Chapter 4:

Materials Management

4.1 Introduction
4.2 Purchasing
4.3 Inventory Management

1
 4.1 Introduction
 Materials management is a function, which aims for integrated approach
towards the management of materials in an industrial undertaking.
 Its main objective is cost reduction and efficient handling of materials at
all stages and in all sections of the undertaking.
 Its function includes several important aspects connected with material,
such as:- purchasing, storage, inventory control, material handling,
standardization etc.

 Functions of materials management

 Materials management is defined as “the function responsible for the
coordination of planning, sourcing, purchasing, moving, storing and controlling
materials in an optimum manner so as to provide a pre-decided service to the
customer at a minimum cost”. 2
4.1 Introduction
 From the definition it is clear that the scope of materials management
is vast. The functions of materials management can be categorized in
the following ways:

Fig. 1 Scope of materials management

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4.2 Purchasing

 Purchasing is an important function of materials management

which finds sources for supplies, negotiates contracts with
suppliers, and progresses deliveries of bought materials and
components.
 Like marketing, purchasing is a commercial function, but it is
more closely related to production control than to marketing.

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4.2 Purchasing
 In any industry purchase means buying of equipments,
materials, tools, parts etc required for industry.
 The moment a buyer places an order he commits a substantial
portion of the finance of the corporation which affects the
working capital and cash flow position.
 The buyer can make the company’s image by his excellent
relations with the vendor.
 The specification of the delivery schedules for purchases, in
order to regulate and control production and the investment
in stocks, is a part of the production control function.
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Function of Purchasing
 To receive purchase requirements and requisitions from various
departments
 To select the materials to be purchased on priority
 To select the source of supply
 To decide the purchasing policy and procedures
 To prepare specifications and obtain tenders and quotations of
materials
 To purchase the proper quantity at proper time
 To purchase good quality of materials at cheapest rate
 To get deliveries at proper place within the prescribed time
 To check and inspect the materials
 To make the prompt payments and co-operate 6
Objectives of Purchasing
 The basic objective of the purchasing function is to ensure continuity
of supply of raw materials, sub-contracted items and spare parts and
to reduce the ultimate cost of the finished goods.
 In other words, the objective is not only to procure the raw materials
at the lowest price but to reduce the cost of the final product.
 The objectives of the purchasing department can be outlined as
under:
1. To avail the materials, suppliers and equipments at the minimum
possible costs: These are the inputs in the manufacturing operations.
The minimization of the input cost increases the productivity and
resultantly the profitability of the operations.
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2. To ensure the continuous flow of production through continuous
supply of raw materials, components, tools etc. with repair and
maintenance service.
3. To increase the asset turnover: The investment in the inventories
should be kept minimum in relation to the volume of sales. This will
increase the turnover of the assets and thus the profitability of the
company.
4. To develop an alternative source of supply: Exploration of
alternative sources of supply of materials increases the bargaining
ability of the buyer, minimization of cost of materials and increases
the ability to meet the emergencies.

8
5. To establish and maintain the good relations with the suppliers: Such
relations are beneficial to the buyer in terms of changing the reasonable
price, preferential allocation of material in case of material shortages, etc.
6. To achieve maximum integration with other department of the
company: The purchase function is related with production department
for specifications and flow of material, engineering department for the
purchase of tools, equipments and machines, marketing department for
the forecasts of sales and its impact on procurement of materials,
financial department for the purpose of maintaining levels of materials
and estimating the working capital required, personnel department for
the purpose of manning and developing the personnel of purchase
department and maintaining good vendor relationship.
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7. To train and develop the personnel: Purchasing department is
manned with varied types of personnel. The company should try to
build the imaginative employee force through training and
development.
8. Efficient record keeping and management reporting: Paper
processing is inherent in the purchase function. Such paper processing
should be standardized so that record keeping can be facilitated.
Periodic reporting to the management about the purchase activities
justifies the independent existence of the department.

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Methods of Purchasing
1. Batch buying method – purchasing starts with a requisition
for a specified quantity of an item.
2. Schedule buying method – calling for the delivery of
specified quantities at a series of future delivery dates.
3. The call-off buying method – usually accompanied by a
delivery forecast or schedule, showing the probable
requirements for a series of future periods.

