UNIT II

Material Cost

Q1) Define Inventory. (8 marks)

A1) A material is a substance (physical term) that is part of a finished product or is composed of a finished product. In other words, a material is a product that is supplied to a business for the purpose of consuming it in the process of manufacturing or providing services, or for the purpose of converting it into a product. The term "store" is often used as a synonym for material, but store has a broader meaning, not only the raw materials consumed or used in production, but also miscellaneous goods, maintenance stores, processed parts, components. Also includes items such as tools. Jigs, other items, consumables, lubricants, etc. Finished and partially finished products are also often included in the term "store". Materials are also called inventory. The term material / inventory include not only raw materials, but also components; work in process, finished products, and scrap.

Material costs are an important component of the total cost of a product. It accounts for 40% to 80% of the total cost. Percentages may vary from industry to industry. But for the manufacturing sector, material costs are paramount. Inventory is also an important component of working capital. Therefore, it is treated the same as cash. Therefore, analysis and control of material costs is very important.

He definition of inventory changes slightly depending on the industry. Here’s a small list of definitions:

Most common definition

Inventory refers to all the items, goods, merchandise, and materials held by a business for selling in the market to earn a profit.

Example: If a newspaper vendor uses a vehicle to deliver newspapers to the customers, only the newspaper will be considered inventory. The vehicle will be treated as an asset.

Manufacturing industry

In a manufacturing business, inventory is not only the final product manufactured and ready to sell, but also the raw materials used in production and the semi-finished goods in the warehouse or on the factory floor.

Example: For a cookie manufacturer, inventory will include the packets of cookies that are ready to sell, the semi-finished stock of cookies that haven’t been cooled or packed yet, the cookies set aside for quality checking, and raw materials like sugar, milk, and flour.

Service industry

In a service industry, since there is no exchange of physical stock, the inventory is mostly intangible in nature. So the service industry inventory mostly includes the steps involved before completing a sale.

Example: For a research consultancy firm, inventory consists of all the information collected for a project. In the hotel industry, a vacant room is inventory for the owner.

Meaning of inventory: Breaking down the definitions

If we break down all the definitions, we can see that there are certain similarities:

Inventory is:

i) An asset, tangible or intangible,

Ii) An asset that can be realized for revenue generation or has a value for exchange, or

Iii) An asset which is in process but is meant for sale in the market

What are the different types of Inventories?

Now, let’s focus on some of the types. To make it easier to understand, let’s continue with the example of a cookie manufacturer:

Raw materials

Raw materials consist of all the items that are processed to make the final product. In a cookie manufacturing company, the raw materials are items like milk, sugar, and flour that are used in the different stages of production.

When we talk about raw materials, it is essential to understand that raw materials used by a manufacturing company can either be sourced from a supplier or be a by-product of a process. In our cookie manufacturing company, the raw materials will be mostly sourced from various suppliers. However, in a sugar manufacturing company, only the sugarcane is brought in from different farmers. When it is processed in the factory to extract the juice, the residual substance is known as bagasse. The juice is sent for boiling and the bagasse is used as a fuel. Here, the sugarcane, juice , and bagasse will all be treated as raw materials.

The concept of raw materials as inventory items exists only in the manufacturing industry. In a trading industry, there is no processing or manufacturing involved, so there are no raw materials.

Work in progress

When raw materials have been sent for processing but have not yet been approved as finished goods, this stage is known as work in progress. In a cookie manufacturing company, after the raw materials have been processed and the cookies have been molded, they go for a quality check before they are passed for final packaging. All the cookies which are waiting for their quality check are considered work in progress. To put it in simple words, the work in progress category consists of all the items that have been processed but not sent for sale.

Finished goods

Finished goods are the final items that are ready for sale in the market. These goods have passed through all stages of production and quality checking. So for the cookie manufacturer, the final packets of cookies that are sent to the market for selling after undergoing quality checks will be the finished goods.

Raw materials, semi-finished goods, and finished goods are the three main categories of inventory that are accounted for in a company’s financial accounts. There are other types as well which are maintained as a precautionary measure or for some other specific purpose. 

MRO inventory

MRO stands for Maintenance Repairing and Operating supplies, this type of inventory is mostly relevant for manufacturing industries. MRO items are not accounted as inventory items in books of accounts; however, they play a crucial role in the day-to-day working of an organization. MRO supplies are used for maintenance, repair, and upkeep of the machines, tools, and other equipment used in the production process. Some examples of MRO items are lubricants, coolants, uniforms and gloves, nuts, bolts, and screws.

