Unit 2
Materials Management
Materials Management is the planning, directing, controlling and coordinating those activities which are concerned with materials and inventory requirements, from the point of their inception to their introduction into the manufacturing process.
Thus, material management is an important function of an organisation covering various aspects of input process, i.e., it deals with raw materials, procurement of machines and other equipment’s necessary for the production process and spare parts for the maintenance of the plant. Thus in a production process materials management can be considered as an preliminary to transformation process.
It involves planning and programming for the procurement of material and capital goods of desired quality and specification at reasonable price and at the required time.
It is also concerned with market exploration for the items to be purchased to have up to date information, stores and stock control, inspection of the material received in the enterprise, transportation and material handling operations related to materials and many other functions. In the words of Bethel, “Its responsibility end when the correct finished product in proper condition and quantity passes to the consumer.”
General Electric Company (G.E.C.) of U.S.A. who are pioneers in the field of Materials Management listed the functions of materials management under following heads:
(i) Planning and programming for materials purchase.
(ii) Stores and Stock control.
(iii) Receiving and issue of the material.
(iv) Transportation and material handling of the material.
(v) Value engineering and value analysis.
(vi) Disposal of scrap and surplus materials.
Objectives of Materials Management:
Materials management contributes to survival and profits of an enterprise by providing adequate supply of materials at the lowest possible costs.
The fundamental objectives of materials management activities can be:
(i) Material Selection:
Correct specification of material and components is determined. Also the material requirement in agreement with sales programme are assessed. This can be done by analysing the requisition order of the buying department. With this standardisation one may have lower cost and the task of procurement, replacement etc. may be easier.
(ii) Low operating costs:
It should endeavour to keep the operating costs low and increase the profits without making any concessions in quality.
(iii) Receiving and controlling material safely and in good condition.
(iv) Issue material upon receipt of appropriate authority.
(v) Identification of surplus stocks and taking appropriate measures to produce it.
The outcome of all these objectives can be listed as given below:
(i) Regular uninterrupted supply of raw-materials to ensure continuity of production.
(ii) By providing economy in purchasing and minimising waste it leads to higher productivity.
(iii) To minimise storage and stock control costs.
(iv) By minimising cost of production to increase profits.
(v) To purchase items of best quality at the most competitive price.
Organization of Materials Management Department:
To facilitate planning, direction, control and co-ordination of various activities related to material in an enterprise there should be a separate department of materials management. The organisational structure of the department can be.
There can be more sub-sections of the department but in general, materials manager controls the four major sections and is responsible for reporting to the president of the organisation.
Key takeaways
1. Materials Management is the planning, directing, controlling and coordinating those activities which are concerned with materials and inventory requirements, from the point of their inception to their introduction into the manufacturing process.
2. Correct specification of material and components is determined. Also the material requirement in agreement with sales programme are assessed. This can be done by analysing the requisition order of the buying department. With this standardisation one may have lower cost and the task of procurement, replacement etc. may be easier.
3. To facilitate planning, direction, control and co-ordination of various activities related to material in an enterprise there should be a separate department of materials management. The organisational structure of the department can be.
The term ‘material handling equipment’ is a pretty broad one. There’s plenty of situations where it’s critical to move large and often heavy materials in a production environment. Any piece of equipment that helps with this process could be labelled ‘material handling equipment’.
Plenty of items fall under this definition, from tools and storage units to vehicles and major appliances. Anything that deals with the transportation, storage and control at any stage of the processing of materials can be classified as material handling equipment.
We stock all types of material handling equipment from the top manufacturers: Wesco, Morse, B&P Manufacturing, Bluff Manufacturing, EGA Products, Harper Hand Trucks, Hilman Rollers, Little Giant, Lift-Rite, Omni Metal Craft, Presto Lifts, and Raymond Products.
4 Main Categories of Material Handling Equipment
There are 4 main categories of material handling equipment:
•Bulk material handling
•Engineered systems
•Industrial trucks
•Storage and handling equipment
Bulk Handling Material Equipment
The term ‘bulk handling equipment’ refers to the storage, control and transportation of materials by bulk, and in loose form. There are plenty of examples of this application – the handling of food, beverages, liquids, metal items (such as screws and nails) and minerals are just a few.
In general terms, these pieces of equipment primarily handle these items when they are loose. One example is a conveyor belt that is used to move items from one part of the production process to another. Drums and hoppers may be used as well, to ‘funnel’ these loose items into a stage where they can be more easily manipulated, or packaged.
Conveyor belts are used for horizontal transportation. For vertical transportation, elevators are most commonly used.
Types of bulk handling material equipment
•Bucket and grain elevators
•Conveyor belts
•Hoppers and silos
•Reclaimers
•Stackers
Engineered Systems
An engineered system is one that is typically automated. Such systems are also usually created from a variety of units. When combined, they work to enable both storage and transportation.
An ‘Automated Storage and Retrieval System’ (or a AS/RS for short) is one example of a system that is engineered. This is a large, automated device that comes complete with racks, shelves and aisles. These storage solutions are accessed by a ‘shuttle’ – a mechanized device that’s similar to a cherry picker. This device can be used by the system operator to manually select the items as needed, or the entire system can be computerized and automated.
An AS/RS can be integrated with a production facility’s existing computer network to keep on top of stock control, plus other logistical systems. It can also be integrated with other stages of the production process, so that as much automation can be offered as possible.
Types of engineered systems
•Automated guided vehicles (AGVs)
•Conveyor systems
•Robotic delivery systems
Industrial Trucks
This term is another broad definition that can be applied to many different types of equipment. Such pieces of equipment do have one thing in common, though – they all provide transportation.
