that directly initiates and drives subsequent activities of the purchasing and manufacturing functions.
3.4.1 Applicability of the MRP System

• It is best suited where production is not done on a continuous basis.
• It is ideally suited for the job shop operations environment.
• It is ideally suited where the demand is directly dependent on the production of other specific inventory items
or finished products.
• It is used where the demand of the individual components are dependent on the requirement of the main
product.
• It can be used where the flexibility is possible in placement of orders or delivery releases is to be done on short term basis.
3.4.2 Inputs for MRP

MRP process is triggered by the Master Production Schedule (MPS) which indicates the production volume of
finished products on weekly basis. MPS is the primary input. Therefore, for a successful run of the MRP, MPS must
have a time schedule that is greater than the total lead time of the finished product.
Bill of Materials (BOM) which is a detailed item wise requirement document is the second input for MPR. It
may contain multistage type of products that may require several stages of a number of components to be fitted or
converted into leading to the making of the final or finished product.
Inventory Record File (IRF) is the third input for MRP. It contains the status of an inventory item. It indicates
the current stock position, the past timing and sizes of all orders, including the open orders for the item, the lead
time for each item. IRF basically happens to be the past experience and serves as a good reference point for planning for
the future MRP.
3.4.3 MRP Process

The MRP process involves the following steps:
• Determine the gross requirements for a particular item.
• Determine the net requirements and when orders will be released for fabrication or subassembly.
• Net Requirements = Total Requirements – Available Inventory.
• Net Requirements = (Gross Requirements + Allocations) – (On Hand) + Scheduled Receipts.
• Develop a master production schedule for the end item (this is the output of the aggregate / production
planning).
• MPS is adjusted accordingly .
• Create schedules identifying the specific parts and materials required to produce the end items. The bill of
materials will be useful here.
• Determine the exact numbers needed.
• Determine the dates when orders for those materials should be released, based on lead times.
3.4.4 Outputs of MRP

The basic outputs of the MRP system are the planned orders from the planned order release row of the MRP matrix
which details the timing and the quantity of subassemblies, parts and raw materials used to plan purchasing and
manufacturing actions. Specifically, these outputs include:
• purchase orders - sent to outside suppliers
• work orders - to be released to the shop floor for in-house production
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• action notices or rescheduling notices - issued for items that are no longer needed as soon as planned or for
quantities that may have changed
3.4.5 Benefits of MRP

The MRP is a framework for providing useful information for decision makers. The key to realizing the benefits
from any MRP system is the ability of the inventory planner to use the information well. The specific benefits of
MRP include the following:
• increased customer service and satisfaction
• improved utilization of facilities and personnel
• better inventory planning and scheduling
• fast response to market changes and shifts
• reduced inventory levels without reduced customer service
The MRP is also a very powerful tool since it takes into consideration changes in certain assumptions especially
under uncertain conditions, especially when the inputs to the MRP system change because of the following realities
in the production area:
• delays in scheduled receipts
• changes in planned order sizes because of capacity constraints
• changes in gross requirements which dictate changes in lot sizes at subcomponent levels
Unavailability of raw materials for one sub-component which negates the need for a fellow sub-component as both
must be ready for the parent production. Utilization of same parts at different levels indicating the need to restructure
the bill of materials and presence of price discounts or some other features which makes it advisable to purchase
more than the anticipated need. Thus MRP can be summarised as being a system which is solely dependent upon
three concepts:
• dependent demand
• inventory / open order netting, and
• time phasing on the basis of requirement period and the lead time for each item
MRP system, thus, generates a complete set of planned orders for all manufactured parts and purchased materials
based on information inputs. Accurate forecast and a timely lead time happen to be the main determinant of its
success in a run.
3.5 Inventory Turnover

Inventory turnover indicates the ratio of materials consumed to the average inventory held. It is calculated as
below:
Inventory turnover = Value of material consumed/Average inventory held

where, Value of material consumed can be calculated as;
Opening Stock + Purchases - Closing Stock
Average inventory held can be calculated as;

(Opening Stock + Closing Stock)/2
Inventory turnover can be indicated in terms of number of days in which average inventory is consumed. It can be
done by dividing 365 days (a year) by inventory turnover ratio.
Illustration 1
From the following data for the year ended 31st March, 2010, calculate the inventory turnover ratio.
Opening Stock 10,000
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Purchases during the year 50,000
Closing Stock 12,000
Value of material consumed = Opening Stock + Purchases - Closing Stock.

= 10,000 + 50,000 – 12,000
= 48,000
Average inventory = (Opening Stock + Closing Stock)/2
= (10,000+ 12,000)/2
= 11,000
Inventory turnover ratio = Value of material consumed /Average Inventory held
= 48,000/11,000
= 4.36 times
Inventory Turnover Period = 365/ Inventory turnover ratio
= 365/4.36
= 84 days
Illustration 2
Opening Stock: 100
Closing Stock: 120
Sales: 1,100
Inventory turnover = Sales / Average Stock

= 1,100/110 = 10 times
Inventory turnover (Average Stock Holding period)
= Average Stock x 365 / Sales
= 110 x 365/1,100 = 37 days
Inventory turnover (Average Stock Holding %)
= Average Stock x 100 / Sales
= 110 X 100/1,100
= 10%
3.5.1 Interpretation of Inventory Turnover
Inventory turnover of 4 times is concerned as normal. Any turnover more than 4 times is desirable. Average
stock holding period of 90 days is concerned as normal. Any stock holding period less than 90 days is desirable.
Average stock holding percentage of 25% is concerned as normal. Any Stock Holding percentage less than 25% is
desirable.
Any turnover more than 4 times also means Stock Holding period less than 90 days which in turn means Stock
Holding percentage less than 25%. From the above illustration it can be seen that the Inventory Turnover can be
expressed in three ways. The meaning of all the three is same. Inventory turnover of 10 times indicates a very high
rate of turnover, which in turn means more profit. 'More turnover, more profit' is the general interpretation.
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Summary
• Inventory models is a mathematical equation or formula that helps a firm in determining the economic order
quantity, and the frequency of ordering, to keep goods or services flowing to the customer without interruption
or delay.
• If a manufacturer orders a quantity which is more than the economic order quantity (EOQ) two things will
happen: reduction in cost and increase in carrying cost.
• There are two basic systems of managing or controlling inventory under the independent demand pattern:
cyclical ordering or fixed period system (Time based), and order point or fixed order quantity system (Quantity
based).
• Fixed period based systems (also called 'cyclical systems') are designed so that each inventory item is reviewed
and reorders are placed after a predetermined time interval
• Order point system / fixed order quantity system of inventory control is based on the order point and order
quantity factors rather than on the time factor.
• Dependent demand occurs when the need for parts, supplies, or materials is dependent upon a predetermined
usage or production schedule. In such cases, a description and quantity of components needed and the exact
date of each need is defined by a production schedule.
• Material requirement planning (MRP) happens to be the best model of dependent demand pattern of inventory.
Under it, the requirement of an item is predetermined as it depends upon the actual need of it, triggered by
certain production schedule.
• MRP has two main characteristics: the known requirement and the known period of requirement (time).
• Materials requirements planning (MRP) is a set of techniques that takes the master production schedule and
other information from inventory records and product structure records as inputs to determine the requirements
and schedule of timing for each item
• Inputs of MRP are: master production schedule (MPS), bill of materials (BOM), and inventory record file
(IRF).
• Outputs of MRP are: purchase order, work orders, and action notices.
• Inventory turnover indicates the ratio of materials consumed to the average inventory held.
References
• 2011. Managing Facilitating Goods [Online] (Updated 21st March, 2011) Available at <http://www.
google.co.in/url?sa=t&source=web&cd=6&ved=0CDcQFjAF&url=http%3A%2F%2Fwww.mccombs.
utexas.edu%2Ffaculty%2FJames.Fitzsimmons%2Flatest%2FPowerPointLectures%2FGoods16.
ppt&rct=j&q=inventory%20models%20ppt&ei=hzWHTZ1Bx6tx5eyQgwM&usg=AFQjCNEgH4luVzBa2-4c-
J3uoG4YnMK8bg&sig2=KolhqlujfhaOKQDegZ-95Q&cad=rja> . [Accessed on 21st March 2011]
• Joshi, Amit, Juyal Ankur, Pasbola Prabhat Inventory Models [Online] (Updated 21st March, 2011) Available
at <http://www.authorstream.com/Presentation/aSGuest42948-373181-inventory-models-models1-business-
finance-ppt-powerpoint/> [Accessed on 21st March, 2011]
• Statistical Inventory Control Models [Online] (Updated 18th March, 2011). Available at <http://www.google.
co.in/url?sa=t&source=web&cd=7&ved=0CD4QFjAG&url=http%3A%2F%2Fwww.foundationcoalition.org%
2Fresources%2Fie%2FInventory2%2Fmodel2.ppt&rct=j&q=inventory%20models%20ppt&ei=hzWHTZ1Bx6t
x5eyQgwM&usg=AFQjCNHDwla1uKXD6oqmXPfy_q6jFAIPhg&sig2=j0laV8v2TByS6kW5Fr49Pg&cad=rja.>.[Accessedon18thMarch2011]
Recommended Reading
• Tijms, H. C., 1972. Analysis of (s S) Inventory Models. 1st ed., Mathematical Centre Tracts;
• Beyer, D., 2009. Markovian Demand Inventory Models (International Series in Operations Research &
Management Science). 1st ed., Springer.
• Bartmann, D., 1992. Inventory Control: Models and Methods (Lecture Notes in Economics and Mathematical Systems).
Springer
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Self Assessment
1. Inventory turnover indicates the ratio of materials consumed to the ____________.