Buffer inventory

In a manufacturing or a trading business, fluctuations and market movements cannot always be predicted. Such changes can have a negative impact on the sales or production process, which can lead to out-of-stock situations. Buffer inventory attempts to compensate for this by following the adage that prevention is better than cure. Buffer inventory (also known as safety stock), consists of the items stored in the warehouse of a store or a factory to cushion the impact of unexpected shocks. A sudden spike in demand, delay in transport, or labor strike can be managed if sufficient buffer inventory is maintained.    

Cycle inventory

Cycle inventory is a term used to describe the items that are ordered in lot sizes and on a regular basis. Cycle inventories are usually materials which are directly used in the production or they are part of some regular process.

Decoupling inventory

Most manufacturing is carried on by multiple machines. The output of one machine is fed into the next machine for further processing. However, the process only works smoothly if all the machines work in tandem. A breakdown in any of the machines can derail the entire process, which is when decoupling inventory comes into the picture. Decoupling inventory consists of items which are kept in reserve to be processed by another machine if the previous machine fails to produce its usual output. In our example of cookie manufacturing, after the dough has been molded, it goes to the oven for baking. To prevent a breakdown in one of the molding machines can delaying the baking process, the manufacturer might keep some extra pieces of molded dough which can be sent to the oven for baking while the machine is being repaired.

Transit inventory

Transit inventory refers to items that are being moved from one location to another, such as raw materials being transported to the factory by railway or finished goods being transported to the store by truck.

Impact of inventory in businesses

Inventory is a major asset for any manufacturing or trading business, so it’s important for business owners to understand what it really means. In addition to the common definition, certain industries like manufacturing and service use specialized definitions that account for all of the assets relevant to that industry. Knowing the different types of inventory, including types that aren’t specifically used in accounting, can help business owners understand how their inventory is working for them.

Q2) What is the purpose of material management system? (5 marks)

A2) Material management: The ability to ensure sufficient inventory of goods to meet all requirements without carrying unnecessarily large amounts of inventory.

Materials management is a core function of supply chain management, involving the planning and execution of supply chains to meet the material requirements of a company or organisation.  These requirements include controlling and regulating the flow of material while simultaneously assessing variables like demand, price, availability, quality, and delivery schedules.

Material managers determine the amount of material required and held in stock, plan for the replenishment of these stocks, create inventory levels for each type of item (raw material, work in progress or finished goods), and communicate information and requirements to procurement operations and the extended supply chain. Materials management also involves assessing material quality to make sure it meets customer demands in line with a production schedule and at the lowest cost. 

Material management systems embrace all of the activities related to materials and are a basic business function that adds value to a finished product. It can also include the procurement of machinery and other equipment needed for production processes as well as spare parts.

Typical roles in Materials Management include inventory analysts, inventory control managers, materials managers, material planners, and expediters as well as hybrid roles like buyer/planners.

Regardless of role, the main objective of Materials Management is assuring a supply of material with optimised inventory levels and minimum deviation between planned and actual results.

Some Definitions of Materials Management:

(i) ‘Materials Management’ is a term used to connote “controlling the kind, amount, location, movement and timing of various commodities used in production by industrial enterprises”.

(ii) 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.

It begins with the determination of materials quality and quantity and ends with its issuance to production to meet customer’s demand as per schedule and at the lowest cost.

(iii) Materials Management is a basic function of the business that adds value directly to the product itself

(iv) Materials Management embraces all activities concerned with materials except those directly concerned with designing or manufacturing the product.

(v) Materials Management deals with controlling and regulating the flow of material in relation to changes in variables like demand, prices, availability, quality, delivery schedules etc.

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.”

The purpose of the material management system is to:

1. Make the material available continuously so that the flow of material for production is uninterrupted. Production cannot be postponed due to lack of materials.

2. Purchase the required amount of materials to avoid working capital locks and minimize the risk of surplus or obsolete stores.

3. Make competitive and wise purchases at the most economical prices so that you can reduce material costs.

4. Purchase the right quality material to minimize the waste of material.

5. Acts as an information centre for material knowledge about prices, suppliers, lead times, quality and specifications.

Q3) Write short notes on Centralized and Decentralized purchases. (8 marks)

A3) Meaning of Centralized and Decentralized Purchasing:

Centralization and Decentralization are the two types of structures, that can find in the organization, government, management, and even in purchasing. Centralization of authority means the power of planning and decision making are exclusively in the hands of top management. It alludes to the concentration of all the powers at the apex level. On the other hand, Decentralization refers to the dissemination of powers by the top management to the middle or low-level management. It is the delegation of authority, at all levels of management.