The scope of this term can include both small, hand-operated devices, and large-scale motorized vehicles. Some items can be driven, while others – such as pallet trucks – simply add mobility to the materials that are being handled.
Many of these types of trucks have useful characteristics such as forks or a flat surface that can be inserted under pallets or other types of storage platforms. Other trucks need a separate item of equipment to use for lifting.
Trucks have the capability to lift via powered or manual means, and can be ridden upon in a driver’s cab, or simply power-assisted when pushed. Such tucks can also be steered by human intervention, or can be completely automated, following a pre-defined track on the production floor, sunken or raised tracks, or coloured strips that are laid out and sensed by optical sensors. Such automated industrial trucks also have anti-collision technology that senses when an employee or other obstacle is near.
Stacking trucks are used to stacks items, while a non-stacking truck is just used for transportation, and not for product loading.
Types of industrial trucks:
•Automated guided vehicles (AGVs)
•Hand, platform and pallet trucks
•Order pickers
•Pallet jacks
•Side-loaders
•Walking stackers
Storage and Handling Equipment
Equipment that is used for storage usually only encompasses items that are not automated. Storage and handling equipment that is automated falls under the term ‘engineered systems’
Storage equipment is equipment that is used to hold products and materials when they are not being used, or when they are waiting to enter or leave the production process. These periods could be long-term, or short-term in order to allow a suitable build-up of stock or finished items.
Most items that can be described as storage and handling equipment refers to pallets, racking or shelves. Materials are stored in a neat and convenient manner to await transportation, or their entry into the production process if necessary.
Having suitable storage equipment will add to any company’s production efficiency. The efficiency of any production system is maximized by the ease at which each stage of the entire system operates. Any inefficient section creates a bottleneck that will have an effect on all other sections of the system further down the production line.
Space is also at a premium if you run a production environment. The better utilized your available space is, the more items you’ll be able to store. This means you can keep your workflow in operation for much longer without worrying about re-stocking. This helps further increase your efficiency.
Types of storage and handling equipment
•Drive-through or drive-in racks
•Pallet racks
•Push-back racks
•Shelving
•Sliding racks
•Stacking frames
Key takeaways:
- The term ‘material handling equipment’ is a pretty broad one. There’s plenty of situations where it’s critical to move large and often heavy materials in a production environment. Any piece of equipment that helps with this process could be labelled ‘material handling equipment’.
- Plenty of items fall under this definition, from tools and storage units to vehicles and major appliances. Anything that deals with the transportation, storage and control at any stage of the processing of materials can be classified as material handling equipment. The term ‘bulk handling equipment’ refers to the storage, control and transportation of materials by bulk, and in loose form. There are plenty of examples of this application – the handling of food, beverages, liquids, metal items (such as screws and nails) and minerals are just a few.
- An engineered system is one that is typically automated. Such systems are also usually created from a variety of units. When combined, they work to enable both storage and transportation. This term is another broad definition that can be applied to many different types of equipment. Such pieces of equipment do have one thing in common, though – they all provide transportation.
- The scope of this term can include both small, hand-operated devices, and large-scale motorized vehicles. Some items can be driven, while others – such as pallet trucks – simply add mobility to the materials that are being handled.
- Equipment that is used for storage usually only encompasses items that are not automated. Storage and handling equipment that is automated falls under the term ‘engineered systems’
What is stock optimization?
The objective of stock optimization is to have the right products in the right place at the right time – as efficiently and cost-effectively as possible. Stock optimization (also known as inventory optimization) plays a key role in ensuring inventory control techniques can be carried out effectively. It’s the art of achieving stock availability, while reducing inventory costs and minimizing the risk of excess items. This is done by forecasting demand and managing supply variables while dynamically adjusting stock rules and inventory parameters.
What is inventory management?
Inventory management is the act of keeping track of a company’s stocked goods and monitoring their weight, dimensions, amounts, and location. The goal of inventory management is to minimize the cost of holding inventory by helping business owners know when it’s time to replenish products, or buy more materials to manufacture them.
What is inventory control?
Inventory control is the process of managing and regulating the supply, storage and distribution of stock. Inventory control is a key function of supply chain management that maintains appropriate quantities of stock to meet customer demand.
Inventory Control Techniques:
1. ABC
Certain products need more attention than others. Using an ABC analysis lets you prioritize your inventory management by separating out products that require a lot of attention from those that don’t. Do this by going through your product list and adding each product to one of three categories:
1.High-value products with a low frequency of sales
2.Moderate value products with a moderate frequency of sales
3.Low-value products with a high frequency of sales
Items in category A require regular attention because their financial impact is significant but sales are unpredictable. Items in category C require less oversight because they have a smaller financial impact and they're constantly turning over. Items in category B fall somewhere in-between.
Pros of ABC inventory management
•Aids demand forecasting by analyzing a product’s popularity over time
•Allows for better time management and resource allocation
•Helps determine a tiered customer service approach
•Enables inventory accuracy
•Fosters strategic pricing
Cons of ABC inventory management
•Could ignore products that are just starting to trend upwards
•Often conflicts with other inventory strategies
•Requires time and human resources
VED
Meaning of VED Analysis
VED analysis is an inventory management technique that classifies inventory based on its functional importance. It categorizes stock under three heads based on its importance and necessity for an organization for production or any of its other activities. VED analysis stands for Vital, Essential, and Desirable
V-Vital category
As the name suggests, the category “Vital” includes inventory, which is necessary for production or any other process in an organization. The shortage of items under this category can severely hamper or disrupt the proper functioning of operations. Hence, continuous checking, evaluation, and replenishment happen for such stocks. If any of such inventories are unavailable, the entire production chain may stop. Also, a missing essential component may be of need at the time of a breakdown. Therefore, order for such inventory should be before-hand. Proper checks should be put in place by the management to ensure the continuous availability of items under the “vital” category.