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Types of Purchasing
1. Centralized purchasing: In centralized purchasing, one purchase
department or its single authority will be authorized and made
responsible to make all types of purchases of all the departments.
Requisitions are supplied from all the departments to a centralized
purchase system. This type of purchasing is suitable to industries
having single plant or number of plants in nearby location.
2. Decentralized purchasing: Decentralized or localized purchasing
permits every individual department or its authority to make
purchases of its own requirements of materials and is responsible to
make its deliveries. This is good industries having plants at different
locations and manufacturing varieties of products.
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Procedures of Purchasing

Fig. 2 Purchasing procedure 13

The Choice of Supplier
 In the past it was customary to choose the supplier who quoted the lowest price
for an item, or to choose a number of suppliers whose prices were the lowest.
This approach is largely discredited today.
 The first problem is to decide between a single supplier (single sourcing) or
several different suppliers for each item.
 The advantage of having several suppliers per item is that if one of them fails,
or has a fire, or suffers a strike, the supply can be maintained by the others.
 The single source, on the other hand, has the advantages that:
(1) the purchase price is often lower, due to larger order quantities;
(2) the purchasing costs are lower as there are fewer suppliers;
(3) the quality tends to be more consistent; and
(4) it is easier to maintain contact with a small number of suppliers
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Parameters of Purchasing
 The success of any manufacturing activity is largely dependent
on the procurement of raw materials of right quality, in the
right quantities, from right source, at the right time and at
right price popularly known as ten R's of the art of efficient
purchasing.
 They are described as the basic principles of purchasing. There
are other well known parameters such as right contractual
terms, right material, right place, right mode of transportation
and right attitude are also considered for purchasing.

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Fig. Purchase parameters 16
Vendors Rating

 In order to compare the performance of various vendors, it is

necessary to rate them.
 The rating of supplier (vendor) will be done on the following
parameters.
(i) Quality performance
(ii) Delivery performance
(iii) Price performance

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Vendors Rating
(i) Quality Performance
 The supplier can be judged for quality performance from the
view point of rejected lots. If a supplier has supplied 100 pieces
and 10 pieces are rejected out of this lot, he has rating of 90%.
(ii) Delivery Performance
Delivery performance can be made in two ways:
(a) Adherence to time schedule and (b) Adherence to quantity schedule.
(iii) Price Performance
Price is very important criterion for evaluating a vendor .

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Example 1: Three suppliers supplied the quotations for supply of a particular item A as
follows, make a comparative statement and select the best supplier for purchase of 8000
units of item A.
Supplier X Item A, price Rs. 11.50 per unit + supply charges at site Rs. 5000.00
Supplier Y Item A, price Rs. 10.00 per unit + all other charges Rs. 15000.00
Supplier Z Item A, price Rs. 15.00 per unit + no other charges
Comparative Statement
Supplier X Supplier Y Supplier Z
Rate Rs. 11.50 Rate Rs. 10.00 Rate Rs. 15.00
For 8000 units:
Charges Rs. 92000.00 Rs. 80000.00 Rs. 120000.00
Other charges Rs. 5000.00 Rs. 15000.00 Nil
Total charges Rs. 97000.00 Rs. 95000.00 Rs. 120000.00
Lowest cost of supplier Y is recommended for purchase of item A at Rs. 95000/8000
= Rs. 11.87 per unit.
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Tenders/Quotations – Pro forma
 On receipt of enquiry, the supplier quotes his prices and terms and
conditions of supply of materials to the purchase department mentioning
prices of materials, quantity and specifications of materials, delivery date,
discount if any.
 The quotations/tenders are legal documents and must be handled properly
and preserved by the purchase department.
 The request for quotation form provides the information that supplier is
required to furnish, description, of items, quantity, date of delivery and
location where material is to be supplied.
 The supplier completes the form providing name, contact person, unit cost
and payment terms. The quotations are to be received on or before a
particular date and time. Purchasing department evaluate the quotations and
selects the supplier most suited to provide the item as per specification. 20
Types of tenders: There are three type of tenders:
1. Single tender
2. Closed tender
3. Open tender
1. Single tender: They are used to purchase materials urgently. The
single tender or quotation is called from some reliable firm and
purchase is done for the item required.
2. Closed tender/Limited tender: Only registered limited firms will be
selected for inviting tenders and placing the order at lowest rate. This
is also called limited tender system.
3. Open tender: It is unlimited tender system. In this system,
publishing it in newspapers and trading journals openly invite tenders.
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4.3 Inventory Control
 Meaning of Inventory
 Inventory generally refers to the materials in stock. It is also called the idle
resource of an enterprise.
 Represent those items which are either stocked for sale or they are in the
process of manufacturing or they are in the form of materials, which are yet
to be utilized.
 The interval between receiving the purchased parts and transforming them
into final products varies from industries to industries depending upon the
cycle time of manufacture. It is, therefore, necessary to hold inventories of
various kinds to act as a buffer between supply and demand for efficient
operation of the system.
 Thus, an effective control on inventory is a must for smooth and efficient
running of the production cycle with least interruptions. 22
Reasons for Keeping Inventories
1. To stabilize production: The demand for an item fluctuates because of the
number of factors, e.g., seasonality, production schedule etc. The inventories (raw
materials and components) should be made available to the production as per the
demand failing which results in stock out and the production stoppage takes
place for want of materials.
2. To take advantage of price discounts: Usually the manufacturers offer
discount for bulk buying and to gain this price advantage the materials are
bought in bulk even though it is not required immediately.
3. To meet the demand during the procurement or replenishment period: The
lead time for procurement of materials depends upon many factors like
location of the source, demand supply condition, etc.