a. average inventory held
b. opening stock
c. closing stock
d. purchases
2. The two main characteristics of material requirement planning are the known requirement and
_____________.
a. known period of manufacturing
b. known period of stock
c. known period of planning
d. known period of requirement

a. MRP is a framework for providing useful information for decision makers.
b. MRP does need carrying of any inventory ahead of requirement.
c. Material Requirement Planning (MRP) happens to be the best model of dependent demand pattern of
Inventory.
d. Orders are placed for each item equal to the difference between current inventory level and a predetermined
maximum.

a. Many a times the suppliers of raw material come with an offer of discount on the catalogue price if a certain
minimum quantity is ordered.
b. In cyclical systems, time between reorders is variable, but reorder quantity is constant.
c. Predetermined minimums are set with a consideration of order lead time.
d. Units of an item are issued until the level of that inventory is low than the predefined reorder point.
5. Average inventory held can be calculated as:

a. (Opening Stock + Closing Stock)/3
b. (Opening Stock + Current Stock)/2
c. (Optimum Stock + Closing Stock)/2
d. (Opening Stock + Closing Stock)/2
6. What does DIL stands for?

a. Desired Inventory Level
b. Determined Inventory Level
c. Desired Inventory Lead
d. Demand inventory Level
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7. ___________turnover can be indicated in terms of number of days in which average inventory is consumed.
a. Stock
b. Inventory
c. Goods
d. Services
8. ___________and a timely lead time happen to be the main determinant of its success in a run.
a. Accurate forecast
b. Inventory planning
c. Fixed order
d. Inventory control
9. Order point system / fixed order quantity system of inventory control is based on the:
a. order point and order planning
b. order time and order quantity
c. order point and order quantity
d. order point and order turnover
10. The key to realizing the benefits from any MRP system is the:
a. ability of the inventory planner to use the information well
b. other information from inventory records
c. requirement of an item
d. demand pattern of inventory
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Chapter IV
Purchase Management
Aim
• explain the concept of purchase management
• elucidate the objectives of purchasing
• introduce the students to the concept of vendor management
Objectives
• recognise the functions of purchase management
• understand the concept of purchase requisition
• discuss purchase procedure
• understand different types of requisitions
Learning outcome
• understand the types of tenders
• know about inspection of materials
• identify the discrepancies in material receipts
• know the several ways of carrying out inspection
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4.1 Introduction to Purchase Management

Corporate purchasing dates back to its history sometimes to the late 1890s. Purchasing was mainly seen then as a
different department except some railroad organizations. Even during the early 1900s, purchasing was considered
to be a clerical work. During World War I and II, purchasing function increased due to the importance of obtaining
raw materials, supplies and services needed to keep the factories and mines operating.
During 1950s and 60s, purchasing continued to gain stature as the techniques for performing the function became
more refined and as the number of trained professionals increased but still purchasing agents were basically order-
placing clerical personnel serving in a staff-support position.
In the late 1960s and early 70s, purchasing personnel became more integrated with a materials system. As materials
became a part of strategic planning, the importance of the purchasing department increased.
In the 1970s the oil embargo and the shortage of almost all basic raw materials brought much of business world’s
focus to the purchasing arena. The advent of just-in-time purchasing techniques in the 1980s, with its emphasis
on inventory control and supplier quality, quantity, timing and dependability, made purchasing a cornerstone of
competitive strategy.
During early 1990s, value proposition in purchasing is increased. People realized that by letting purchaser negotiate
and ask for discount bring lots of cost reduction. Cost savings become a buzz word and of course control over the
buying process remains one important function of purchasing.
During late 1990s, the purchasing evolved into strategic sourcing. Enterprise wide process that continuously
improves and re-evaluates the purchasing activities of a company had started. More emphasis on supplier data base
begun. Contracts were sourced for long term basis to have better cost. Supplier relationship building and supplier
management started.
Purchasing function in a business environment is one of the most critical functions as it provides the input for the
organisation to convert into output. Materials today are lifeblood of industry. They must be available at the proper
time, in the proper quantity, at the proper place and the proper price. Company costs and company profits are greatly
affected by them as normally, a manufacturing organisation spends nearly 50% of its revenue in purchasing.
4.1.1 Objectives of Material Management

The key objectives of material management are given below:
• to buy the materials at the lowest price
• consistent with desired quality and service
• to maintain continuity of supply of materials and ser vices to users
Purchasing administration plays an important role in this regard. Every organisation establishes a purchase department
to carry out different functions. Purchasing is responsible for spending nearly half of a company’s income for buying
the input materials. Obviously, any saving achieved by it results into direct saving for the company and all such savings
are a company’s profit. One percent saving achieved in purchasing results in 5% profit for any organization.
4.2 Functions of Purchase Department

The job of a materials manager is to provide, to the user departments, the right material at the right time in right
quantity of right quality at right price from the right source. To meet these objectives, the activities undertaken include
selection of sources of supply, finalisation of terms of purchase, placement of purchase orders, follow up, maintenance
of relations with vendors, approval of payments to vendors, evaluating, rating and developing vendors.
The functions of purchase department are to:

• support company operations with an uninterrupted flow of materials and services
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• buy competitively and wisely
• help keep a minimum inventory
• develop reliable alternate sources of supply
• develop good vendor relationship and a good continuing supplier relationship
• achieve maximum integration with the other departments of the firm
• train and develop highly competent personnel who are motivated to make the firm as well as their department
succeed
• develop policies and procedures which permit accomplishment of the preceding objectives at the lowest
reasonable operating cost
Before deciding the quantity to be purchased, the following factors should be taken into consideration:
• Quantity already ordered
• Quantity reserved: It may happen that a particular quantity, though in hand, might have been reserved for a
particular job which is not available for other purposes. In such cases, this quantity is treated as if it is not in
stock.
• Funds availability: Amounts which are kept aside for drawing up purchase budget should be considered are
used.
For any organization, purchasing function assumes importance for the reason that it fulfils, to a great extent, the
input needs of the organization. An organization needs input of right quality at right price from the right source in
right quantity at the right time. Called 5 R’s (right things to do), these determine the broad parameters within which
the purchasing functions in any organization.
Depending upon the size and nature of operation, the quantum of purchase of product and services vary. Purchase
Department carries out all the tasks associated with the development of policies, procedures, controls and the
mechanics for coordinating purchasing operations with those of other departments.
The following are the important activities of a purchase department:

• Buying activity: It addresses to a wide gamut of activities such as, reviewing requisitions, analyzing specifications,
investigating vendors, interviewing sales people studying costs and prices and negotiating.
• Expediting: This is basically the order follow up activity involving various types of vendor relationship work. It
involves reviewing order status, providing clarifications on transportation, writing and emailing vendors etc.
• Special projects (Non routine): In order to facilitate smooth purchasing in a highly competitive business
environment, purchasing authorities have to keep building the capacity to do better by taking up as special projects
activities such as vendor development, vendor registration, value analysis, market studies, system studies etc.
• Routine: Purchasing process or procedure involving routine or every day activities such as dealing specific
purchase file, placing orders, maintaining records of commodities, vendors etc.
4.2.1 Purchasing Function vs. Purchase Department

Purchasing functions Purchase department
• This function is commonly seen in all those • It is a unit of an organisation that performs
organisations that undertake purchasing activi- purchasing function.
ties. • It is directed by an efficient manager to
• It is usually performed by a specialised and achieve the performance in an economical
centralised purchasing department. manner.
Table 4.1 Purchasing function vs. purchase department
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4.2.2 Procurement vs. Purchasing

Procurement is one of several supply functions involved in logistics activities. In the broadest sense procurement
includes the entire process by which all classes of resources (people, materials, facilities and services) for a particular
project are obtained.
Where as,
Purchasing is a unique function, it differs a bit from procurement in the sense that while procurement, with the same
objective has a wider domain, purchasing with the same objective is included in it.
4.2.3 Objectives of Purchasing

The basic objective of purchasing is to derive the maximum value for each unit of money spent in buying. A purchaser
has to find answers to the following questions:
• Are we buying at right cost?
• Supplier is producing it at right quantity or not?
• Whether supplier is producing the right product or not?
• Whether material will come at right time or not?
• Whether buyer is buying for the company or for personnel gain?
Formalized systems and procedures are required to run its purchasing function, to ease in operation and accountability.
Formal procedures are required to be laid down for initiating purchase, selecting suppliers, placing purchase orders,
follow-up, receiving materials and so on.
4.3 Purchase Requisition

Purchase Requisition is an indication given to the purchases department to purchase certain material. It is issued either
by the storekeeper (in respect of material required for regular production purposes) or by production department (in
respect of special materials required).
Following particulars must appear in purchase requisition:

• Material to be purchased: It should be clearly specified. To make it more specific, in addition to the description
of the material required, the code number should also be specified.
• When it is required: Unless the material is required for regular production purposes (when the storekeeper
himself will place the purchase requisition as soon as it reaches the ordering level), purchase requisition should
mention the last date by which the material is required. Ideally, the material should be purchased whenever the
market for the same is favourable.
• How much to be purchased: Purchase requisition should state the quantity of the material required.
4.3.1 Types of Purchase Requisitions