E- Essential category
The essential category includes inventory, which is next to being vital. These, too, are very important for any organization because they may lead to a stoppage of production or hamper some other process. But the loss due to their unavailability may be temporary, or it might be possible to repair the stock item or part.
The management should ensure optimum availability and maintenance of inventory under the “Essential” category too. The unavailability of inventory under this category should not cause any stoppage or delays.
D- Desirable category
The desirable category of inventory is the least important among the three, and their unavailability may result in minor stoppages in production or other processes. Moreover, the easy replenishment of such shortages is possible in a short duration of time.
Importance of VED Analysis
It is of utmost importance to any organization to maintain an optimum level of inventory. Maintaining inventory has its costs, and hence, this analysis bifurcates inventory in three parts to help in managerial decisions on inventory maintenance. There are four types of costs to maintain stock which are:
Item cost
This is the cost or price of the inventory items. It is the actual purchase value of holding stock. Therefore, it will be high with more inventory and vice-versa.
Ordering / Set-up Cost
The purchase of inventory involves certain costs. These may include transportation charges, packing charges, etc.
Holding Costs
After the purchase of inventory items, there are a few costs too. These may be related to storage, insurance charges of stock or inventory, labor costs associated with the handling of stock, etc. Moreover, it includes any damage, leakage, or pilferage of the stock in hand.
Stock Out Cost
These costs are the result of an inventory item running out of stock. It includes loss of production due to a spare part getting out of stock. Moreover, this may delay the product sale. Also, the product itself may get out of stock. Such losses are a part of the stockout cost.
VED analysis is a crucial tool to understand and categorize inventory according to its importance. Because of it, the management can optimize costs by investing more in the vital and essential categories of stock and lesser in the desirable category of inventory.
Usage of VED Analysis
Small and big organizations both widely use VED analysis. The most important application of this analysis is in maintaining medical inventory in hospitals and their drug stores. Drugs and related supplies comprise a significant portion of a hospital’s budget. Moreover, maintaining the right quantity of the right drugs is an extremely challenging task for management. While a shortage of critical medicine can lead to crises and even loss of lives, an abundance of non-important medications can lead to blockage of money and space, both.
VED analysis helps in dividing medicines into the three categories as per their usage and importance. Therefore, medication in the vital group is to be kept in stock compulsorily, as they would be critical for patients. Medicines which are a bit less risky, or which can be obtained from other sources too at short notice, become part of an essential category. Those that are least critical and their shortage will not pose any danger to a patient’s health, and lives get its place in the desired class. As a result, the hospital’s management can wisely allocate resources on medical inventory as per their respective VED categories.
FSN
Meaning of FSN Analysis
FSN Analysis is an inventory management technique which is based on the rate of consumption of spares and goods in an organization. This analysis divides the inventory into three categories based on their speed or rate of utilization, their consumption rate, and average stay. FSN stands for Fast-moving, Slow-moving, and Non-moving.
Fast-moving inventory
Fast-moving inventory comprises of inventory, which moves in and out of stock fastest and most often. Therefore these goods have the highest replenishment rate. Items in this category generally comprise less than 20% of the total inventory.
Slow-moving inventory
Items in this category move slower, and hence, their replenishment is also slower. This category comprises of around 35% of the total inventory in an organization.
Non- moving inventory
The last category of this analysis is the least moving portion of the inventory and also includes the dead stock. Replenishment of such inventory may or may not take place at all after utilization. This category can go as high as 55%-60% of the total inventory in organizations.
FSN Analysis and calculation
FSN analysis makes use of a few parameters to arrive at the three categories of goods in the inventory. Since it is a scientific analysis and not based on the judgment of a few individuals, formulas are used to arrive at figures which tell us if a good belongs to a fast-moving or slow-moving or non-moving category.
Average Stay: Number of cumulative days inventory is held/ (Opening Balance of the good + Number of goods received during the period)
Consumption Rate: Total number of goods issued/ Total period
The next step is to calculate the Cumulative average stay and Cumulative consumption rate.
Cumulative average stay: Average stay of the item + Average stay of all goods having an average stay more than itself
Cumulative consumption rate: Consumption rate of the item + Consumption rate of all goods that are consumed faster
Percentage average stay: (Cumulative average stay of the item/ Cumulative average stay of all goods) x 100
Percentage consumption rate: (Cumulative consumption rate of the item/ Cumulative consumption rate of all goods) x 100
Interpretation
As per Cumulative average stay, FSN analysis goods have three categories as:
• Fast-moving goods comprise of 10% or lesser of the average cumulative stay calculated.
• Slow-moving goods comprise of 20% or lesser of the average cumulative stay calculated.
• Non-moving goods comprise of 70% or lesser of the average cumulative stay calculated.
Therefore as per the classification, fast-moving goods stay only 10% or lesser of the cumulative average stay of the total inventory. In other words, they have the quickest movement time of all the inventory.
As per Cumulative consumption rate, the three categories will be:
• Goods with 70% or less of consumption rate are fast-moving.
• Goods with 20% of the cumulative consumption rate are slow-moving.
• Items with 10% or lesser of the cumulative consumption rate are non-moving.
Therefore, again we see that as per the classification, goods that are consumed the quickest are the fast-moving goods. Those with the lowest consumption rates are non-moving goods.