Centralized purchase: Centralized purchase means the purchase of materials by one specialized department. The purchasing department has personnel with expertise in all aspects of the material. The purchasing department has the authority to make purchases for the entire organization.

In this system, the requirements of the entire organization are confirmed through the creation of purchasing budget, the purchasing department makes purchases according to the accepted principle, and the materials are distributed to each production department according to the requirements.

In most cases, the purchasing department purchases materials based on the requisition form issued by the store. The supplier delivers the material to the Material Receipt section. Individual departments are not allowed to purchase their own materials when centralized purchases are made.

Under centralized purchasing purchases are made at one central point for the whole organization and material is issued to respective departments or jobs as and when needed. Also, Centralized purchasing is suitable in cases where the organization runs one plant. It will bring about economies of purchasing and buying in small lots will avoid.

It ensures consistent buying policies in the future and purchasing powers are concentrated in the hands of one person, the in-charge of the purchasing department. This type of purchasing is very helpful in the quick implementation of decisions regarding purchasing. It also ensures bulk buying which ensures favorable prices. The staff requirements under this type are limited and specialists in buying may appoint.

Centralized purchasing is further helpful to the vendors since their selling costs are reduced as they can easily coordinate and supply goods to a single buyer instead of a large number of buyers. The most important benefit which can draw from centralized buying is that it keeps the inventories in control and checks the wasteful investment in materials and equipment etc. thereby ensuring the overall economy in purchasing.

Advantages of Centralized Purchasing:

A centralized purchasing system generally prefers because of the following advantages of it;

1. Specialized and expert purchasing staff can concentrate on one department.
2. Better layout of storage space.
3. Utilization of high technical skills.
4. A firm policy can initiate which may result in favorable terms of purchase, e.g., higher trade discount, easy terms of payment, etc.
5. Standardization of quality of raw material facilitates.
6. Minimum finance required.
7. Better supervision of materials usage, and.
8. Also, better control over purchasing is possible because reckless buying by various individuals avoid. Keeping all records of purchase transactions in one place also helps in control.

Disadvantages of Centralized Purchasing:

A centralized purchasing system generally refuses because of the following disadvantages of it;

1. The high cost of internal transport.
2. The creation and maintenance of a special purchasing department lead to higher administration costs which small concerns may not be in a position to afford.
3. Non-availability of materials for production in time.
4. Greater risk of obsolescence, and.
5. Centralized purchasing is not suitable for plants or branches located at different places that are far apart.

Decentralized purchase: Decentralized purchases mean that each department can purchase materials according to their needs. Decentralized purchasing is just the reverse of centralized purchasing. This is suitable for organizations running more than one plant. Under this type, each plant has its purchasing agents. In other words, every department makes its purchases. This also calls localized purchasing. Also, Decentralized purchasing is quite flexible and can quickly adjust following the requirements of a particular plant.

More attention can pay by the departmental head to buying problems as he will be carrying the limited number of activities in his department and he can hold responsible for the purchase of goods and the overall performance of the plant. The serious drawback which emerges from this type is the lack of uniformity in purchasing procedure in the organization.

At the same time, uniformity in prices cannot ensure and every departmental head may not possess the caliber of an expert buyer. This method also poses the problems of coordination among various departments of the organization and usually leads to unplanned buying. In comparison to centralized buying, this method involves a lesser economy in purchasing.

Therefore, the authority to make purchases rests with the individual departments.

(A) Advantages of local purchase: If the production unit is far from the body, it is beneficial to have the unit available for purchase locally. You can enjoy the benefits of basic low price and seasonal price, and reduce the cost.

(B) Reduction of transportation costs: By supplying materials locally, transportation costs will be significantly reduced.

(C) Quick reQ of the problem: Disputes caused by refusals, shortages and returns can be resolved easily and quickly.

Advantages of Decentralized Purchasing:

A Decentralized purchasing system generally prefers because of the following advantages of it;

1. Materials can purchase by each department locally as and when required.
2. Timely availability of materials.
3. Materials are purchasing in the right quantity of the right quality for each department easily.
4. No heavy investment requires initially.
5. Less cost of internal transport.
6. Lower chance of obsolescence.
7. Purchase orders can place quickly, and.
8. The replacement of defective materials takes little time.