Different kinds of requisitions used are as follows:
Standard requisition
Also called as indent for material (or service), materials requisition plan etc., a requisition is made by an authorized
person in the concerned department. However, it has to be countersigned by a senior officer who checks the entries
made in. Normally, a requisition, in a pre-printed format, contains particulars such as, the detailed description of
materials or services to be purchased, desired quantity, schedule for receipt of such material/service, the estimated
price, possible sources and the account head, requisitioner’s identity.
In any organisation, only a limited number of personnel are empowered to countersign the requisition as it amounts
to authorisation of the expenditure. Purchase department usually maintains a list of such officers so as to check
the validity of the purchase requisitions. Normally, there is a delegation of power of authority for authorising a
requisition. This is expressed in terms of the financial limits up to which an officer can authorise a requisition for a
capital or revenue item. These details must also be available with the purchase department.
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Travelling requisition
As the name suggests, this requisition form travels from the requisitioning department to the purchaser directly
who then only authorizes the supplier through a purchase order to deliver the required material. This document is
generally used for requisitioning items that are required frequently in bulk quantities over a long period of time.
Usually, for repeat items such as, in inventory, a card containing the details of previous supply containing material
specifications, suppliers details, last purchased price , reorder point, usage details are written permanently and
provisions for entering date, quantity required, names of requisitioned and authoriser are available. On getting it,
the purchaser only has to take these details for placement of order. The travelling requisition which is a permanent
document of the originating department is returned to it. It reduces the paper work and eases the operation.
Bills of materials
Bill of material is a comprehensive list of materials needed to produce a product or service. It is basically the details
of materials needed, their specification, quantity, required delivery schedule etc. It is often used as a sequel to firming
of a production plan, a stage where the exact material/service needs are known.
4.4 Purchase Procedure

A purchase department is usually engaged in purchasing a number of materials and services falling in different
categories. The activities are performed regularly by purchase professionals with the objective of fulfilling
organisation’s materials and services needs. Therefore, depending upon the nature of procurement, environmental
practices etc the purchasing systems and procedures may also vary substantially. However, purchase procedure can
be seen to have a bit of standardisation across the globe.
A professional purchasing system does show following steps that eventually constitute a purchasing cycle:
• recognition and description of need
• transmission of need
• selection of source to satisfy the need
• contracting with the accepted source
• following up with the source
• receiving and inspecting material
• payment and closure of the case
4.5 Types of Purchasing

The following are the different types of purchasing:
• Forward buying
• Tender buying
• Systems contract
• Speculative buying
• Rate contracts
• Reciprocity in buying
• Zero stock buying
• Blanket orders
4.5.1 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.
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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. Such an arrangement
is a win-win situation for both, the buyer and the supplier
4.5.2 Tender Buying

Tender buying has always been considered the only way of buying materials / services in the government and quasi
government procurements. Selecting a supply source (supplier) out of many sources available is called tender buying.
Many applicants 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 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 that are found suitable are subjected to price comparison 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 comparison whereas in some
other place all the tenderer’s who meet the minimum requirement are considered accepted for price comparison
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.
Price/Quantity High Medium Low

Low Q1L1 Q2L1 Q3L1
Medium Q1L2 Q2L2 Q3L2
High Q1L3 Q2L3 Q3L3
Table 4.2 Matrix of price and quality of the tenders
Q1L1, Q1L2 and Q1L3 are short listed. After negotiations Q1L1 is selected normally. Q3L1, Q3L2 and Q3L3 are
normally rejected at the initial stage.
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
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commonly used types of tendering / tender buying are mentioned below:
• Global tender
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.
• 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.
• 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.
• Single tender enquiry
An STE is issued only when either the item is proprietary 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 fulfil the needs.
The mode to tender 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.
4.5.3 Systems Contract

Systems contract 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. System
contracting is particularly useful for items with low unit price and high consumption profile and thus, relieves the
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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. Obviously, the systems contracts
are an excellent way of simultaneously cutting costs while building efficiencies through simplifications.
4.5.4 Speculative Buying

When purchasing is done purely from the point of view of taking advantage of a speculated 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.
4.5.5 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 organisations 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 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 is 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. How-
ever, there is no compulsion that the demand be uniform over the period of time.
4.5.6 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.
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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.
4.5.7 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. 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.
4.5.8 Blanket Orders

Under this 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 buyer’s 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. It 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.
4.6 Vendor Management

Prerequisite to a successful materials management is the availability of a sound vendor base which is now rightly
acknowledged as an extended arm of the business. One of main reasons of failure of many supply chains has been the
inability to hold trusted vendors together. Vendor management, therefore, requires careful planning and execution,
over a fairly long period of time.
Management of vendors is attempted through the following ways:

• Vendor Registration
• Vendor Development
• Vendor Rating
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• Vendor Exploration
For ensuring continuous supply of right quality materials required, at the optimum cost, it is essential to have a
dependable, competent & competitive vendor base. The Limited Tender Enquiry (LTE) is issued only when reliable
manufacturers/suppliers/traders/contractors are known and for this purpose, there is a need to maintain a list of
registered vendors. So, vendors are empanelled for the supply of various categories/subcategories of items.
Vendor registration
For this purpose, the vendors interested to supply the specific category/subcategory of items are asked to submit the
application along with all the documents required to establish their financial & technical capability. The application
forms so received are scrutinized and the vendor capacity assessment is carried out through inspection department
/ technical experts to establish the technical capability of the vendors. These vendors are listed as ‘registered’ after
following up certain processes.
Vendor development
Many process industries like to search the alternative and less costly material as substitution of the currently used
costlier materials. The less the procurement cost the more is the profit. Also, there may be situations where the
existing suppliers may not be willing to supply the items on various grounds, thus, necessitating, looking into
different alternatives.
An efficient materials manager would devote enough time to develop substitutes & sources of supply with a view
to reduce cost of input materials and also to have reliable alternative source for foreign sources. Normally, in large
manufacturing organisations, a Vendor Development Cell (VDC) remains engaged all through for the purpose. When
the need to develop a vendor for an item is felt the requisition for such items is made by concerned department
indicating the trial quantity and the potential vendors. Trial orders are placed on potential vendors and also necessary
help is rendered to them to come up to the desired level.
Vendor rating
The vendors also like to be given priority to be the purchaser if it constantly improves its selling performance which
from a purchaser point of view is mainly its offered price, quality and punctuality in delivery.
For purchaser, there shall always be a need to continuously monitor and update its registered vendor base so that the
organisation continues to have the most competent & competitive vendors in its list of vendors. For this purpose the
efforts are made to monitor supply performance of the vendors and rate them objectively. The major factors usually
considered for such vendor rating are competitiveness of vendor (price), quality of supply and delivery adherence.
Vendor rating may also be used for removing a vendor from registered vendor list and also in the selection of
vendors while issuing Limited Tender Enquiry.
Vendor exploration
To have competitive & competent sources of supply, efforts are made to explore suitable vendors from various
sources like, internet websites, international bulletins, vendors list of other similar manufacturing organisations etc.
This is known as vendor exploration and in the competitive environment it is taken as a serious activity.
4.7 Inspection of Materials

Any organization, big or small, shall look for quality input (materials) from suppliers to have the desired output or
use. For this reason, it devises ways to control the incoming materials by having a check system on quantity, quality
and readiness for use. Control on incoming materials is exercised through inspection by the purchaser. Inspection is
an important aspect of integrated materials management. It is an accessory to the purchase function to ensure that
the incoming materials of right quality are procured for use.
The word quality has numerous meanings. The most appropriate meaning of quality in the present context
is “Conformance to Ordered Specification & Fitness for Use”, whether for products or services. Depending
upon the nature, criticality & value of items, inspection is conducted either at supplier’s premises or at plant
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stores after receipt.
There are several ways of carrying out inspection. A few of these are mentioned below:
4.7.1 Pre Dispatch Inspection

This is inspection before dispatch of material. Usually specified in the Purchase Order (PO), the inspection is carried
out at supplier’s premises (works). Supplier gives an Inspection Request (IR) to the inspection agency mentioned
in the PO. On receipt of IR, the inspecting officer visits the supplier’s premises along with documents necessary for
inspecting such as copy of PO, drawing, specification etc.
The following checks are conducted depending on the nature of item:

• Visual check
• Dimensional check
• Functional check
• Physical testing such as hardness, pressure test, load test etc
• Electrical and other on-bed testing such as high voltage test, insulation resistance test etc.
The accepted materials are marked by stamping/punching/stickers/ seal/ tag etc as a mark of acceptance. The supplier
is asked to deliver the same to the consignee as mentioned in the PO.
4.7.2 Stage Inspection / Final Inspection

For critical items, it is required to conduct stage inspection of semi-finished items (such as, castings, forgings etc.)
at suppliers premises. In such cases, the supplier gives an interim Inspection Request (IR) to the inspection agency.
During stage inspection, sample is collected by the inspecting officer for chemical analysis / physical testing at
either their own facility or at 3rd party locations.
On receipt of test results, conformance to specification is verified & clearance is given to the supplier for further
processing of the item. After readiness of the material in all respect & internal checking, the supplier gives the
final inspection request to the inspection agency. In some critical cases, joint inspection by indenter & inspection
is carried out at supplier’s premises.
4.7.3 Document Inspection

Sometimes and usually for every standard ,off the shelf items, inspection can be carried out through the verification of
supplier given certificates such as, Material Test Certificate (MTC), Manufacturing Certificate (Mfg. TC), Guarantee
Certificate (GC) etc. After ensuring conformance of materials to the ordered specification in all respect, Inspection
Certificate (IC) is issued by the inspecting officer to the supplier.
4.7.4 Stores/Receipt Inspection

Majority of items are inspected through this route. Materials are received in the receiving bays of stores. Such items
are usually accepted based on visual examination & verification of documents. Materials in the receiving bay are
segregated into several categories, based on their quality control status and destination. Procedures in receiving
provide for storage and transport of material in each category.
The major categories include:

• Awaiting inspection - This category consists of material that has been received and is awaiting inspection
before being moved into stock.
• Acceptance upon certification - This category consists of material that may be accepted pending
certification.
• Rework - This category contains the materials that are defective and must be reworked.
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• Return - This category contains materials that are defective and will be returned to the supplier for credit or
replacement.
• Materials to be tested - This category consists of materials which have been received and are awaiting delivery
to the using/testing department.
4.7.5 Third Party Inspection