Both the parameters, i.e., the average stay of goods in the inventory and consumption rate of that product, should be simultaneously calculated and used. It helps to arrive at accurate FSN analysis results, and inventory management decisions can be effectively taken based on it.
Importance and Usage of FSN Analysis
FSN analysis helps the management to make informed and accurate inventory decisions. It helps in the optimum utilization of scarce resources and guides the management to make the best use of money, time, and space available.
• It helps to identify the “deadstock.” The management needs to invest only as per the actual stay and consumption of that product and not make extra purchases. Also, it can identify which item is not moving at all and dispose of it at discounted rates.
• FSN analysis also helps in space management effectively. Slow-moving and non-moving category of goods can be bought only in limited quantities to avoid jamming of storage space. Also, fast-moving goods can be stored at locations near to entry and exit points of godowns or warehouses that have clear access all the time. It would help in saving time and labor.
• This analysis can be an excellent buying guide in the case of seasonal products. The management will have a clear picture of the time of the year when a product turns into a fast-moving one from a slow or non-moving category. As a result, it can time its purchase accordingly.
FSN analysis helps to effectively allocate monetary resources to items that are fast moving and beneficial for the organization. As a result, it helps to avoid blocking money in the slow-moving or non-moving category of goods.
GOLF
The GOLF classification of inventory items is done considering the nature of suppliers. As the source of supply of different items are different, with a view to determining the lead time, order quantities, safety stock and terms of purchase and payment. Here, under this classification:
G = Government controlled supplies
O = Open market supplies
L = Local supplies
F = Foreign market supplies
For certain items, imports are channelized through government agencies viz; State trading corporation, Minerals and Metals Trading Corp, Indian drugs and Pharma. Here control techniques are not applied.
XYZ,
The XYZ analysis is a way to classify inventory items according to variability of their demand.
X – Very little variation: X items are characterised by steady turnover over time. Future demand can be reliably forecast.
Y – Some variation: Although demand for Y items is not steady, variability in demand can be predicted to an extent. This is usually because demand fluctuations are caused by known factors, such as seasonality, product lifecycles, competitor action or economic factors. It's more difficult to forecast demand accurately.
Z – The most variation: Demand for Z items can fluctuate strongly or occur sporadically. There is no trend or predictable causal factors, making reliable demand forecasting impossible.
The following charts illustrate the characteristics of the three classes.
The classes have significant implications for stock management. Due to low demand volatility, A class inventory management can usually be fully automated. And due to the predictability of demand, a low buffer inventory can be held either by the organisation itself or, in a Just In Time (JIT) arrangement, by the supplier – reducing holding costs.
For B class items, buffer stocks may need to be higher, or more manual intervention of an otherwise automated stock management process may be required. JIT supplier arrangements may be more difficult to negotiate for B class inventory as the suppliers may not have the expertise for predicting demand that the organisation itself would have.
Since it is virtually impossible to predict demand for C class inventory items, the policy may be to replenish-to-order.
The variability of demand for an inventory item can be expressed as a variation coefficient. The steps for classifying items by degree of demand volatility are:
• Determine the items to be included in the analysis.
• Calculate the variation coefficient for each item.
• Sort the items by increasing variation coefficient and accumulate.
• Agree and set the boundaries between cumulative variation coefficients.
For XYZ analysis to work, it's vital to understand and apply an appropriate time span for assessing demand volatility. For example, if demand for items is seasonal, computing volatility over a month may not be appropriate. Alternatively, where product lifecycles are short, computing the volatility of items with sporadic demand could mean stocked items become obsolete.
The cost of items could also influence inventory management policy. For example, some A class items could be high cost and the organisation may not wish to rely on full automated replenishment. At the other extreme, some C class items may be very low cost. So it may be more cost effective (and improve customer service) to manually set buffers and automate replenishment to maintain the buffers, rather than to replenish-to-order. Combining the ABC with XYZ approaches is a useful way of thinking about inventory management policy.
What benefits does the approach provide?
• Improves accuracy of forecasting.
• Reduces stock-outs, which:
– Improves production stability and efficiency.
– Improves customer satisfaction.
• Increases stock churn.
• Reduces stock obsolescence.
• Clarifies service levels for items with volatile demand.
Implementing XYZ inventory management? Questions to consider
• Is there reliable and accessible cost and demand information by item?
• Will your inventory management systems and processes facilitate efficient and effective implementation and operation of the XYZ approach?
• Have the costs and benefits of implementing and operating XYZ been quantified and is the business case compelling?
• Has the impact of the change to XYZ on capability been assessed and planned for?
SOS
‘S’ stands for Seasonal items and ‘OS’- Off Seasonal items. In general it is merit to seller to buy seasonal items at lower price and keep inventory and sell them at high price during off seasons. If not the seller has to buy the goods at higher prices during off seasons. Decisions are taken based on the fluctuations and availability.
SOS Inventory is ideal for small to medium sized businesses looking for powerful, yet affordable inventory software. Do not let the price tag deceive you; you can perform every inventory control function in SOS Inventory that you can with high end ERP software. Accessed and stored in the cloud, SOS will manage your purchases, warehousing, sales, stock and more. Run over 60 different reports for a full view of your inventory at any point in time. Identify top sellers, products that require re-ordering and items about to expire that need to be sold at a discount.
SOS analysis is based on seasonality of items and it classifies all the items into two categories ‘Seasonal ‘
And ‘Off seasonal ‘
The analysis helps in:
Identifying items that are available only during a limited period of the year .For e.g. Raw mangoes are only available only during a summers
Identifying items that are seasonal but available throughout the year however their costs in offseason are relatively high.