Disadvantages of Decentralized Purchasing:

A Decentralized purchasing system generally refuses because of the following disadvantages of it;

1. Organization losses the benefit of a bulk purchase.
2. Poor layout of space.
3. More finance requires.
4. Duplicate purchase of materials.
5. Specialized knowledge may be lacking in purchasing staff.
6. There is a chance of over and under-purchasing of materials.
7. Fewer chances of effective control of materials.
8. Less technical skill obtains.
9. More clerical work, and.
10. Lack of proper co-operation and co-ordination among various departments.

Q4) What do you mean by Purchase requisition? (5 marks)

A4)  The decision to purchase the material is made by the purchasing department after receiving the purchase request from the authorized department. A purchase request is made from an approved department to the purchasing department in a prescribed form called a purchase request.

Requisitions provide three basic pieces of information that help buyers perform their purchasing functions efficiently.

In any business, multiple departments need materials from time to time—from basic office supplies to raw materials, equipment, and services. Purchasing is universal, but how it’s handled makes a difference. When firms enable line managers or departmental managers to place orders with suppliers directly, it can lead to increased expenses and increased cases of expense fraud.

Let’s say the IT department in your firm needs a number of new laptops to replace old ones and equip new employees. What happens next? Does the head of the IT department simply pick the laptops they prefer and make the large purchase on their own? Without protocols in place, they could purchase far more than the department budget can accommodate, or even misuse company funds and buy devices for personal use. This throws a wrench in the business’ budget and can negatively impact its cashflow. At times, staff who are working in good faith can still accidentally violate budget limits or requirements that they did not know about.

This is why many companies have a streamlined purchasing process with well-defined approval workflows. If your business has tightened its spend scrutiny, is dealing with cash flow problems, or is on a strict budget, implementing an effective purchasing process can help cut down on unnecessary expenses and reduce spending. This process starts with a document called a purchase requisition form.

Purchase Requisition Form

A purchase requisition form is an internal document used by an employee to purchase goods or services on behalf of their firm. These purchases may be for business operations (such as office supplies), inventory, or manufacturing inputs.

The purchase requisition form is submitted to the purchase department for approval which is the first step in creating an effective audit trail for purchasing. Once the purchase requisition is approved by the relevant department, a purchase order is issued to the vendor of the requested goods or services.

Contents of a purchase requisition form

Purchase requisition forms generally require the following information:

1. Name and department of the requestor
2. The date of request
3. The products or services requested
4. Item description, quantity, and price
5. Reason for purchase
6. Legal name of the supplier

The information is as follows:

• What materials to buy (purchasing the right quality).
• When to buy (appropriate time).
• Amount to purchase (appropriate quantity).

Purchase requisitions are received by the purchaser from:

(I)  Shopkeepers of all standard materials.

(II) Production control department of non-standard materials required for production.

(III) Plant and maintenance engineers for special maintenance and capital investment.

(IV)  Head of special items such as office supplies.

The requisition is created three times. Two copies will be sent to the purchasing department, one copy will be retained as proof of approval and the other copy will be returned to the inventor after quoting the order details. Purchasing department. A third copy is kept by the store for office records and future references.

Material specifications or bill of materials:

The requisition contains details and specifications of the materials to purchase. Material specifications are known as bills of material. This starts in the production control department or the plant and maintenance engineer department. The BUI of Material is a complete schedule of materials or parts required for a particular job or work order created by a drafting office. A bill of materials is created for every job and a copy is sent to the storekeeper.

Q5) Define Purchase order. (5 marks)

A5) A purchase order is a commercial source document that is issued by a business’ purchasing department when placing an order with its vendors or suppliers. The document indicates the details on the items that are to be purchased, such as the types of goods, quantity, and price. In simple terms, it is the contract drafted by the buyer when purchasing goods from the seller.

Steps in Ordering

1. Buyer creates a purchase requisition

Before sending out the purchase order to the supplier, the first step is to create a purchase requisition. This is a document issued within the company to the purchasing department to keep track of the goods ordered.

The purchase requisition also helps the company keep an account of their expenses. The PO is created only after the purchase requisition is approved by the authorized manager.

2. Buyer creates a purchase order

When the goods that need to be purchased are agreed upon, the purchase order is created. The PO lists the date of the order, FOB shipping information, discount terms, names of the buyer and seller, description of the goods being purchased, item number, price, quantity, and the PO number.

The PO number is a unique number associated with a certain order. It serves two purposes. One is to ensure that the goods ordered match the ones that are received. Secondly, the PO number is matched to the invoice to make sure the buyer is charged the right amount for the goods.