In case of specialized items, which require special proficiency for inspection, help of third party inspection agencies
is taken. After material is received from the supplier, the quantity received actually, is compared with quantity
ordered. Variations, if any, are taken up with the supplier again.
Excess material received may be dealt with using any of the following ways:
• accepting all the material received
• accepting the material ordered and return the excess to the supplier
Before accepting, material may be subjected to inspection. The extent of inspection may vary from material to
material. The supplier’s invoice received for the supply of material is subjected to scrutiny before a voucher is
passed for the same for making the entry in the books of accounts. For this purpose, the supplier’s invoice may be
compared along with the following documents.
• Purchase Order
• Goods Received Note
• Inspection Report
If the quantity and/or rate as per purchase order and invoice match with each other, the invoice of the supplier is
passed for making the entry in the books of accounts. If the quantity and/or rate as per purchase order and invoice
differ from each other, the difference is adjusted by raising a debit or credit note in favour of the supplier.
Discrepancies in material receipts

The material physically received when compared with material ordered as per the purchase order may reveal certain
discrepancies which may take any of the following forms.
• Quantity received in excess
• Quantity received in short
• Quantity received of different quality
Excess quantity received may be retained and accepted, if required, with the approval of the purchase department.
Alternatively, if it is not accepted, it may be returned to the supplier with Goods Returned Note (GRN). The usual
form in which Goods Returned Note is prepared in the following format:
GOODS RETURNED NOTE
To: No.
Date:
Following material supplied by you vide your D.C. No.____________ and Invoice No.____________
against our Purchase Order No. ______________is being returned to you for the reasons stated below:
Description Quantity Reasons
Signature
Usually, three copies of Goods Returned Note (GRN) are prepared to be distributed as below:
• one copy to the supplier
• one copy to the purchase department
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• one copy to be retained by the stores department
Excess quantity accepted

If excess quantity is already billed in the invoice, it will be approved and paid. If not, either the supplier may be
asked to give a supplementary invoice or credit note may be issued to the supplier for amending the amount.
Excess quantity returned

If excess quantity is already billed in the invoice, debit note may be issued to the supplier for amending the amount.
In case the quantity received is short, purchase department may take up the case with the supplier or carrier or
insurer as per the terms of purchases. If quantity short supplied is billed in the invoice, invoice is suitably amended
and debit note is issued to the supplier. If quantity received is of different quality and is rejected in inspection, it
can either be retained or returned. It may be retained by accepting some mutually decided concessional price. The
variation in prices may be adjusted by issuing either the credit note or debit note in favour of the supplier.
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Summary
• Purchasing function in a business environment is one of the most critical functions as it provides the input for
the organisation to convert into output.
• Purchasing is responsible for spending nearly half of a company’s income for buying the input materials.
• The job of a materials manager is to provide, to the user departments right material at the right time in right
quantity of right quality at right price from the right source.
• Factors to be kept in mind before deciding the quantity to be purchased are: quantity already ordered, quantity
reserved and funds availability.
• The important activities of purchase department are: buying activity, expediting, special projects, and routine.
• Purchase Requisition is an indication given to the purchases department to purchase certain material. It is issued
either by the storekeeper or by production department.
• Standard requisition is also called as indent for material; it is a requisition is made by an authorized person in
the concerned department, which has to be countersigned by a senior officer who checks the entries made in.
• Travelling requisition form travels from the requisitioning department to the purchaser directly who then only
authorizes the supplier through a purchase order to deliver the required material.
• Bill of material is a comprehensive list of materials needed to produce a product or service. It is often used as
a sequel to firming of a production plan, a stage where the exact material/service needs are known.
• The steps in a purchasing cycle are: recognition and description of need, transmission of need, selection of
source to satisfy the need, contracting with the accepted source, following up with the source, receiving and
inspecting material, and payment and closure of the case.
• Different types of purchasing are: forward buying, tender buying, systems contract, speculative buying, rate
contracts, reciprocity in buying, zero stock buying and blank orders.
• A global tender is floated with a view to elicit offers/response from any vendor situated anywhere in the
world.
• 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.
• 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.
• A Single Tender Enquiry (STE) is issued only when either the item is proprietary 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 fulfil the needs.
• Management of vendors is attempted through; vendor Registration, vendor Development, vendor rating, and
vendor Exploration.
• Control on incoming materials is exercised through inspection by the purchaser. Inspection is an important
aspect of integrated materials management.
References
• Aher, Kiran, 22nd March,. 2011, Purchasing Management [Online] (Updated 22nd March, 2011) Available at <
http://www.authorstream.com/Presentation/kiranaher1989-387753-purchase-management-mgmt-entertainment-
ppt-powerpoint/>. [Accessed on 22nd March 2011]
• 22nd March, 2011, Purchasing Management [Online] (Updated 22nd March, 2011) Available at <http://www.
scribd.com/doc/14816975/Purchasing-Management>. [Accessed on 22nd March 2011]
• 22nd March, 2011, Purchase Management [Online] (Updated 22nd March, 2011) Available at <http://www.
scribd.com/doc/195864/Purchase-Management>. [Accessed on 22nd March 2011]
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Recommended Reading
• Anderson, Ernest L. & Morgan, James P., 1998. The Systems Purchasing Breakthrough. 1st ed., Cahners Pub.
Co.
• Farrington, B., 2001. Creative Control of Purchase Prices. Spiro Press.
• Sabri, Ehap H. & Gupta A., 2006. Purchase Order Management Best Practices: Process, Technology, and
Change Management. J. Ross Publishing.
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Self Assessment
1. Standard requisition is also known as:

a. Bill of materials
b. Indent of material
c. Open requisition
d. Global requisition
2. __________is basically the order follow up activity involving various types of vendor relationship work
a. Expediting
b. Purchasing
c. Selling
d. Inspection

a. Purchasing is responsible for spending nearly half of a company’s income for buying the input materials.
b. For any organization, purchasing function assumes importance for the reason that it fulfils, to a great extent,
the input needs of the organization.
c. An organization needs input of right quality, at right price, from the right source in right quantity at the
right time.
d. Formalized systems and procedures are required to run its manufacturing function, to ease in operation and
accountability.
4. __________ is one of several supply functions involved in logistics activities

a. Procurement
b. Inspection
c. Tender buying
d. Purchasing
5. The basic difference assumed between an open tender and a global tender enquiry is:
a. order follow up activity
b. capabilities of the vendors
c. receiving and inspecting material
d. essentially the range of its applicability
6. Which of the following is issued only when either the item is proprietary in nature, that is only one supplier
produces that item or where there may be more vendors?
a. Open tender
b. Single tender enquiry
c. Global tender
d. Limited tender enquiry
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a. A purchase department is usually engaged in purchasing a number of materials and services falling in one
category.
b. Forward buying helps a firm in booking capacity of a supplier and thus often results into a safeguard against
a competitor acquiring his capacity.
c. Tender buying is selecting five supply sources or suppliers out of many sources available.
d. A global tender is floated with a view to elicit offers/response from any vendor situated anywhere with in
the country.
8. In certain business situations a buyer may give preference to a supplier who also happens to be his customer,
this relationship is known as ________.
a. reciprocity
b. indentation
c. expediting
d. procurement
9. _____________is a comprehensive list of materials needed to produce a product or service.

a. Purchase requisition
b. Inventory list
c. Bill of material
d. Open tender
10. Materials in the receiving bay are segregated into several categories, based on their quality control status
and________.
a. destination
b. industry type
c. cost
d. usage
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Chapter V
Stores Management
Aim
• introduce the students to the concept of store management
• explain the functions of stores department
• elucidate the company motives to hold the inventory
Objectives
• recognise the four types of movements of material from the stores department
• understand the concept of bin card and stores ledger
• discuss proper storage function
Learning outcome
• understand the methods for valuation of issues
• know about valuation of material in three ways
• understand the comparison of value of stock under different methods
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5.1 Introduction to Stores Management
Management of inventory assumes importance due to the fact that investment in inventory constitutes one of the major
investments in current assets. The various forms in which a manufacturing concern may carry inventory are:
• Raw Material: These represent inputs purchased and stored to be converted into finished products in future by
making certain manufacturing process on the same.
• Work in Progress: These represent semi-manufactured products which need further processing before they
can be treated as finished products.
• Finished Goods: These represent the finished products ready for sale in the market.
• Stores and Supplies: These represent that part of the inventory which does not become a part of final product
but are required for production process. They may be in the form of cotton waste, oil and lubricants, soaps,
brooms, light bulbs etc. Normally, they form a very minor part of total inventory and do not involve significant
investment.
5.1.1 Motive to Hold Inventory

A company may hold the inventory with the following motives:
• Transaction motive: A company may be required to hold the inventories in order to facilitate the smooth and
uninterrupted production and sales operations. It may not be possible for the company to procure raw material
whenever necessary. There may be a time lag between the demand for the material and its supply. Hence it is
needed to hold the raw material inventory. Similarly, it may not be possible to produce the goods immediately
after they are demanded by the customers. Hence it is needed to hold the finished goods inventory. The need to
hold work in progress may arise due to production cycle.
• Precautionary motive: In addition to the requirement to hold the inventories for routine transactions, the
company may like to hold them to guard against the risk of unpredictable changes in demand and supply
forces. For example- the supply of raw material may get delayed due to the factors like, strike, transport,
disruption, short supply, lengthy processes involved in import of the raw materials etc. Hence the company
should maintain sufficient level of inventories to take care of such situations. Similarly, the demand for finished
goods may suddenly increase (especially in case of seasonal types of products) and if the company is unable to
supply them, it may mean gain of the competitions. Hence, the company will like to maintain sufficient stock
of finished goods.
• Speculative motive: A company may like to purchase and stock the inventory in the quantity which is more
than needed for production and sales purpose. This may be with the intention to get the advantages in terms of
quantity discounts connected with bulk purchasing or anticipated price rise.
After the material is received, inspected and approved, the process of storing comes into operation which deals
with storing the material in good condition till it is required for use by production departments and issuing the same
whenever required. Stores department plays an important role in this respect.
5.2 Functions of Stores Department