Non Seasonal items
As discussed above there are a number of methods used for selective inventory control and each method highlights a different aspect .The right method should be selected on the purpose for which we wish to carry out the selective inventory control.
For e.g. SOS analysis can be selected when we want to determine the seasonality of items and the right season for procuring them.
HML
HML Analysis
HML Analysis classifies inventory based on how much a product costs/its unit price. The classification is as follows:
High Cost (H) – Item with a high unit value.
Medium Cost (M) – Item with a medium unit value.
Low Cost (L) – Item with a low unit value.
Likewise ABC analysis, items are classified on the basis of cost of the items. The point of difference between these two techniques is that under HML analysis, for the purpose of classifying inventories into various categories, only cost of the items is considered while their annual consumption value is totally ignored.
Conducting HML analysis:
Prepare the list of all the items of inventory in the descending order of their unit value and then to employ price criterion by management for three categories.
For Example, in case of luxury retailing, the management may decide all items as follows
Key Takeaways
- Inventory control is the process of managing and regulating the supply, storage and distribution of stock. Inventory control is a key function of supply chain management that maintains appropriate quantities of stock to meet customer demand Certain products need more attention than others.
- Using an ABC analysis lets you prioritize your inventory management by separating out products that require a lot of attention from those that don’t. Do this by going through your product list and adding each product to one of three categories:
- VED analysis is an inventory management technique that classifies inventory based on its functional importance. It categorizes stock under three heads based on its importance and necessity for an organization for production or any of its other activities. VED analysis stands for Vital, Essential, and Desirable
- FSN Analysis is an inventory management technique which is based on the rate of consumption of spares and goods in an organization. This analysis divides the inventory into three categories based on their speed or rate of utilization, their consumption rate, and average stay. FSN stands for Fast-moving, Slow-moving, and Non-moving.
- The GOLF classification of inventory items is done considering the nature of suppliers. As the source of supply of different items are different, with a view to determining the lead time, order quantities, safety stock and terms of purchase and payment. Here, under this classification.
- The XYZ analysis is a way to classify inventory items according to variability of their demand.
- SOS Inventory is ideal for small to medium sized businesses looking for powerful, yet affordable inventory software. Do not let the price tag deceive you; you can perform every inventory control function in SOS Inventory that you can with high end ERP software. Accessed and stored in the cloud, SOS will manage your purchases, warehousing, sales, stock and more.
- HML Analysis classifies inventory based on how much a product costs/its unit price. The classification is as follows:
- High Cost (H) – Item with a high unit value.
- Medium Cost (M) – Item with a medium unit value.
- Low Cost (L) – Item with a low unit value.
Economic order quantity is also popularly known as EOQ. It is defined as a production scheduling concept as it is used to determine the frequency and volume of orders that are needed to satisfy a specific demand while reducing the cost per order to minimum levels.
This measurement tool is applicable in the fields of supply management, logistics, and operations and is computed by merchandising as well as manufacturing companies.
The merchandising organizations use it for computing the optimal order size of inventory related to ready-to-use merchandise, whereas the manufacturing companies for an optimal order size of inventory related to raw materials.
Understanding ordering cost and holding costs in an economic order quantity
The EOQ is the level at which the combined holding and ordering cost is at its minimum level. It is important to gather information about the two most important factors of EOQ as there is an inverse relationship between both the ordering cost and holding cost.
Ordering costs – Whenever a company places an inventory order with the supplier the cost which incurs is known as ordering costs. The total will vary as it is dependent upon the frequency of placing orders.
If the number of orders that have been placed increases in a given year then the annual ordering cost will also increase, and the same applies if the company places small number o orders because then the ordering cost will be lower. Some ordering costs are delivery charges, telephone expenses, payment processing charges, and invoice verification charges.
Holding costs – Holding costs are also known as carrying costs as it is incurred while holding the inventory in a warehouse or a store.
The total cost is dependent upon the size of the order, and larger the order the higher is the annual holding cost and vice versa. It includes storage space rent, property tax, and insurance.
The formula of economic order quantity
The economic order quantity equation takes into account inventory holding costs like shortage costs, ordering costs, and storage. It is based on the assumption that it is holding costs, order, and demand remain constant over time. The formula of economic order quantity is
Q = Economic order quantity
D = Demand in units
S = Order cost
H = Holding costs
The goal of this formula is to identify the maximum number of units so that an organization can minimize its costs in terms of storing, taking delivery, and buying the units. The formula is easily modified to gather information about varying production levels.
It has become a cash flow tool that can minimize the amount of cash and the cost of inventory that is integrated into the inventory balance. The formula also calculates inventory reorder point of an organization.
This helps the company as it avoids running out of inventory so that it can fulfill all the orders promptly.
Assumptions of economic order quantity
The computation of economic order quantity is possible because of certain assumptions for instance
•The total ordering cost in an EOQ remains constant
•The total units that are to be consumed are certain
•The ordered inventory is delivered in one attempt
•The inventory costs are assumed constant
•The maximum quantity for every stock item is computed on a separate basis
•No availability of any discount on quantity or cash
•There is no fluctuation of lead time
Advantages of economic order quantity
The advantages of economic order quantity are as follows
•The economic order quantity helps in reducing the holding costs of inventory. The company does not have to order excess stocks that need to be stored in warehouses and thus saves money that would have to be spent on rent and other expenses related to storage.
•The economic order quantity equation helps an organization to determine the number of units and the number of units it needs to purchase. This reduces the ordering costs as the company orders in fewer times and saves on costs related to transportation, packing, etc.
•The EOQ helps the organization to manage its inventory in a better manner. It is now able to minimize its operational costs, and this ultimately leads to profits.