3. Seller accepts (or rejects) purchase order

At the bottom of the purchase order is a dotted line for the authorized manager of the seller to sign off on the order. The PO includes all the details about the transaction and what the buyer expects to receive. Once the seller receives the PO, they have the right to either accept or reject the document. However, once the PO is accepted, it becomes a legally binding contract for both parties involved.

4. Buyer records purchase order

Once the order has been placed, the purchase order remains “open.” An open purchase order is a PO where the order is placed but the goods have not yet been received, or it can mean that only part of the order has been received. Either way, it signifies that the delivery of the goods is not complete.

Benefits of Purchase Orders

1. Avoids duplicate orders

Purchase orders bring several benefits to a company. The most important is that it helps avoid duplicate orders. When a company decides to scale the business, POs can help keep track of what has been ordered and from whom.

Also, when a buyer orders similar products, matching the invoices can be difficult. The PO serves as a check for the invoices that need to be paid.

2. Keeps track of incoming orders

In addition, POs help keep track of incoming orders, and a well-organized purchase order system can help simplify the inventory and shipping process.

3. Serves as legal documents

Purchase orders serve as legal documents and help avoid any future disputes regarding the transaction.

How Does the Supplier Use the Purchase Order?

Purchase orders play a major role in the inventory management process. When the supplier receives the PO, they will take the items listed in the PO from their inventory. The PO helps keep a record of the inventory on hand and identify any discrepancies between the values shown in the records and the actual stock.

Additionally, the supplier needs the PO to fill the order correctly. The buyer will also be charged by the supplier based on the payment terms agreed upon in the PO.

Purchase Order vs. Invoice

The purchase order is a document generated by the buyer and serves the purpose of ordering goods from the supplier. The invoice, on the other hand, is generated by the supplier and shows how much the buyer needs to pay for goods bought from the supplier. The PO is a contract of the sale while the invoice is the confirmation of the sale.

Purchase Order vs. Sales Order

While the purchase order shows what goods were ordered from the supplier, the sales order is generated by the supplier and sent to the buyer. It signifies the confirmation or approval of the sale. Nowadays, the PO process is no longer paper-based, and the buyer usually sends its suppliers an electronic PO. This is done using the PO module in ERP software. It helps speed up the purchasing process while decreasing the chance of error.

A purchase order is an agreement between a material buyer and a supplier. It is a requirement from the purchaser to the supplier to supply goods of a specific quantity and quality in accordance with the terms set forth in the contract. It also means the buyer's commitment to deliver and pay for the goods according to the terms and conditions stated on the purchase order.

After carefully determining the purchase quantity, the purchasing department should place an order with the supplier of choice. You need to choose a supplier that can deliver the products you need at a competitive price and at the right time. We are looking for a quote from our supplier.

Quotations received from different suppliers are compared and an acceptable supplier is selected. After completing the above procedure, a purchase order will be issued to the supplier to supply the required quantity of goods at the specified time.

Purchase order i is issued in the prescribed format, produced in quadruples (4 copies), and sent to the next department for reference and coordination.

(I) the first copy will be sent to the supplier.

(Ii) One copy will be sent to the department that sent the purchase requisition.

(Iii) One copy will be sent to the store or the internal department of the product.

(Iv)  One copy will be kept in the purchasing department as a permanent record.

(V) A copy will be sent to your account department.

Q6) What are the important methods to follow in pricing material issuance? (8 marks)

Explain any four.

A6) The important methods to follow in pricing material issuance are: -

1. Actual cost method

2. First-in first-out (FIFO) method

3. Last-in first-out (LIFO) method

4. Maximum first-in first-out method (HIFO) method

5. Simple average cost method

6. Weighted average cost method

7. Periodic average cost method

8. Standard Cost method

9. Exchange cost method

10. Last-in first-out (NIFO) method

11. Base stock method.

1. Actual cost method:

If you purchase a material specifically for a particular job, the actual cost of the material will be charged to that job. Such materials are usually kept separately and published only for that particular job.

2. First-in first-out (FIFO) method:

CIMA defines FIFO as "a method of setting the price of material issuance using the purchase price of the oldest unit in stock." With this method, the materials are issued out of stock in the order in which they were first stocked. It is assumed that the material that opens first is the material that is used first.

Advantage:

(A) Easy to understand and easy to price in question.

(B) It is a good store management practice to ensure that raw materials leave stores in chronological order based on age.

(C) This is an easy method with less administrative costs than other pricing methods.

(D) This inventory valuation method is accepted under standard accounting practices.

(E) Consistent and realistic practices in inventory and finished product valuation.