The following are the types of movement of the material from the stores department:
• Receipt of material
• Issue of material
• Return of material from Production Department to Stores Department.
• Transfer of material
5.2.1 Receipt of Material

Usually the receipt of material is accompanied by delivery challan given by the supplier. On receipt of the material,
quantity received is checked with the quantity ordered by the stores department. The received material may be
inspected, before acceptance either by separate inspection department or by stores department itself. A document
known as Goods Received Note or Goods Received Report (GRN or GRR) is prepared to record the details of the
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material received. The usual form in which GRN or GRR is prepared is as below:
GOODS RECEIVED NOTE

No.
Date:
S. No. Description Code Qty. Recd. Qty. Accepted Qty. Rejected Remarks
Prepared by Received by Inspected by Store Keeper
It may be prepared in quadruplicate to be distributed as follows:

• one copy to purchases department for comparing with purchases order and approving the invoice of the
supplier
• one copy to accounts department for making the payment of supplier’s invoice
• one copy to costing department for pricing and entering in stores record
• one copy to be retained by stores department
GRN/GRR should be serially numbered in order to locate the material which is physically received but for which
invoice is not received.
5.2.2 Issue of Material

Here, the issue of material refers to issue of material from stores department to production department. The material
should not be issued from the stores unless a proper authority in writing is produced before the stores department.
Usually, this authority is in the form of material requisition note or material requisition slip.
The normal contents of this note/slip are as follows:

• number and date (ideally, they should be serially numbered)
• department demanding the material
• description and code of material demanded
• quantity of material demanded
• signature of authority approving the demand
• signature of the person receiving the material
Normally one note/slip is prepared for requisitioning a single item of material. The usual form in which it is prepared
is as below:
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MATERIAL REQUISITION NOTE
Production/Job Order No.
No.
Bill of Materials No.
Date :
Department :
Description
Code
Qty.
Unit Cost (for costing Dept. only)
Rate per unit Amount Rs.
Authorised by Issued by Received by Entered by Valued by
Normally, it is prepared in three copies. Two copies to stores department which in turn passes one copy to costing
department for pricing while second copy is retained by the stores department. One copy is for demanding
department.
5.2.3 Return of Material

There can be some situations, when material once issued to production department is returned back to the stores. It
can happen in the following circumstances.
• material issued in excess than the requirement
• scrap or defective work arising out of the production processes
Under these circumstances, a document in the form of materials returned note is prepared, which is to record return
of unused materials. The usual form in which this document is prepared is as below:
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MATERIALS RETURNED NOTE
Production/Job Order No. No.
Bill of Materials No. Date :
Department :
Description Code Qty. Unit Cost (for costing Dept. only)
Authorised by Received by Posted by
As far as the valuation of the returned material is concerned, it may be treated as the fresh receipt of the material or
alternatively, it may be treated as the negative (minus) issues.
5.2.4 Transfer of Materials

In some situations, considering the urgency for the requirement of the material, it may be necessary to transfer the
material from one production/job order to another. Such transfer of material is usually accompanied by preparing a
document in the form of material transfer note. The usual form in which this document is prepared is as below:
MATERIAL TRANSFER NOTE

No.
Date :
From…………Dept. To…………..Dept.
Production/Job Production/Job
Order No. Order No.
Description Code No. Qty. Cost (for costing Dept. only)
Authorised by Received by Posted by
Transfer of materials does not result into any fresh issue of material. However, material transfer notes will have to
be valued and considered in order to compute the material cost as per the job orders and production orders.
5.2.5 Proper Storage Function

The proper conduct of storage function requires that material should be properly stored in a good condition till it is
required for use by production departments and should be issued whenever required. This proper conduct is ensured
by what is known as 'Perpetual Inventory System'. The aims of the perpetual inventory system are two fold:
• Recording receipts and issues in such a way so as to know at any time, the stock in hand, in quantity and/or
value, without the need of physical counting. This aim is achieved by maintaining what is called as bin card
and stores ledger.
• Continuous verification of physical stock at regular intervals.
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Bin Card
It is only a quantitative record of receipts, issues and closing balance of an item of material. Separate bin card is
maintained for each item of material. The usual form in which a bin card is maintained is as below.
BIN CARD
Description Maximum level
Code No. Minimum level
Location/Unit Reorder level
Date Document No. Receipt Issue Balance Remarks
Entries in receipts column are made on the basis of goods received note or material returned note. Entries in issues
column are made on the basis of material requisition note. After every entry of either receipts or issues, the balance
quantity is calculated and recorded so that the balance can be known at any point of time. The levels indicated on
bin card enable the stores department to keep a watch on balance and replace the material as soon as it reaches the
reorder level. Ideally, the bin card should be placed along with the material. But it may not be possible in all the
cases, so the bin cards are placed at a centrally located place but within stores department only.
Stores Ledger
Like the Bin Card, it is maintained for the recording of all receipts and issue transactions of material, but with the
exception that it records not only the quantities received or issued or in stock but also the financial expressions of
the same. The usual form in which the stores ledger is maintained is as follow:
STORES LEDGER
Description Maximum level
Code No. Minimum level
Location/Unit Reorder level
Date Doc. Receipts Issues Balance

No.
Quantity Rate Rs. Quantity Rate Rs. Quantity Rate Rs.
By summing up the amounts appearing in the ‘issues’ column of stores ledger, one can get the cost of material
issued to production department which forms the ‘Material Cost’. As in case of bin card, separate store ledger sheets
are maintained in case of each item of material. The stores ledger sheets are maintained either in loose form or in
bound book form.
Bin Card vs. Stores Ledger

If the stores ledger is having all the information mentioned in a bin card plus some additional information is
also available, the next question which arises is why is it necessary to maintain both bin card and stores ledger
simultaneously as it will be only duplication of work. In the situations of computerized inventory accounting
system, maintenance of bin card and stores ledger simultaneously can be avoided. However, in the situation of
manual inventory accounting system, it will be ideal to maintain bin card and stores ledger simultaneously due to
the following reasons:
• Bin card is maintained by stores department while stores ledger is maintained by costing department.
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• Bin card is not an accounting record but only a quantity record and as such is not concerned with the financial
implications of stores transactions.
• Maintenance of stores ledger provides a second check on maintenance of bin cards.
Reconciliation of Bin Card and Stores Ledger

As the source documents for the entries in Bin Card and Stores Ledger are the same, the closing balances disclosed
by both of them should match with each other. But in practice, they may not match due to the following reasons.
• arithmetical error in calculating balance
• non-posting of a certain document’ in either of these documents
• posting on wrong bin card or stores ledger sheet
• treating receipts transaction as issue transaction or vice versa
If the closing balance as per bin card and stores ledger is not matching, the very purpose of maintaining these two
documents simultaneously will be defeated. As such, it is necessary to reconcile both balances at regular intervals by
keeping all the entries up to date. If the balances as on a particular day are not matching, all the previous transactions
should be checked to locate differences.
5.3 Valuation of Material

The stores ledger considers not only the movement of material in terms of quantity but also in terms of its financial
implications. As such, it is necessary that all the possible movements of material are valued properly and are expressed
in terms of money. We will consider this problem under the following heads.
• Valuation of receipts
• Valuation of issues
• Valuation of returns from production department to stores department
5.4 Valuation of Receipts

Valuation of receipts is a relatively easy task, as the invoice or bill received from the supplier of the material is
available as a starting point. Following propositions should be considered for this purpose.
• The price as billed by the supplier will be the valuation of the receipts. The trade discount is deducted from
the basic price and all other amounts as billed by the supplier are added, like excise duty, sales tax, octroi duty,
transport/insurance charges, etc. There are different opinions in respect of the treatment of cash discount. One
opinion says that cash discount should be ignored, being purely of a financial nature, while valuing the receipts,
while another opinion says that it should be considered while valuing the receipt of the material.
• In some cases, more than one item of material is included in one single bill and some costs are jointly incurred
for all the items of material. Such joint costs may be distributed on the basis of the basic price of the material.
• In case of the imported material, the cost of the material consists of a basic price (which may be stated in foreign
currency and should be converted in Indian Rupees), customs duty, clearing charges, transport charges, octroi
duty, etc. In some cases, the point of receipt of imported material and the point of making the payment of invoice
amount may be different. As such, the rate of foreign currency may be different at the time of payment of the
customs duty and at the time of payment of the invoice amount. In such cases, the rate of exchange existing
at the time of making the payment of invoice amount should be considered for valuing basic cost of material
imported.
Illustration 1
The particulars relating to 1,200 kilograms of a certain raw material purchased by a company during April, 2010
are as below:
a. Lot prices quoted by suppliers and accepted by the company for placing the purchase order.
Lot up to 1000 kgs. @ Rs. 22 per kg. For
Between 1000 - 1500 kgs. @ Rs. 20 per kg. Supplies
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Between 1500 - 2000 kgs @ Rs. 18 per kg. to Factory
Trade Discount 20%.
Additional charge for containers @ Rs. 10 per drum of 25 kg.
Credit allowed on return of containers @ Rs. 8 per drum.
Sales Tax at 10% on raw material and 5% on drums.
Total freight paid by the purchaser Rs. 240.
Insurance at 2.5% (on net invoice value) paid by the purchaser.
Stores Overheads applied at 5% on total purchase cost of material.
The entire quantity was received and issued to production:
The containers are returned in due course. Draw up a suitable statement to show:
• total cost of material purchased
• unit cost of material issued to production
Solution
a. Statement showing cost of purchases
Basic Cost (Rs.) Rs.1,200 kg x Rs. 20/kg = 24,000
Less: Trade discount @ 20% 4,800
Total cost 24,000 – 4,800 = 19,200
Container Cost
48 Drums x Rs. 10/Drum 480
Total cost 19,200 + 480 = 19,680
Sales Tax
10% on Rs. 19,200 192
5% on Rs. 480 24
Total Tax 216
Total cost 19,680 + 216 = 19,896
Other charges
Insurance 2.5% on Rs. 21,264.00 531.60
Freight 240.00
20.667
Less: Credit for drums returned
Rs. 8 per Drum x 48 Drums 384.00
TOTAL COST 22,020.60
Add: Stores Overheads 5% 1,101.03
23,121. 63
b. Unit cost for valuation of issues: Rs. 23,121/1,200 kg = Rs. 19.268/kg
5.5 Valuation of Issues