•It makes restocking an easy process as the formula helps to determine how often you should be placing orders.
•The EOQ model helps the company to find the best deal because now you are purchasing only what you require and not any excess that can become a waste.
Disadvantages
The disadvantages of economic order quantity are as follows
•The economic order quantity needs several assumptions to survive and operate
•As per the formula of economic order demand, the consumer demand is constant, and this makes it impossible to calculate during seasonal changes
•Forecasting the demand accurately is simply not possible because the demand is not static. It continues to rise and fall substantially and thus changes the equation every time
•Sometimes the company places an order with the supplier, but he does not have the required raw materials. This can cause problems as the organization is unable to meet the unexpected and high demand for the product. The EOQ model states that the demand is constant, and this can cause a loss for the firm.
•It is important to monitor the reorder levels if it is following the economic order quality formula. This is a time-consuming and expensive process because you will have to hire a team to do so regularly.
Simple numerical on EOQ
Problem No.1
The john equipment company estimates its carrying cost at 15% and its ordering cost at $90 per order. The estimated annual requirement is 78,000 units at a price of $4 per unit.
Required:
(i). What is the most economical no. of units to order?
(ii). No. of orders to be placed in a year.
(iii). About how often will an order need to be placed?
Solution
(i). Economical No. or Units to Order:
Annual requirement = 48,000 units
Ordering cost = $9 per order
Carrying cost = 15% of per-unit cost.
Per unit cost = $4 per unit
(ii). No. of orders to be placed in a year:
= Annual requirement / EOQ
= 48,000 units / 1,200 units
= 40 orders
(iii). About how often will an order need to be placed (i.e. frequency of orders):
Frequency of orders = No. of days in one year / No. of orders
= 360 days / 40 orders
= 9 days
Model and formula
The classical EOQ formula (see the Wilson Formula section below) is essentially a trade-off between the ordering cost, assumed to be a flat fee per order, and inventory holding cost. Although this formula dating for 1913 is extremely well-known, we advise against using such a formula in any modern supply chain environment. The underlying mathematical assumptions behind this formula are simply incorrect nowadays.
The historical formula assumes that the cost of the act of ordering is the one key business driver. It certainly was an important factor back in 1913 when an army of clerks was required to manually keep track of the books, but with inventory management software and possibly EDI, this factor is usually insignificant. As a result, the "optimization" performed by the formula makes little sense, and completely ignores any price break that can be available when larger quantities are ordered.
Thus, we propose here an EOQ formula variant that optimizes the trade-off of carrying costs vs volume discounts. Let's introduce the variables:
Z be the lead demand.
H be the carrying cost per unit for the duration of the lead time (1).
δ be the delta inventory quantity needed to reach the reorder point (2).
P be the per unit purchase price, a function that depends on the order quantity q.
(1) The time scope considered here is the lead-time. Hence, instead of considering the more usual annual carrying cost Hy, we are considering H=d365Hy assuming that d is the lead time expressed in days.
(2) The delta quantity needs to take into account both the stock on hand qhand and the stock on order qorder, which gives the relationship δ=R−qhand−qorder where R is the reorder point. Intuitively, δ+1 is the minimal quantity to be ordered in order to maintain the desired service level.
Then, the optimal order quantity is given by (the reasoning is detailed below):
Q=argminq=δ+1..∞(12(q−δ−1)H+ZP(q))
Despite it's seemingly complicated look, this function can be easily computed with Microsoft Excel, as illustrated by the sheet provided here above.
What about the order cost?
At first glance, it might look as if we are assuming a zero ordering cost, but not quite so. Indeed, the framework we introduce here is relatively flexible and the order cost (if any) can be embedded into the price function P.
Cost function
In order to model the cost function for the order quantity which takes into account volume discounts, let's introduce R the reorder point. The inventory cost is the sum of the inventory carrying cost plus the purchase cost, that is:
C(q)=(R+q−δ−12)H+ZP(q)
Indeed, taking an amortized viewpoint over the lead time period, the total quantity to be ordered will be Z the lead demand.
Then, the inventory level is varying all the time, but if we consider strict minimal reorders (i.e. q=δ+1) then, the average stock level over time is equal to R the reorder point. Then, since we are precisely considering order quantity greater than δ+1, those extra ordered quantities are shifting upward the average inventory level (and also postponing the time when the next reorder point will be hit).
The (q−δ−1)/2 represents the inventory shift caused by the reorder assuming that the lead demand is evenly distributed for the duration of the lead time. The factor 1/2 is justified because an increased order quantity of N is only increasing the average inventory level of N/2.
Minimization of the cost function
In order to minimize C(q), we can start by isolating the part that does not depends of q with:
C(q)=RH+12(q−δ−1)H+ZP(q)
Since RH does not depend on q, optimizing C(q) is the same as optimizing C∗(q) where:
C∗(q)=12(q−δ−1)H+ZP(q)
Then, in this context, since the volume discount function P is an arbitrary function, there is no direct algebraic solution to minimize this formula. Yet, it does not imply that this minimization is hard to solve either.
A simple minimization for C∗(q) consists of a (naive) extensive numerical exploration, that is computing the function for a large range of q values. Indeed, virtually no business is needing order quantities greater than 1,000,000 units, and letting a computer explore all costs values for q=1..1,000,000 takes less 1 second even if the calculation is done within Excel on a regular desktop computer.
However, in practice, this computation can be vastly accelerated if we assume that P(q) is a strictly decreasing function, that is to say that the price per unit strictly decreases when the order quantity increases. Indeed, if P(q) decreases, then we can start the value exploration at q=δ+1, iterates, and finally stop whenever the situation C∗(q+1)>C∗(q) gets encountered.