(F) Inventory is valued at the latest market price, close to the value based on replacement costs.

Cons: Disadvantages:

(A) If confused with other materials purchased at a different price at a later date, it is uncertain whether the material with the longest stock will be used.

(B) If the price of the purchased material fluctuates significantly, there will be more clerical work and errors may occur.

(C) Manufacturing costs are modest in situations where prices are rising.

(D) Inflationary markets tend to lower prices for key issues. The deflationary market tends to set higher prices for these issues.

(E) Generally, it is necessary to adopt multiple prices for the publication of a single document.

(F) This method makes it difficult to compare costs for different jobs when billed for the same material at different prices.

3. Weighted average cost method:

This is a permanent weighted averaging system in which the issue price is recalculated each time after each receipt, taking into account both the total quantity and the total cost when calculating the weighted average price. For example, three batches of material received in a quantity of 1,000 units @ Rs. 15, 1,300 units @ Rupee 16 and 800 units @ Rs. 14.14.

The weighted average price is calculated as follows:

(1,000 units x Rs .15) + (1,300 units x Rs .16) + (800 units x Rs .14) / 1,000 units + 1,300 units + 800 units

= Rs. 15,000+ rupees 20,800 + rupees 11,200 / 3,100 units = rupees 47,000 / 3,100 units = 15.16 per rupee unit

This method tends to smooth out price fluctuations and reduce the number of calculations because each issue is billed at the same price until you receive a new batch of material.

This method is easier than FIFO and LIFO because you do not have to identify each batch individually. However, this method adds more clerical work in calculating the new average price each time you receive a new batch. The calculated issue price rarely represents the actual purchase price.

4.  Basic stock method:

With this method, the specified quantity of material is always kept in stock and priced as a buffer or base stock at its original cost. In addition, issuance of materials that exceed the basic stock quantity is priced using one of the above methods.

This method shows how prices fluctuate over time. However, this method is uncommon and makes stock valuation completely unrealistic and is not accepted by standard accounting practices.

Q7) What is EOQ? (5 marks)

A7) This refers to the size of the material purchase order, so that he will be able to obtain the material in a year with the minimum total cost associated with the material. The costs associated with the material are:

EOQ is the order size with the lowest material-related costs to meet a particular material requirement over a period of time. In this way, adopting EOQ as the order quantity or reorder quantity rather than the total payment of material costs minimizes ordering and storage costs. If the price of the material does not change due to the change in order size, the EOQ is determined solely by the order and storage costs.

Purchase Costs:

The cost of obtaining raw materials from a supplier is called the purchase cost.

Order Cost:

All costs associated with an order are considered order costs. Examples: Transportation costs, purchaser transportation costs, telephone costs, printing costs, stationery costs, etc. are just a few examples of ordering costs. The order cost per order is assumed to be constant. The larger the order size, the smaller the number of orders, and therefore the total order cost for a particular time period, and vice versa.

Storage Cost:

This includes all costs associated with the cost of ownership example: interest on equity investments, insurance, downlinks, bin costs, theft, corruption, aging, etc. Larger order sizes result in higher average investment costs and total storage costs, and vice versa.

Out of Stock Cost:

The costs that result from defaulting on delivery promises are called out-of-stock costs, lost sales, lost credit, lost customers, and so on. This is related to too little inventory.

EOQ Graphic Decisions: In order cost exercises, the larger order size is advantageous because the number of orders is smaller. Total order and less total order cost. Smaller order sizes result in lower average inventory and therefore lower storage costs, so storage cost exercises result in lower order sizes.

The EOQ or minimum cost order size is determined when these pulls match each other exactly. Therefore, the EOQ is determined by the intersection of the order cost curve and the storage cost line.

In EOQ

Therefore, EOQ refers to the size of the purchase order for a material, so that the material is available at the lowest total cost associated with the material in a given year (that is, ordering cost + storage cost). If the quantity of material ordered is otherwise, the total cost of ordering and storing will be even higher.

Impact of changes in ordering and storage costs:

If the order cost per order increases, we recommend reducing the total number of orders during the period. As a result, the size of the EOQ increases. As ordering costs decrease, these costs become less attractive and the size of the EOQ shrinks.

As storage costs per unit increase, it is beneficial to maintain less inventory. Therefore, the size of the EOQ is smaller. As storage costs decrease, these costs become less attractive and the cost of carrying inventory decreases. As a result, the size of the EOQ increases.