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4. To prevent loss of orders (sales): In this competitive scenario, one has
to meet the delivery schedules at 100 per cent service level, means they
cannot afford to miss the delivery schedule which may result in loss of
sales. To avoid the organizations have to maintain inventory.
5. To keep pace with changing market conditions: The organizations
have to anticipate the changing market sentiments and they have to stock
materials in anticipation of non-availability of materials or sudden
increase in prices.
6. Sometimes the organizations have to stock materials due to other
reasons like suppliers minimum quantity condition, seasonal availability
of materials or sudden increase in prices.

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Inventory Control
 Inventory control is a planned approach of determining what to order,
when to order and how much to order and how much to stock so that
costs associated with buying and storing are optimal without
interrupting production and sales.
 Inventory control basically deals with two problems: (i) When should
an order be placed? (Order level), and (ii) How much should be ordered?
(Order quantity).
 The scientific inventory control system strikes the balance between
the loss due to non-availability of an item and cost of carrying the
stock of an item.
 It aims at maintaining optimum level of stock of goods required by the
company at minimum cost to the company. 25
Objectives of Inventory Control
 To ensure adequate supply of products to customer and avoid
shortages.
 To make sure that the financial investment in inventories is
minimum.
 Efficient purchasing, storing, consumption and accounting for
materials.
 To maintain timely record of inventories of all the items and to
maintain the stock within the desired limits.
 To ensure timely action for replenishment and a reserve stock for
variations in lead times .
 To provide a scientific base for both short-term and long-term
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planning of materials.
Benefits of Inventory Control

 It is an established fact that through the practice of scientific

inventory control, following are the benefits of inventory control:
 Improvement in customer’s relationship because of the timely
delivery of goods and service.
 Smooth and uninterrupted production and, hence, no stock out.
 Efficient utilization of working capital. Helps in minimizing loss
due to deterioration, obsolescence damage and pilferage.
 Economy in purchasing.
 Eliminates the possibility of duplicate ordering.

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Inventory Counting Systems
 A physical count of items in inventory to know its level.

 Periodic/Cycle Counting System: Physical count of items

made at periodic intervals.

 Continuous Counting System: System that keeps track of

removals from inventory continuously, thus monitoring
current levels of each item.

o Universal Bar Code - Bar code printed on a label that has

information about the item to which it is attached. 28
Inventory Classification
 In any organization, depending on the type of business,
inventory is maintained. When the number of items in
inventory is large and then large amount of money is needed to
create such inventory, it becomes the concern of the
management to have a proper control over its ordering,
procurement, maintenance and consumption.
 Inventory classification is a process of classifying items into
different categories, thereby directing appropriate attention to
the materials in the context of company’s viability.

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Inventory Classification
 The different techniques of inventory classifications are: (1)
ABC analysis, (2) HML analysis, (3) VED analysis, (4) FSN
analysis, (5) SDE analysis, (6) GOLF analysis and (7) SOS
analysis.
 The most widely used method of inventory control is known as
ABC analysis. In this technique, the total inventory is
categorized into three sub-heads and then proper management
is exercised for each sub-heads.