In practice, unit price rarely increases with quantities, yet, some local bumps in the curve may be observed if shipments are optimized for pallets, or any other container that favors certain package sizes.
Lead Time
What Is Lead Time?
Lead time is the amount of time that passes from the start of a process until its conclusion. Companies review lead time in manufacturing, supply chain management, and project management during pre-processing, processing, and post-processing stages. By comparing results against established benchmarks, they can determine where inefficiencies exist.
Reducing lead time can streamline operations and improve productivity, increasing output, and revenue. By contrast, longer lead times negatively affect sales and manufacturing process
Understanding Lead Time
Production processes and inventory management can affect lead time. In regards to production, building all elements of a finished product onsite may take longer than completing some items offsite. Transportation issues can delay delivery of necessary parts, halting or slowing production and reducing output and return on investment (ROI).
Using locally sourced parts and labor can shorten lead time and speed production, and offsite sub-assemblies can save additional time. Reducing production time allows companies to increase production during periods of high demand. Quicker production can increase sales, customer satisfaction, and the company’s bottom line.
Efficient inventory management is necessary to maintain production schedules and meet consumer demand. Stockouts occur when inventory, or stock, is unavailable preventing the fulfillment of a customer's order or product assembly. Production stops if an organization underestimates the amount of stock needed or fails to place a replenishment order and suppliers cannot replenish materials immediately. This can be costly for a company's bottom line.
One solution is to use a vendor-managed inventory (VMI) program, which provides automated stock replenishment. These programs often come from an off-site supplier, using just-in-time (JIT) inventory management for ordering and delivering components based on usage.
Special Considerations
The lead time varies among supply chain sources, causing difficulty in predicting when to expect the delivery of items and coordinating production. Frequently the result is excess inventory, which places a strain on a company’s budget.
Lead time scheduling allows for the receipt of necessary components to arrive together, and reduces shipping and receiving costs. Some lead time delays cannot be anticipated. Shipping obstructions due to raw material shortages, natural disasters, human error, and other uncontrollable issues will affect lead time. For critical parts, a company may employ a backup supplier to maintain production. Working with a supplier who keeps inventory on hand while continuously monitoring a company’s usage helps alleviate the issues resulting from unanticipated events.
Stockpiling necessary parts may be cost-prohibitive, but reducing the number of surplus parts also helps place a ceiling on production costs. One solution is for companies to use kitting services to organize their inventory. With kitting services, inventory items are grouped based on their specific use in the project. Workers save time choosing from smaller lots of parts, keeping production more organized and efficient.
Using offsite assembly in overseas markets instead of shipping completed goods can help companies save money on tariffs.
Example of Lead Time
Imagine a large festival that takes place during the first week of August every year that attracts 100,000 people on average and typically sells 15,000 festival T-shirts. The vendor that supplies the T-shirts needs one business day to complete the shirt design, one business day to have it proofed and make any necessary fixes, one business day to print the shirts, and two business days to ship the items. The lead time in this example would be five business days. In other words, the festival organizers need to place their order with the T-shirt supplier at least five business days before the opening of the festival in order to get the shirts on time.
Of course, that lead time can be shortened in some extreme situations if the buyer is willing to pay a premium. If T-shirt sales on the first day of the festival exceed expectations, festival organizers may decide to order additional shirts on the second day with the hope that they can be delivered by the third day. Since the shirts have already been designed and approved, that means five days of lead time can be reduced to three. To meet that shortened lead time, the vendor would need to print the additional shirts as quickly as possible in order to ship them overnight for delivery the following morning.
Additional factors can affect lead time in this example. If festival organizers want a certain percentage of the T-shirts to be fuchsia and the vendor does not regularly keep fuchsia T-shirts in stock, that can increase the lead time because the vendor will need to order shirts in that color.
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Reorder Level
In management accounting, reorder level (or reorder point) is the inventory level at which a company would place a new order or start a new manufacturing run.
Reorder level depends on a company’s work-order lead time and its demand during that time and whether the company maintain a safety stock. Work-order lead time is the time the company’s suppliers take in manufacturing and delivering the ordered units.
Identifying the correct reorder level is important. If a company places a new order too soon, it may receive the ordered units earlier than expected and it would have to bear additional carrying costs in the form of warehousing rent, opportunity cost, etc. However, if the company places an order too late, it would result in stock-out costs, for example lost sales, etc.
Formula
Reorder level depends on whether a safety stock is maintained.
If there is no safety stock, reorder level can be worked out using the following formula:
Reorder Level = Average Demand × Lead Time
Both demand and lead time must be in the same unit of time i.e. both should in in days or weeks, etc.
If a company maintains a safety stock, reorder level calculation changes are follows:
Reorder Level = Average Demand × Lead Time + Safety Stock
Examples
Example 1: ABC Ltd. is a retailer of footwear. It sells 500 units of one of a famous brand daily. Its supplier takes a week to deliver any ordered units.
The inventory manager should place an order before the inventories drop below 3,500 units (500 units of daily usage multiplied with 7 days of lead time) in order to avoid a stock-out.
Example 2: ABC Ltd. has decided to hold a safety stock equivalent to average usage of 5 days. Calculate the reorder level.
Safety stock which ABC Ltd. has decided to hold equals 2,500 units (500 units of daily usage multiplied by 5 days).
In this scenario, reorder level would be 6,000 units (2,500 of safety stock plus 3,500 units based on 7 days of lead time)
Safety Stock
What is safety stock?