Q8) Explain the Pareto Principle and Power Law of ABC Analysis. (5 marks)

A8) The ABC analysis is based on empirical observations known as the Pareto principle or the 80/20 rule, and no matter which unit of measure you choose, the top 20% of items typically represent 80% of sales. Therefore, in this situation, it makes sense to segment the elements of interest (items in inventory) according to the important "size", the ABC class.

From a more mathematical point of view, size-oriented analyzes such as the ABC analysis are attractive whenever there is a "fat tail" in the underlying (probability) distribution, that is, a large deviation from the mean. (1). These situations occur frequently in natural phenomena and human activity. For example, the following distribution is usually fat tail.

1. Number of employees of a company in a country
2. Biomass (tons) of species in the region
3. Box office revenue for a particular year
4. Recall (unit) in the automobile industry

There is an entire "bestiary" of mathematical distributions known to fit these situations. The most widely used distributions are probably power law and Zipf distributions. These mathematical functions differ greatly in their ability to "weight" the tail of the distribution, that is, to reflect the probability that a very rare situation will occur.

In certain cases of the supply chain, simple economic forces usually work to artificially limit the scale of outliers. For example, keep in mind that for items that are back in stock, the ones with the worst performance are usually permanently removed from the assortment. So, for example, a product that he sells only once a year is not observed because the company stopped selling long before reaching this sales level.

Conversely, if the product is selling very well, the company has an incentive to introduce variations in color, size, or other technical attributes to further increase overall sales volume. However, items that sell tens of millions of units may never be observed. This is because by the time the item reaches this volume, variants have been introduced that cannibalize the sale of the original item.

General Practices based on the ABC analysis

ABC analysis is used to support routine inventory-related decisions, such as passing purchase orders to suppliers. While it is controversial whether practices based on the ABC analysis are considered good practices (see the section below on the limitations of the ABC analysis), certain practices are widespread:

1. Assigning service levels based on the item's class-the first class has the highest target and the last class has the lowest target.
2. Assign uniform manpower (attention) to all classes-Example: A supply chain expert spends an hour reviewing class A (100 items) and then his one to review class D (10,000 items). Spend time
3. Segment all his KPIs by class, as well as segment all dashboards or reports according to the class of interest.
4. Establish performance reviews for supply chain teams based on rules that rely on the ABC class itself.
5. Indeed, ABC classes are easy to create and maintain, so they tend to blend in with your company's supply chain practices.

Q9) What is the Purpose of substance management? (5 marks)

A9) Purpose of substance management:

1. Continuous supply of materials for uninterrupted production flow: Production outages due to out-of-stock materials should be avoided. Such outages are very costly in terms of overhead costs, refusals to sell, or panic purchases.

2. Optimal investment in materials: Excessive investment due to excess inventory of materials not only locks large capital without making a profit, but also increases storage costs, which reduces the profitability of the business.

3. Economics of purchase: Materials should be purchased at the lowest possible cost without sacrificing quality, regularity and reliability of supply.

4. Strict quality control: A strict quality control system is required. The order of supply of raw materials of appropriate quality should be approved. Materials should be tested upon receipt and a report initialized by the person who tested them to correct liability should be generated.

5. Minimal processing cost and time: Materials should be stored in the following locations and in the following ways:

1. You can place materials with confidence
2. Make it available to the user department with minimal effort
3. The time it takes to track the material and deliver it to the user   department should be kept to a minimum.

6. Manage payments for materials: Prevent payments for materials that you have received but have not ordered, materials that you have not received, or materials that are defective in quality.

7. Approved Issues: Prevent issues from the store without proper approval. The shopkeeper must be accountable for all issues.

8. Minimize waste: Minimize waste when receiving, shipping, and handling materials in use at the user department. We need to revise the norms of waste at each stage and investigate waste that goes beyond the norms.

9. Plagiarism and Leakage and Other Loss Management: A system must be in place to prevent plagiarism of goods. Materials that are easy to steal require special control.

10. Detection of slow-moving and fast-moving substances: The system should regularly detect slow-moving and non-moving substances. This helps regulate additional purchases of such materials and prevent losses. In many cases, it is better to dispose of something that does not move than to leave it damaged and bear the cost of storage.

11. Management of misappropriation: Prevent misappropriation of materials. This is because when leaks occur in the system, they are inherently prone to recurrence.

12. Regular and reliable information about materials: For each material type, regular and reliable information records, namely inventory location, minimum level, maximum level, special issues with a particular material, and a list of reliable suppliers. Is required. This helps you order the right quantity from the right supplier at the right time.