This is a more complex process than the valuation of the receipts. It is because of this reason that the material may
be issued out of the various lots which might have been purchased at various prices. As such, a problem may arise
as to which of the receipt prices should be used to value the material requisition notes.
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Various methods used for this purpose are as below:

• First In First Out (FIFO)
• Last In First Out (LIFO)
• Highest In First Out (HIFO)
• Simple Average Rate (SAR)
• Weighted Average Rate (WAR)
• Market rate
5.5.1 First In First Out (FIFO) Method

Under this method, the price of the earliest available lot is considered first and if that lot is exhausted, the price of
the next available lot is considered. It should be remembered that the physical issue of the material may not be made
out of the said lots, though it is presumed that it is made out of these lots.
Illustration
Following transactions have taken place in respect of a material during March 2010.
Date:
1 Opening Balance 400 units @ Rs. 10 per unit
3 Purchased 100 units @ Rs. 9.5 per unit
7 Issued 300 units
15 Issued 200 units
22 Issued 50 units
30 Issued 350 units
Prepare the Stores Ledger assuming that the issues are valued on FIFO basis.
Solution
Valuation of stock by FIFO method
Date Receipts Issues Balance Total
Quantity Rate Rs. Quantity Rate Rs. Quantity Rate Rs. Value
1 400 10.00 4,000 4,000
3 100 9.50 950 400 10.00 4,000
100 9.50 950 4,950
7 300 10 3,000 100 10.00 1,000
100 9.50 950 1,950
10 500 9.75 4,875 100 10.00 1,000
100 9.50 950
500 9.75 4875 6,825
15 200 10 2,000 500 9.75 4875 4,875
22 50 10 488 450 9.75 4,388 4,388
28 300 10.25 3,075 450 9.75 4,388
300 10.25 3,075 7,463
30 350 10 3,413 100 9.75 975
300 10.25 3,075 4,050
The objections raised against this method are mentioned below:

• Calculations become complicated if the lots are received frequently and at varying prices
• Costs may be wrongly presented if the price of different lots of material is being used for pricing issues to
various batches of production
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• In case of varying prices, the pricing of issues does not consider current market prices
5.5.2 Last In First out (LIFO) Method

Under this method, the price of the latest available lot is considered first and if that lot is exhausted, the price of the
lot prior to that is considered. Here also, it should be remembered, that the physical issue of the material may not
be made out of the said lots, though it is presumed that it is made out of the lots.
Illustration
The same example given under 5.5.1 above is solved as per LIFO method.
Valuation of stock by LIFO method

1 400 10.00 4,000 4,000
3 100 9.50 950 400 10.00 4,000
100 9.50 950 4,950
7 100 9.50 950
200 10.00 2,000 200 10.00 2,000 2,000
10 500 9.75 4,875 200 10.00 2,000
500 9.75 4,875 6,875
15 200 9.75 1,950 200 10.00 2,000
300 9.75 2,925 4,925
22 50 9.75 488 200 10.00 2,000
250 9.75 2,438 4,438
28 300 10.25 3,075 200 10.00 2,000
250 9.75 2,438 7,463
300 10.25 3,075 7,513
30 300 10.25 3,075 200 10.00 2,000
50 9.75 488 200 9.75 1,950 3,950
The advantages of this method are as below:

• It is simple to operate.
• The cost of materials issued considers fairly recent and current prices. The prices quoted on this cost fairly
represent the real cost.
• It can be conveniently applied if transactions are not too many and prices of the material are fairly steady.
The objections raised against this method are as below:

• Calculations become complicated if the lots are received frequently and at varying prices.
• Costs may be wrongly presented if the price of different lots of material is used for pricing issues to various
batches of production.
• In case of falling prices in the market, this method may give wrong results.
5.5.3 Highest In First Out (HIFO) Method

This method assumes that the stock should always be shown at the minimum value and hence the issues should
always be valued at the highest value of receipts. For example, assume a situation as follows:
Mar. 1 Purchased 100 units @ Rs. 12
On March 20, 120 units are issued to production and they will be valued at Rs. 18 per unit being the highest price.
This method is not very popular. It always overvalues the issues and undervalues the closing stock. This method
71/MITSDE
may be useful in case of the organisations dealing with monopoly products which is a rare possibility.
Illustration
The same example given under 5.5.1 in this unit will be solved as per weighted average rate method.
Valuation of stock by HIFO method
1 400 10.00 4,000 4,000
3 100 9.50 950 400 10.00 4,000
100 9.50 950 4,950
7 300 10.00 3,000 100 10.00 1,000
100 9.50 950 1,950
10 500 9.75 4,875 100 10.00 1,000
500 9.75 4875 6,825
15 100 10.00 1,000 100 9.50 950
100 9.75 975 400 9.75 3900 4,850
22 50 9.75 488 100 9.50 950
350 9.75 3,413 4,363
28 300 10.25 3,075 100 9.50 950
350 9.75 3,413
300 10.25 3,075 7,438
30 300 10.25 3,075 100 9.50 950
50 9.75 488 300 9.75 2,925 3,875
5.5.4 Average Rate Method

Both the above methods i.e. FIFO and LIFO, consider the exact or actual cost for valuing the issue of material.
However these methods may prove to be disadvantageous if the transactions are too many and are at varying prices.
In such cases, instead of considering the exact or actual cost, average cost may be considered to lessen the effect of
variation in prices, either upward or downward.
For example: Assume a situation as below:
Mar. 1 - Received - 1500 units @ Rs. 10 - Rs. 15,000
Mar. 15 - Received - 1600 units @ Rs. 30 - Rs. 48,000
On March 20, 1800 units were issued to production.
If FIFO method is followed to price the issues, the issues will be valued as below:
1500 units @ Rs. 10 per unit Rs. 15,000
Total Rs. 24,000
The issues will be considerably under-valued and closing stock will be considerably over valued, as compared to
the current market prices.
If LIFO method is followed to price the issues, the issues will be valued as below:
Total Rs. 50,000
The closing stock will be considerably under valued as compared to the current prices.
To lessen the effect of such drastic price variation, both on the valuation of issues as well as of closing stock,
instead of considering the actual/exact price of Rs. 10 per unit or Rs. 30 per unit, average price may be taken into
consideration.
There are mainly two ways in which average prices may be considered.
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• Simple Average Rate Method
• Weighted Average Rate Method
5.5.4.1 Simple Average (SAR) Method

Under this method, the simple average of the prices of the lots available for making the issues is considered for
pricing the issues. After the receipt of new lot, a new average price is worked out. It should be remembered in this
connection that, for deciding the possible lots out of which the issues could have been made, the method of First
in First Out (FIFO) is followed.
This method is suitable if the material is received in uniform quantity. If the material quantity of each lot varies
widely, this method may lead to wrong results.
Illustration
Date Receipts Issues Balance

1 400 10.00 4000.00
3 100 9.50 950 500 9.75 4875.00
7 300 9.75 2925 200 9.75 1950.00
10 500 9.75 4875 700 9.75 6825.00
15 200 9.75 1950 500 9.75 4875.00
22 50 9.75 487.5 450 9.75 4387.50
28 300 10.25 3075 750 10.00 7500.00
30 350 10.00 3500 400 10.00 4000.00
5.5.4.2 Weighted Average Rate (WAR) Method

As stated above, the simple average method of valuation of issues may lead to wrong results, if the quantity of each
lot of material received varies widely.
For example: Assume the following situation.

Mar. 1 - Received - 100 units @ Rs. 10 Rs. 1,000
Mar. 10 - Received – 5,000 units @ Rs. 30 Rs. 1, 50,000
Total Rs.1, 51,000
On March 20, 4800 units were issued to production. As both the lots are possible lots for making the issue, the
average of prices of both the lots will be taken into account if simple average method is considered. Hence, per unit
issue price will be.
(Rs. 10 + Rs. 30)/2 = Rs. 20
As such, the issue quantity will be priced at : 4,800 units x Rs.20 i.e. Rs. 96,000, which will be incorrect, as considering
the quantity of issue, the price of the material received on March 10 should get more weightage.
To overcome this drawback of simple average method, weighted average method may be used which considers
not only the price of each lot but also the quantity of the same. Though this method involves considerable amount
of clerical work, in practice, this method proves to be very useful in the event of varying prices and quantities. In
practice, the calculation of weighted average rate proves to be very simple. The products of quantity and price divided
by the total quantity of all lots, just before the issue, gives the unit price in respect of the subsequent issues.
73/MITSDE
Illustration
The same example given under 5.5.1 in this unit will be solved as per weighted average rate method.
Valuation of stock by weighted average method.
Date Receipts Issues Balance
1 400 10.00 4000.00
3 100 9.50 950 500 9.90 4950.00
7 300 9.90 2970 200 9.90 1980.00
10 500 9.75 4875 700 9.79 6855.00
15 200 9.79 1959 500 9.79 4896.43
22 50 9.79 489.6 450 9.79 4406.79
28 300 10.25 3075 750 9.98 7481.79
30 350 9.98 3492 400 9.98 3990.29
Q1R1 = 4000 Q2R2 = 950 Q1R1+ Q2R2 = 4950. Q1+Q2 = 500

Weighted Average Cost = (Q1R1+Q2R2)/( Q1+Q2) = 4950/500 = 9.9
Comparison of value of stock under different methods:

Sl. No. Method of valuation Value of Inventory
1 First in First Out 4,050.00
2 Last in First out 3,950.00
3 Highest in first Out 3,875.00
4 Simple Average 4,000.00
5 Weighted Average 3,990.29
From the above table it is clear that the value of stock will be different in different methods of valuation. It is expected
that a company should follow the same method every year. This is called principle of consistency in accounting. If
the method of valuation is changed, it may lead to change in profit. In such case, the effect of change in the method
on profitability has to be shown separately.
5.5.5 Market Rate

Explained below are three methods of valuation under market rate:
Market Price
Under this method, market price is considered to be the base for pricing the issues. In this case, market price may be
treated as the latest purchase price, realisable price or replacement price. This method is used mainly in respect of
obsolete stock items or non-moving stock items. The defect in respect of this method is that the price concessions
obtained in respect of bulk purchases are not reflected in the cost of material.
Specific Price
If the material is purchased against a specific job or production order, the issue of material is priced at actual purchase
price. This method can be adopted if the purchase prices are fairly stable.
Standard Price
This is the normal or ideal price which will be paid in the normal circumstances, based on the basis of estimated
market conditions, transportation costs and normal quantity of purchases. Any issue of material will be priced at
standard prices irrespective of actual prices. This enables the simplification of accounting system with reduced
74/MITSDE
clerical work and also enables to decide the efficiency of purchase department.
5.6 Valuation of Returns

This indicates the material returned by the production department to stores department
The way in which the returned material can be valued is shown below:
• At the same price as when issued
The original price of issue will be a base for valuing the returns, for which original material requisition
note will be the base.
• At the current price of issues
The method which is followed for valuing the issue on the same date is considered for valuing the
returns.
This will avoid the clerical efforts, but at the same time the track of original issue of material can’t be
maintained.
Treatment of shortages
In some cases, the physical verification of stock may reveal that the physical stock is less than the stock as per the
stores ledger. The valuation of this shortage is done as if it is an issue of material. The treatment given to the valuation
of shortages in cost accounts depends upon the nature of the shortage i.e. normal shortage or abnormal shortage.
Bill of materials
In order to ensure proper inventory control, the ‘basic principle to be kept in mind is that proper material is available
for production purposes whenever it is required. This aim can be achieved by preparing what is normally called as
'Bill of Materials'.
A bill of material is the list of all the materials required for a job, process or production order. It gives the details
of the necessary materials as well as the quantity of each item. As soon as the order for the job is received, bill of
materials is prepared by production department or production planning department.
The form in which the bill of material is usually prepared is as below:
BILL OF MATERIALS
No. Date of Issue Production/Job Order No.
Department authorised
S. No. Description Code Qty. For Department Use only
Remarks of Material No. Material Date Quantity
Requisition No. demanded
The functions of bill of materials are as below:

• Bill of material gives an indication about the orders to be executed to all the people concerned.
• Bill of material gives an indication about the materials to be purchased by the purchases department if the same
is not available with the stores.
• Bill of material may serve as a base for the production department for placing the material requisitions ships.
75/MITSDE
• Costing/Accounts Department may be able to compute the material cost in respect of a job or a production
order. A bill of material prepared and valued in advance may serve as a base for quoting the price for the job
or production order.
• Perpetual Inventory System: In order to exercise proper inventory control, perpetual inventory system may be
implemented. It aims at two facts, given below.
maintenance of bin cards and stores ledger in order to know about the stock in quantity and value at any
point of time
continuous verification of physical stock to ensure that the physical balance and the book balance tallies
The continuous stock taking may be advantageous from the following angles:
• Physical balances and book balances can be compared and adjusted without waiting for the entire stocktaking
to be done at the year-end. Further, it is not necessary to close down the factory for annual stocktaking.
• The figures of stock can be readily available for the purpose of periodic profit and loss account.
• Discrepancies can be located and adjusted in time.
• Fixation of various levels and bin cards enables the action to be taken for the placing the order for acquisition
of material.
• A systematic maintenance of perpetual inventory system enable in locating the slow and non-moving items and
to take remedial action for the same.
• Stock details are correctly available for getting the insurance of stock.
76/MITSDE
Summary
• Management of inventory assumes importance due to the fact that investment in inventory constitutes one of the
major investments in current assets. The various forms in which a manufacturing concern may carry inventory
are; raw material, work in progress, finished goods and stores and supplies.
• A company may hold the inventory with the following motive: transaction motive, precautionary motive, and
speculative motive.
• The types of movement of the material from the stores department are: receipt of material, issue of material,
return of material from production department to stores department, and transfer of material.
• The proper conduct of storage function requires that material should be properly stored in a good condition till
it is required for use by production departments and this is ensured by perpetual inventory system.
• Valuation of material is done in valuation of receipts, valuation of issues and valuation of returns from production
department to stores department.
• Valuation of receipts is a relatively easy task, as the invoice or bill received from the supplier of the material
is available as a starting point.
• Valuation of the issues is done by First In First Out (FIFO), Last In First Out (LIFO), Highest In First Out
(HIFO), Simple Average Rate (SAR), Weighted Average Rate (WAR) and Market rate.
• First in First out (FIFO) method: the price of the earliest available lot is considered first and if that lot is exhausted,
the price of the next available lot is considered.
• Last in First out (LIFO) method: the price of the latest available lot is considered first and if that lot is exhausted,
the price of the lot prior to that is considered.
• Highest in first out method assumes that the stock should always be shown at the minimum value and hence
the issues should always be valued at the highest value of receipts.
• Simple average (SAR) method, the simple average of the prices of the lots available for making the issues is
considered for pricing the issues.
• Weighted average (WAR) method considers not only the price of each lot but also the quantity of the same.
• Valuation of the returns is done on two bases: at the same price at which issued and at the current price if
issues.
References
• Stores Management in Non government organizations, 24th March, 2011[Online] (Updated on 24th March,
2011) Available at <http://www.had.gov.hk/file_manager/docs/public_services/store_e.pdf> [Accessed on 24th
March 2011]
• Stores systems and procedures, 24th March, 2011 [Online] (Updated on 24th March, 2011) Available at <http://
www.materials-manage.com/stores/stores-system.htm> [Accessed on 24th March, 2011]
• Stores Management and Stock control study guide, 24th March, 2011 [Online] (Updated on 24th March, 2011)
Available at <http://www.scribd.com/doc/49258864/stores-management-notes> [Accessed on 24th March
2011]
Recommended Reading
• Carter, R. & Price, P., 2004. Stores and Distribution Management. Liverpool Academic Press
• Carter, R.J., 1982. Stores Management and Related Operations (M & E Handbook Series). Trans-Atlantic
Publications
• Farrington, F., 2010. Store management-complete. Nabu Press
77/MITSDE
Self Assessment
1. Which of the following document is used to record the details of the material received?
a. Inspection receipt
b. Goods received report
c. Bin card
d. Stores ledger
2. Which of the following methods assumes that the stock should always be shown at the minimum value and
hence the issues should always be valued at the highest value of receipts?
a. First in first out
b. Last in first out
c. Highest in first out
d. Simple average rate
3. If the material is purchased against a specific job or production order, the issue of material is priced at _________
purchase price.
a. actual
b. cost
c. selling
d. inventory
4. Which of the following statement is false?

a. A company may be required to hold the inventories in order to facilitate the smooth and uninterrupted
production and sales operations
b. Usually the receipt of material is accompanied by delivery challan given by the supplier
c. On receipt of the material, quantity received is checked with the quantity ordered by the stores
department
d. The material can be issued from the stores without a proper authority in writing is produced before the
stores department
5. Which of the following system ensures the proper conduct of storage?

e. Perpetual inventory
f. Bin card
g. Stores ledger
h. Valuation of receipts
6. Which of the following method may be useful in case of the organisations dealing with monopoly products
which is a rare possibility?
a. First in first out
b. Last in first out
c. Highest in first out
d. Simple average rate
78/MITSDE
a. Bill of material gives an indication about the orders to be executed to all the people of the organisation
b. Bill of material gives an indication about the materials to be purchased by the purchases department if the
same is available with the stores
c. Bill of material may serve as a base for the production department for placing the material requisitions
ships
d. Bill of material prepared and valued later on and may serve as a base for quoting the price for the job or
production order
8. Bin card is maintained by stores department while stores ledger is maintained by ________department.
a. manufacturing
b. distribution
c. packaging
d. costing
9. The levels indicated on bin card enable the stores department to keep a watch on balance and replace the material
as soon as it reaches the ___________level.
a. minimum
b. re-order
c. actual
d. valuation
10. The stores ledger considers not only the movement of material in terms of quantity but also in terms of its
_________implications.
a. distribution
b. economical
c. financial
d. production
79/MITSDE
Application I
Swarupa Industries manufactures a special product ‘Vick’. The following particulars are collected for the year
1986.
• Monthly demand of “Vick” - 1000 units
• Cost of placing an Order - Rs. 100
• Annual carrying cost per unit - Rs. 15
• Normal Usage 50 units per week
• Minimum Usage 25 units per week
• Maximum Usage 75 units per week
• Re-order period 4 to 6 weeks
Questions:
Compute the following:
2. Re-order Level
3. Minimum Level
4. Maximum Level
Answers:
1. Reorder Quantity:
EOQ = √(2 A O)/C
= √(2 X 12,000 x 100) / 15
= √(24,00,000/15)
= √1,60,000
= 400 units
2. Reorder Level = Maximum Lead Time x Maximum Usage

= 6 weeks x 75 units
= 450 units
3. Minimum Level = Reorder Level – (Normal Usage x Normal Lead time)

= 450 units – (50 units X 5 weeks)
= 200 units
4. Maximum Level
= Reorder Level + Reorder Quantity – (Minimum Usage x Minimum Lead-time)
= 450 units + 400 units – (25 units X 4 Weeks)
= 750 units

= (Minimum Level + Minimum Level) / 2
= (200 units + 750 units) / 2
= 475 units
80/MITSDE
Application II
Fill in the Blanks on the basis of the following information:
Annual Requirement 10000

Ordering cost per order 300
Carrying cost 15%
Price per unit 200
Lot size No. of orders Ordering cost Carrying cost Total cost
50 200 750 60,750
100 100 30,000 31,500
67 20,000 2,250 22,250
200 50 15,000 3,000
250 12,000 3,750 15,750
500 20 6,000 13,500
1000 10 3,000 15,000 18,000
2000 5 1,500 30,000 31,500
The following information is given about M/s Shankar Industries.