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ABC Classification
 ABC analysis (Always Better Control analysis): In this analysis, the
classification of existing inventory is based on annual consumption
and the annual value of the items.
 Hence we obtain the quantity of inventory item consumed during the
year and multiply it by unit cost to obtain annual usage cost.
 The items are then arranged in the descending order of such annual
usage cost.
 The analysis is carried out by drawing a graph based on the
cumulative number of items and cumulative usage of consumption
cost.

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ABC classification system
 Classifying inventory according to measure of importance and
allocating control efforts accordingly.
 Importance measure= price*annual sales

A - very important

B - mod. important

C - least important

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ABC Classification Example
 A Items:

 Typically 10 - 25% of the items accounting for 70 - 80% of

the inventory (Vital few).

 B Items:

 Typically an additional 20 - 30% of the items accounting for

10 - 25% of the inventory value (moderate).

 C Items:

 Typically the remaining 60% - 70% of the items accounting

for only 5% - 15% of the inventory value (Trivial many).
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ABC Classification Example

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Steps in ABC Analysis
a) Compute Annual Usage in Dollars for each item and

Compute Total Annual Usage.

b) Compute the percentage of Annual Usage for each item.

c) Sort the list of items by the percentage of Annual Usage in

Dollars, from largest to smallest.

d) Calculate the Cumulative Percentage of Annual Usage in Dollars

for the first item, first 2 items, first 3 items, etc. For the last item,

the cumulative % should be 100%. Using Cumulative % as a guide,

assign the items to A, B, and C categories.

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ABC Analysis Example

36
ABC Analysis Example

37
ABC Analysis Example

38
Other Inventory Classification Techniques
2. HML analysis: In this analysis, the classification of existing
inventory is based on unit price/cost of the items. They are
classified as high price, medium price and low price items.
3. VED analysis: In this analysis, the classification of existing
inventory is based on criticality of the items. They are classified as
vital, essential and desirable items.
4. FSN analysis: In this analysis, the classification of existing
inventory is based on consumption of the items. They are
classified as fast moving, slow moving and non-moving items.

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Other Inventory Classification Techniques
5. SDE analysis: In this analysis, the classification of existing
inventory is based on free availability of the items. They are
classified as scarce, difficult and easily obtainable items.
6. GOLF analysis: In this analysis, the classification of existing
inventory is based on sources of the items. They are classified as
Government supply, ordinarily available, local availability and
foreign source of supply items.
7. SOS analysis: In this analysis, the classification of existing
inventory is based on nature of supply of items. They are
classified as seasonal and off-seasonal items.
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Inventory Costs
 Holding costs: the costs of holding or “carrying” inventory
over time.

 Housing costs (including rent or depreciation, operating

costs, taxes, insurance)

 Material handling costs (equipment lease or depreciation,

power, operating cost)

 Pilferage

 Space, and obsolescence

 Labor cost 41
Inventory Costs
 Ordering costs: the costs of placing an order and receiving goods,
Fixed, constant dollar amount incurred for each order placed.

 Processing and inspecting incoming inventory

 Inventory inquiries, Utilities, phone bills, and so on for the

purchasing department

 Salaries and wages for purchasing department employees

 Supplies such as forms and paper for the purchasing department.

 Shortage costs: Loss of customer goodwill, back order handling, and

lost sales.

 Investment costs: borrowing costs, taxes, and insurance on inventory.

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Inventory Models
 Inventory models deals with determining optimum inventory
level that should be kept to keep the inventory cost to the minimum
and customer satisfaction or service level to the maximum.

 When to order?

 How much to order?

 Level of inventory

 Inventory Models

Economic Order Quantity (EOQ)

Price Discount Models/Price Break Models 43

Economic Order Quantity (EOQ)
 An optimizing method used for determining order quantity and
reorder points. Part of continuous review system which tracks
on-hand inventory each time a withdrawal is made.

 Assumptions:

 Only one product is involved

 Annual demand requirement is known and constant.

 Lead time does not vary.