Safety stock is an extra quantity of a product which is stored in the warehouse to prevent an out-of-stock situation. It serves as insurance against fluctuations in demand.
Importance of safety stock
Safety stock helps eliminate the hassle of running out of stock. If you hold sufficient safety stock, you needn’t rely on your suppliers to deliver quickly or turn away customers because of depleted inventory levels. Safety stock covers you until your next batch of ordered stock arrives. Let’s see how safety stock is important for your business:
Protection against demand spikes
Safety stock protects you against the sudden demand surges and inaccurate market forecasts that can happen during a busy or festive season. It serves as a cushion when the products you’ve ordered take longer to reach your warehouse than you expected. It ensures that your company doesn’t run out of popular items and helps you keep fulfilling orders consistently.
Buffer stock for longer lead times
Even if your supplier has been consistent with delivering products on time and you’ve never faced a supply lag yet, this might not always be the case. Unexpected delays in production or transportation, such as a bottleneck at your supplier’s end or a weather-related shipping delay, can cause your products to reach you later than expected. During these situations, safety stock acts as your defense against a possible stockout scenario and helps you fulfill your orders until your ordered stock is delivered to you.
Prevention against price fluctuations
Unpredicted market fluctuations can cause the cost of your goods to increase suddenly. This can be due to a sudden scarcity of raw materials, an increase in price of raw materials, unexpected demand surges in the market, new competitors, or new government policies. If you’ve got enough safety stock during these unpredictable situations, it can help you avoid the costs of buying stock at higher prices without sacrificing sales.
How to calculate safety stock
To get the benefits of keeping safety stock, you need to know how much safety stock to keep. This is because too much safety stock can lead to higher holding costs, and too little safety stock results in loss of sales. Using a formula will help you calculate the optimal amount of safety stock for your business.
Each method of calculating safety stock uses slightly different details, but they all require you to know your lead time, which is the time between the initiation of an order and the completion of the delivery process.
There are several different methods to calculate safety stock:
1. Fixed safety stock
2. Time-based calculation
3. The general formula
4. Heizer Render’s formula
5. Greasley’s method
Fixed safety stock
Fixed safety stock is a method used by production planners. They determine the amount of safety stock to keep from the maximum daily usage for over a period of time, but without using a particular formula. The value for fixed safety stock generally remains unchanged unless the production planner decides to change it. Fixed safety stock levels can even be set to zero for items that you want to phase out. However, if there is a sudden demand surge for an item with very little safety stock, you might not be able to fulfill the orders.
Time-based calculation
In this method, safety stock levels are calculated over a particular time period, based on the future forecast for the product. This method includes a combination of actual demand from sales orders, and forecasted demand based on statistical methods. This method cannot predict business uncertainties, so using it involves a risk that you might end up carrying too much unwanted stock if your products are moving slower than forecasted.
The general formula
This is the simplest and commonly used method to calculate safety stock. It calculates the average safety stock the company needs to hold during a stockout scenario, but it doesn’t consider the seasonal fluctuations of demand.
Safety stock is calculated by multiplying maximum daily usage (which is the maximum number of units sold in a single day) with the maximum lead time (which is the longest time it has taken the vendor to deliver the stock), then subtracting the product of average daily usage (which is the average number of units sold in a day) and average lead time (which is the average time taken by the vendor to deliver the stock).
Heizer & Render’s formula
Heizer & Render’s formula is ideal when there are significant variations in supply on your vendor’s end. It uses the standard deviation of the lead time distribution, giving you a more accurate picture of your lead time and how frequently you deal with very late shipments. However, it doesn’t take demand changes into account.
Safety stock is calculated by multiplying your desired service factor (Z score) by the standard deviation in lead time, which is the degree and frequency by which the average lead time differs from the actual lead time.
The Z score, also called the desired service factor, is a way to decide how confident you want to be about having enough stock. It is a value that you select so that you don’t face a stockout scenario. A lower score means you’ll have higher chances of running out of stock. For instance, if you select a Z score of 2.33, there is a 99% chance that you won’t face a stockout situation.
Greasley’s formula
Greasley’s formula takes both lead time and demand fluctuations into account, which provides a more accurate way of calculating safety stock. But it doesn’t take into account stock which is still in production and not yet ready for sale.
Using Greasley’s formula, safety stock is calculated by multiplying average dem (Davg) (average demand is the total total quantity of a material required each day over a fixed period) with the desired service factor (Z score) and the standard deviation in lead time .
Safety stock acts as a defense against unexpected circumstances. Calculating safety stock accurately is crucial to avoid losing sales due to stockouts or supply chain interruptions. Like many other kinds of business decisions, there is no one-size-fits-all formula that will work for all businesses, so choose the method that works the best for your business.
Key takeaways
- Economic order quantity is also popularly known as EOQ. It is defined as a production scheduling concept as it is used to determine the frequency and volume of orders that are needed to satisfy a specific demand while reducing the cost per order to minimum levels.
- Lead time is the amount of time that passes from the start of a process until its conclusion. Companies review lead time in manufacturing, supply chain management, and project management during pre-processing, processing, and post-processing stages. By comparing results against established benchmarks, they can determine where inefficiencies exist.
- Reorder level depends on a company’s work-order lead time and its demand during that time and whether the company maintain a safety stock. Work-order lead time is the time the company’s suppliers take in manufacturing and delivering the ordered units.
- Safety stock is an extra quantity of a product which is stored in the warehouse to prevent an out-of-stock situation. It serves as insurance against fluctuations in demand.
Reference:
1. Course Notes - National Institute of Technology, Calicut
2. Production and Operation Management - DDCE Utkal University