Normal usage : 40 units per week each
Minimum usage : 30 units per week each
Maximum usage : 60 units per week each
Reorder quantity : 300 units
Recorder period : 3 - 5 weeks
Questions:
Compute the following from the above information:
2. Re-order Level
3. Minimum Level
4. Maximum Level
81/MITSDE
Application III
Inventory Models
Following is the information about M/s Sangeeta industries.
1 Annual Requirement Units 2,000

2 Ordering cost per order 200
3 Carrying cost 20%
5 Discount Quantity Units 400
6 Discount Rate offered 1%
Advise whether the company should accept the offer of discount.
Question:
Show your answer in the following format.
A) If EOQ model followed

1 EOQ Units
2 No. of orders
3 No. of orders rounded off
4 Ordering cost
5 Carrying cost
6 Material cost
7 Total cost rupees
B) If discount offer is accepted

1 Discount Quantity
2 No. of orders
3 No. of orders rounded off
4 Ordering cost
5 Carrying cost
6 Material cost
7 Total Cost rupees
C) Benefit of discount offer

D) Decision
82/MITSDE
Bibliography
References
• 22nd March, 2011, Purchase Management [Online] (Updated 22nd March, 2011) Available at <http://www.
scribd.com/doc/195864/Purchase-Management>. [Accessed on 22nd March 2011]
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scribd.com/doc/14816975/Purchasing-Management>. [Accessed on 22nd March 2011]
• Aher, Kiran, 22nd March,. 2011, Purchasing Management [Online] (Updated 22nd March, 2011) Available at <
http://www.authorstream.com/Presentation/kiranaher1989-387753-purchase-management-mgmt-entertainment-
ppt-powerpoint/>. [Accessed on 22nd March 2011]
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Deepakpati/abc-analysis>. [Accessed on 18th March 2011]
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org/resources/ie/EOQ/EOQ.ppt>. [Accessed on 18th March 2011]
• Joshi, Amit, Juyal Ankur, Pasbola Prabhat Inventory Models [Online] (Updated 21st March, 2011) Available
at <http://www.authorstream.com/Presentation/aSGuest42948-373181-inventory-models-models1-business-
finance-ppt-powerpoint/> [Accessed on 21st March, 2011]
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Fitzsimmons%2Flatest%2FPowerPointLectures%2FGoods16.ppt&rct=j&q=inventory%20models%20ppt&ei=h
zWHTZ1Bx6tx5eyQgwM&usg=AFQjCNEgH4luVzBa2-4c-J3uoG4YnMK8bg&sig2=KolhqlujfhaOKQDegZ-
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knowledgebase/Material%20Management/Scope%20and%20functons%20of%20materals%20management.
pdf> [Last accessed on 16th March 2011]
• Purchasing Process Structure [Online] (Updated on 16th March 2011) Available at <http://www.
taskmanagementsoft.com/solutions/departments/purchasing-management-process.php> [Accessed on 8th April,
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co.in/url?sa=t&source=web&cd=7&ved=0CD4QFjAG&url=http%3A%2F%2Fwww.foundationcoalition.org
%2Fresources%2Fie%2FInventory2%2Fmodel2.ppt&rct=j&q=inventory%20models%20ppt&ei=hzWHTZ1
Bx6tx5eyQgwM&usg=AFQjCNHDwla1uKXD6oqmXPfy_q6jFAIPhg&sig2=j0laV8v2TByS6kW5Fr49Pg&
cad=rja.>. [Accessed on 18th March 2011]
• Stores Management and Stock control study guide, 24th March, 2011 [Online] (Updated on 24th March, 2011)
Available at <http://www.scribd.com/doc/49258864/stores-management-notes> [Accessed on 24th March
2011]
• Stores Management in Non government organizations, 24th March, 2011[Online] (Updated on 24th March,
2011) Available at <http://www.had.gov.hk/file_manager/docs/public_services/store_e.pdf> [Accessed on 24th
March 2011]
83/MITSDE
• Stores systems and procedures, 24th March, 2011 [Online] (Updated on 24th March, 2011) Available at <http://
www.materials-manage.com/stores/stores-system.htm> [Accessed on 24th March, 2011]
Recommended Reading
• Anderson, Ernest L. & Morgan, James P., 1998. The Systems Purchasing Breakthrough. 1st ed., Cahners Pub.
Co
• Bartmann, D., 1992. Inventory Control: Models and Methods (Lecture Notes in Economics and Mathematical
Systems). Springer
• Beyer, D., 2009. Markovian Demand Inventory Models (International Series in Operations Research &
Management Science). 1st ed., Springer.
• Carter, R. & Price, P., 2004. Stores and Distribution Management. Liverpool Academic Press
• Carter, R.J., 1982. Stores Management and Related Operations (M & E Handbook Series). Trans-Atlantic
Publications
• Emmett, S., 2005. Excellence in Warehouse Management: How to Minimise Costs and Maximise Value.
Wiley.
• Farrington, B., 2001. Creative Control of Purchase Prices. Spiro Press
• Farrington, F., 2010. Store management-complete. Nabu Press
• Frazelle, E., 2001. World-Class Warehousing and Material Handling. 1st ed., McGraw-Hill.
• Heywood, J.Brian, 2001. e-procurement: A Guide to Successful e-procurement Implementation (Management
briefings: finance). Financial Times Prentice Hall
• Muller, M., 2003. Essentials of Inventory Management. AMACOM
• Neef, D., 2001. e-Procurement: From Strategy to Implementation. FT Press
• Piasecki, David J., 2009. Inventory Management Explained: A focus on Forecasting, Lot Sizing, Safety Stock,
and Ordering Systems. 1st ed., Ops publishing.
• Piasecki, Edward A., 1998. Inventory Management and Production Planning and Scheduling. 3rd ed., Wiley.
• Richards, G., 2011. Warehouse Management: A Complete Guide to Improving Efficiency and Minimizing Costs
in the Modern Warehouse. Kogan Page.
• Sabri, Ehap H. & Gupta A., 2006. Purchase Order Management Best Practices: Process, Technology, and
Change Management. J. Ross Publishing
• Stoehr, T., 2002. Managing e-Business Projects. 1st ed., Springer
• Tijms, H. C., 1972. Analysis of (s S) Inventory Models. 1st ed., Mathematical Centre Tracts.
84/MITSDE
Self Assessment Answers
Chapter I
1. b
2. a
3. d
4. d
5. c
6. c
7. a
8. b
9. a
10. a
Chapter II
1. c
2. d
3. d
4. a
5. b
6. b
7. b
8. d
9. a
10. d
Chapter III
1. a
2. d
3. b
4. a
5. d
6. a
7. b
8. a
9. c
10. a
Chapter IV
1. b
2. a
3. d
4. a
5. d
6. b
7. b
8. a
9. c
10. a
85/MITSDE
Chapter V
1. b
2. c
3. a
4. d
5. a
6. c
7. c
8. d
9. b
10. c
86/MITSDE

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Material and Store Management

This book is a part of the course by MITSDE, Pune.

The content in the book is copyright of MITSDE. All rights reserved.

• introduce the students to material management

• explain the scope of material management

• elucidate the various motives of inventory

• discuss the classification of inventory

• recognise the key objectives of material management

• enlist the functions of material manager

• understand the materials requirement planning technique (MRP)

• know about the process of purchasing

• know the effects of overstocking and under stocking

1.1 Introduction to Material Management

1.2 Classification of Inventory

Fig. 1.1 Inventory classification

1.3 Meaning of Material Management

Materials management has such sub-fields as:

1.4 Objectives of Materials Management

• of the right quality

The key objectives of material management are as follows:

1.5 Motives of Materials Management

1.7 Material Planning

Factors affecting Material planning

1.8 Technique of Planning Materials

Cataloguing or coding the materials

Use of drawing numbers

1.9 Process of Codification

Abrasives Bearings Belt and beltings

Table 1.1 List of classification of inventories

Specifications are divided generally into two main categories:

• target completion date of the project

Procurement involves the following activities:

Inspection is generally divided into three categories:

1.15 Quality Control

1.18 Inventory Control

1.21 Functions of Material Manager

1.22 Effects of Over Stocking and Under Stocking

Overstocking will result into the following consequences:

Understocking will result into the following consequences:

4. Which of the following statement is false?

6. ________ is first subjected to a manufacturing process before it becomes finished goods.

9. Which of the following statements is true?

• introduce the concept of economic order quantity

• explain the material cost management

• elucidate the various inventory levels

• discuss material cost

• recognise the drawbacks of economic order quantity model (EOQ)

• understand the ABC analysis

• assimilate the XYZ analysis

• learm about AX control

• identify the advantages of ABC analysis

Cost of increasing production and employment level, involves the following:

Cost of decreasing production and employment level, involves the following:

The functions of inventories are to:

2.2 Material Cost

packing material etc.

Example: For calculating material cost-

Elements of cost Amount per unit

The following further particulars are available:

2.3 Economic Order Quantity (EOQ) Models

Economic lot size or economic order quantity model assumptions are:

• Production rate is infinite, i.e. production is instantaneous

Objective of the EOQ