 Each order is received in a single delivery.

o Infinite production capacity

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EOQ Model

1. You receive an order quantity Q. 4. The cycle then repeats.

Q Q Q

R
L L
2. You start using them
up over time. Time 3. When you reach down to a level
of inventory of R, you place your
next Q sized order.
R = Reorder point
Q = Economic OQ
L = Lead time
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EOQ Model Costs

46
EOQ Model
Total Annual Costs = Annual Ordering Costs + Annual Holding Costs
T.C = 1/2QH + (D/Q)S
Where T.C = Total annual cost, Q = Order quantity, H = Holding cost
per item per year, D = Annual demand, S = Ordering cost per order.

 The optimal or minimum cost occurs at the intersection point of

holding cost and ordering cost. So using calculus the Q value at
this point can be computed.

Reorder level (R) can be computed as demand during lead time times lead time.

R= d*L
R= d*L + ss (safety stock) 47
EOQ Model Terms
 Reorder point (R): Level of inventory on hand at which the next
order should be placed.

 Cycle Interval (T): the total time between one order receipt
period and next order receipt.

 Order frequency (N): total number of orders per year (per full
inventory cycle).

 Cycle Inventory (Q/2): Average inventory kept per cycle

interval.

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EOQ Example 1
 Annual Demand = 1,000 units;  Holding cost per unit
 Days per year considered in = $2.50 / yr;
average 365;
 Lead time = 7 days;
 Daily demand = 1000/365;
 Cost to place an order = $10;  Cost per unit = $15;

Given the information above, what are the EOQ, reorder point (R), Cycle
inventory, Order frequency (N) and Cycle interval (T)?

2D S 2 (1 ,0 0 0 )(1 0 )
Q OPT = = = 8 9 .4 4 3 u n its o r 9 0 u n its
H 2 .5 0

1,000 units/year
d= = 2.74 units/day Cycle Inventory = Q/2 = 45 Units
365 days/year
_
T= Q/d = 32.85 days
R = d L = 2.74units/day (7days) = 19.18 or 20 units

N = D/Q = 11.1 Orders T.C = H.C + O.C = ½(90*2.5) + (11.1*10) = $ 223.5 49

EOQ Example 2
 An oil engine manufacturer purchases lubricants at the rate of $ 42 per
piece from a vendor. The requirements of these lubricants are 1800 per
year. What should be the ordering quantity per order, if the cost per
placement of an order is $16 and inventory carrying cost is 20% of
purchasing cost per item per year.
 Solution:
 D=1800 per year, Ordering cost (S) = $16 per order, Holding cost (H) =
0.2*Unit cost = 0.2*$42 = $8.4

2DS 2(1800 )(16)

Q OPT = = = 83 units
H 8.4

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EOQ Example 3
 A manufacturing company purchase 9000 parts of a machine for its
annual requirements ordering for month usage at a time, each part
costs $20. The ordering cost per order is $15 and carrying charges are
15% of the purchasing price per unit per year. You have been
assigned to suggest a more economical purchase policy for the
company. What advice you offer and how much would it save the
company per year?
 Solution:
 D = 9000 parts per year, Purchase price (P) = $20, S = $15 per order,
H = 0.15*20 = $3 per unit per year
2DS 2(9000 )(15)
Q OPT = = = 300 units
H 3 51
EOQ Example 3
 How much would it save the company per year?
 First for EOQ of 300 units:

T.C = H.C + O.C = ½(300*3) + (30*15) = $ 900

 Then for existing system, assuming purchasing will be done every

month, Q is then 9000/12 = 750 units.

T.C = H.C + O.C = ½(750*3) + (12*15) = $ 1,305

 Hence there is a saving of $1,305 - $900 = $405 per year.

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Price Break (Quantity Discount) Models
 Reduced prices are often available when larger quantities
are purchased.
 Trade-off is between reduced product cost and increased
holding cost.

53
Price Break (Quantity Discount) Models
 Price break model procedure

 Calculate the EOQ for each price break.

 Determine whether the EOQ is feasible at that price, check

whether the EOQ is in the discount range.

 Will the vendor sell that quantity at that price?

 If yes, stop – if no, continue.

 If EOQ is not feasible select the next higher quantity,

minimum on the discount range.

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Price Break (Quantity Discount) Models
 Price break model procedure

 Calculate the total costs (including total item cost) for the
feasible EOQ model of each price break.

 Compare the total cost of each option & choose the lowest
TC alternative.

