Material

Material Procedures and Documentation:

Raw material is provided by stores department to production department for manufacturing of a product. If raw material required by production department is not available then it is purchased from a buyer.

 The material purchase procedures differ from company to company however in a large company with separate purchase department and stores department, basic steps involved might be as follows.

•  Formal request by stores department to the purchase department to purchase an item of raw material which is called “Material Purchase Requisition”
•   Placing of order (Purchase Order) with the selected supplier by the purchase department
• “Delivery Note” is given by the supplier to the stores department showing the identity and quantity of items delivered. Delivery note also confirms the delivery.
• “Goods Receipt Note” is prepared by the stores department showing the detail of the material items received.
• Copies of the “Delivery Note” and “Goods Receipt Note” are sent to the accounts department where they are matched with the copy of “Purchase Order”
• The supplier gives the “Purchase Invoice” asking for payment. The accounts department, checks the details on the purchase invoice with details on the purchase order and goods receipt note to confirm that correct material item has been delivered in correct quantity.
• The accounts department, after the above confirmation, records the purchase through purchase invoice.

    

    INVENTORY MANAGEMENT

v Costs Associated with Inventory

Costs associated with the inventory may be classified into the following categories:

·        Purchase Price

·        Reorder Costs

o   Cost of delivering of purchased items

o   Cost of placing an order

o   Cost of checking the inventory after delivery

o   Cost of  batch setup cost ( if produced internally)

·        Inventory Holding Costs

o   Cost of capital tied up

o   Insurance cost

o   Cost of  warehousing

o   Cost of obsolescence, deterioration and theft

·        Shortage/Stock out Costs

o   Loss of profit on sale

o   Future loss of profit due to loss of goodwill

o   Costs due to production stoppage due to shortage of raw materials

v Economic Order Quantity (EOQ)

Economic order quantity is the mathematical model used to calculate the quantity of inventory to order from a supplier each time that an order is made. It is the quantity at which inventory costs are minimum.

Assumptions of EOQ Model and their Implications

Assumptions	Implications
Ø No bulk purchase discounts	Ø Purchase price can be ignored being irrelevant cost
Ø The order lead time is constant and known	Ø Delivery coincide with running out of inventory (Maximum Inventory=Quantity Ordered(Q)) Ø No risk of being out of stock Ø Shortage costs can be ignored
Ø Annual demand is constant throughout the year	Ø Average inventory is Q/2

                                                         

As a result of simplifying assumptions, Relevant costs are “Annual holding costs and Annual Ordering Costs”         

Formula for calculating Economic Order Quantity (EOQ):  

_{EOQ=√ (((2×Co × D))/CH)}  

Where:

 EOQ = Economic order quantity

C_o = Cost per order

C_H   = Annual cost of holding an item of inventory (Holding cost per unit per annum) 

D = Annual Demand

Formulas associated with minimizing inventory costs

Ø Average Inventory Held = Reorder Quantity (Q) /2

Ø Total holding Costs Per Year = Reorder Quantity (Q)/2 × C_H

Ø Number of Orders = Annual Demand (D) / Reorder Quantity (Q)

Ø Total ordering Costs Per Year = Annual Demand (D) / Reorder Quantity (Q) × C_O

Important Note:                   At EOQ:       Annual Holding Costs = Annual Ordering Costs

v Optimum Order Quantity with Price discounts for Large Orders

 In case supplier offers discounts for large orders, Order quantity that minimizes Inventory Costs is either:

Ø EOQ ;      OR

Ø The minimum order quantity necessary to obtain the price discount.

INVENTORY LEVEL FORMULAS

v Reorder Level (In case of certain lead time and constant demand)

Reorder Level = Demand × Lead Time

• Reorder Level is the level of inventory (or quantity of inventory left in store) at which new order of inventory should be placed with the supplier.
• Lead Time is the time frame from the date of ordering the inventory to the date when the order(inventory) is received from supplier.  

v Reorder Level (In case of Uncertain lead time, Uncertain demand and Without Safety Stock)

Reorder Level = Maximum Demand × Maximum Lead Time

v Reorder Level (With Safety Stock)

Reorder Level=(Average Demand ×Average Lead Time)+ Safety Stock

v Safety Inventory/ Buffer Stock/ Safety Stock/ Minimum Inventory Level

Safety inventory is the minimum inventory level that should be maintained at every time to avoid any stock out.

Safety Stock=(Max.Demand ×Max.Lead Time)- (Avg.Demand×Avg.Lead Time)

OR

Safety Stock=Reorder Level- (Avg.Demand×Avg.Lead Time)

v Average Inventory

Average Inventory= (Order Size(Q))/2                         (Without Safety Stock)

OR

Average Inventory=(Order Size(Q))/2+ Safety Stock        (If there is Safety Stock)

OR

Average Inventory=(Min.Inventory Level+Max.Inventory Level)/2

v Maximum Inventory Level    

  It is the level of inventory that a company should not exceed. It would not be cost effective to hold inventory above this level. 

Maximum Inventory Level=(Reorder Level+Reorder Quantity)- (Min.Demand×Min.Lead Time)

v Danger Level

 It is the level of inventory that an organization must have at any time.

Danger Level = Normal Daily Usage × Time required to get emergency supplies

METHODS OF CONTROLLING AND MANAGING INVENTORY

Ø Economic Order Quantity (EOQ)

Please see my earlier posts for this method.

Ø Just in Time (JIT)

According to this method of inventory control, holding inventory is useless because it adds to total cost only and carries no benefit. So there should be no inventory at all. JIT method has two aspects:

·        Just in Time Production

This system tells that production should only be started when a new order of inventory is received. This means that production should be fast so that order may be delivered in time.

·        Just in Time Purchasing

This system tells that purchase order should only be placed with supplier when a new order of inventory is received. This means that supply system should be very efficient.

Ø Two Bin System

Under this method of inventory control two large containers are used for the purpose of holding inventory. As soon as the first container falls short of inventory, order is placed with the supplier. During the period of ordering inventory and receiving delivery of inventory from supplier (i.e. Lead Time), second container is used. Quantity of inventory in second container is enough to be used while new inventory is received from supplier. When second container becomes empty, again a new order is placed with the supplier and in this way, the process continues.

Ø Periodic Review System

Under this system of inventory, there is reorder level and reorder quantity for each item of inventory.

Inventory levels are checked periodically after, say, one, two, three or four weeks. When inventory levels fall below the limit, new order is placed with the supplier.

Ø ABC method of Inventory Control

There are three categories of inventory in this method of control. A, B and C. Category “A” inventory has high holding costs. Category “B” has moderate holding costs (Holding costs higher than Category C and lower than category “A” inventory). Category “C” inventory has low holding costs.

According to this method, each category of inventory should be controlled differently and the closest control should be applied to each category of inventory.

Category “A” may be controlled using EOQ model.

Category “B” may be controlled using Periodic Review System.

Category “C” may be controlled using Two bin System.

Identifying Inventories:

1.     Calculate total amount spent for each item of inventory.

2.     Rank the individual inventory items by the amount total spent and sum the column.

3.     Express each individual total spent item figure as a percentage of the total spent and sum the percentage column..

4.     Identify categories using stated policy.