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Price Break (Quantity Discount) Models
 Example: Let the annual demand of item X is 5000 units, Ordering
cost is $49 per order, Holding cost is 20% of unit price per item per
year. Determine the optimal order quantity that minimizes the total
cost.
 Here the value of holding cost depends on the amount of units to be ordered,
and it varies for each discount. For the above example: H = iP and Total
product cost per year is = PD, where i is percentage of holding cost.

Discount Discount Price

Number Discount Quantity Discount (%) (P)*100
1 0 to 999 no discount $5.00
2 1,000 to 1,999 4 $4.80
3 2,000 and over 5 $4.75

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Price Break (Quantity Discount) Models

2DS
Q* =
iP

2(5,000)(49)
Q1* = (.2)(5.00) = 700 items order

2(5,000)(49)
Q 2* = (.2)(4.80) = 714 items order, adjusted to 1000 items.

2(5,000)(49)
Q 3* = (.2)(4.75) = 718 items order, adjusted to 2000 items.

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Price Break (Quantity Discount) Models
 The total cost of each price break is computed as follows including the annual
product cost and holding cost for each range which depends on product price.

TC = QH/2 + DS/Q + PD

Annual Annual
Discount Unit Order Annual Ordering Holding
Number Price Quantity Product Cost Cost Cost Total

1 $5.00 700 $25,000 $350 $350 $25,700

2 $4.80 1,000 $24,000 $245 $480 $24,725

3 $4.75 2,000 $23.750 $122.50 $950 $24,822.50

 Choose the price and quantity that gives the lowest total cost
 Buy 1,000 units at $4.80 per unit, Discount number 2.
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Reorder Point and Safety Stock
 Reorder Point - When the quantity on hand of an item drops to this amount,
the item is reordered. We call it R.

 Determinants of R:

 The rate of demand, lead time

 Demand and/or lead time variability and Safety stock

 Safety Stock - Stock that is held in excess of expected demand due to

variable demand rate and/or lead time. We call it SS.

 Service Level - Probability that demand will not exceed supply during lead
time. We call this cycle service level, CSL.

 Risk of a stockout = 1 – (service level)

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Reorder Point and Safety Stock

60
Reorder Point and Safety Stock

61
Reorder Point and Safety Stock
 Without safety stock:
R = dL
Where R = reorder points, d= daily demand, L= Lead time
 With safety stocks:
R = dL + SS
Where SS = Safety stock
SS = ZσdL
Where, Z = number of standard deviations associated with desired
service level
σ = standard deviation of demand during lead time

R = dL + ZσdL
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ROP and Safety Stock Example 1
 Daily demand = 20 units  Service level (Z) = 90%
 Lead time = 10 days  Determine:
 S.D. of lead time demand  Safety stock
= 50 units  Reorder point

R= dL + SS
R = dL + σ(1- SL)
The value of area under normal
distribution (Z) can be found from Z
R = 20*10 + 50(norm of 10%)
table and for 10% stockout the value of
= 200 + 50(1.28) = 264 units
Z is 1.28.

SS =50(norm of 10%) Refer Z Table

= 50(1.28) = 64 units

63
ROP and Safety Stock Example 2
 DDLT follows a normal distribution.
 μ = 350, σ = 10
 95% service level (i.e. 5% probability of a stockout).
 Here μ is expected demand during lead time with standard deviation of σ.
 Find R and ss

R= dL + SS
R = dL + σ(1- SL)

SS =10(norm of 5%)
= 10(1.650) = 16.5 units

From Z table area under 5% is 1.65

R = 350 + 10(norm of 5%)

= 350 + 10(1.650) = 366.5 units
Refer Z Table
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 Quiz -1
 Each month, a gas station sells 4,000 liters of gasoline. Each
time the parent company refills the station’s tanks, it charges
the station $50 plus 70¢ per liter. The annual cost of holding a
liter of gasoline is 30¢.

a. How large should the station’s orders be?

b. How many orders per year will be placed?

c. How long will it be between orders?

d. If the lead time is two weeks, what is the reorder point?

65
 Quiz -2
 An item sells for $25 a unit, but a 10% discount is offered for
lots of 150 units or more. A company uses this item at the rate
of 20 units per day. The ordering cost is $50, and the holding
cost per unit per day is $0.30. The lead time is 12 days. Should
the company take advantage of the discount? Assume: 300
working days per year.

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Class Discussion 4:
 Compare and contrast 'Inventory' and 'JIT'

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