Part B

Q10) The components A and B are used as follows:

Normal usage  300 units per week each

Maximum usage 450 units per week each

Minimum usage 150 units per week each

Reorder Quantity A 2,400 units; B 3,600 units.

Reorder period A 4 to 6 weeks, B 2 to 4 weeks.

Calculate for each component:

(a)  Re-order Level (b) Minimum Level (c) Maximum Level (d) Average Stock Level. ( 8 marks)

A1)

Q11) Find the Re-order quantity if consumption is 80-100 units per day, delivery period is 3-5 days and maximum level is 660 units. ( 5 marks)

A2)

Re-order Level = Maximum Consumption × Max Re-Order period.

= 100×5 = 500.

Maximum Level = Re-Order Level + Re-Order Quantity- (Minimum Consumption × Minimum Re-Order period)

Hence,

Re-Order Quantity = Maximum Level – Re-Order Level + (Minimum Consumption ×Minimum Re-Order period).

= 660-500+ (80×3) = 400 units.

Q12) A producer has estimated annual requirements of a material as 7200 units. Cost of placing an order is estimated as Rs 50/order and annual storage cost/unit of material is Rs. 5. Calculate the optimum order quantity or EOQ. Also show that at EOQ level, total ordering cost is equal to total storage cost.

A3)

Q=

2AO

= c

2x 72,000 x 50

= 5

= 1200 units

Total ordering Cost = No. Of orders × ordering cost per order.

= Total annual requirements × Ordering cost per order Order size

=Number of orders × Ordering cost per order

= 72000 × 50

1200

= 6 ×50 = 3000

Total Storage Cost = Average Stock x Annual Storage Cost per unit.

= Ordering Size × S.

2

= 1200 × 5 = 3000

2

Therefore, at EOQ = Total Storage Cost = Total Ordering Cost 3000 = 3000

Q13) Find the Maximum Stock level from the following:

Consumption rate is 80-100 units per week Delivery period is 5-7 weeks

EOQ is 660 units. (5 marks)

A4)

Maximum Level= Re-order Level + Re-order quantity- (Minimum weekly Consumption × Minimum Delivery period)

Re-order Level = Maximum weekly Consumption × Maximum Delivery Period.

= 100×7=700 units

Hence: Maximum Stock Level= 700+660-(80×5) = 960 units

Q14) A company uses 3000 units of material per month. Cost of placing an order is Rs. 200.The Cost per unit is Rs. 20. The reorder period is 4-8 weeks. The minimum consumption of raw material is 100 units to 350 units whereas the average consumption is 275 units. The Carrying cost of inventory is 20% per annum. Calculate:

1. EOQ/ Re-order quantity
2. Re-order level. (8 marks)

A5)

Q:

EOQ =

Or reorder quantity

Where: A = Annual Usage of Inputs in units O = Ordering Cost / Order

C = Carry Cost / Unit / annum EOQ= Economic Order Qty.

2x 36,000 x 200

= 20 x 20%

= =1897.33

b.         Re order Level=Maximum consumption x Maximum Delivery period

= 350 x 8 =2800 units

Q15) A company buys its annual requirement of 36,000 units in six instalments. Each unit costs Rs.10 and the ordering cost is Rs.250. The inventory carrying cost is estimated at 20% of the unit value per annum. Find the total annual cost of the existing inventory policy. How much money can be saved by economic order quantity? (8 marks)

A6) Calculation of the Annual cost of Existing Inventory Policy

Calculation of Economic Order Quantity

EOQ =

2x 36,000 x 250

= 10 x 20% =  

18000000

2

= 3,000 units

Calculation of the Annual cost if ordering as per EOQ

Calculation of saving in cost if ordered as per EOQ

(Note: Carrying cost will always be calculated on the average no of units carried)

Q7) ABC Company buys in lots of 125 boxes which is a three-month‟s supply. The cost per box is Rs.125 and the ordering cost is Rs. 250 per order. The inventory carrying cost is estimated at 20% of unit value per annum. You are required to ascertain:

1. The total annual cost of existing inventorypolicy.
2. How much money would be saved by employing the economic order quantity? (8 marks)

A7)

Calculation of the Annual cost of existing inventory policy

Calculation of Economic Order Quantity

EOQ =

2x 500 x 250

= 25

= 100 units

Calculation of the Annual cost if ordering as per EOQ

Calculation of saving in cost if ordered as per EOQ

Q16) A company manufactures 5000 units of a product per month. The cost of placing an order is Rs. 100. The purchase price of a raw material is Rs. 10/kg. The re-order period is 4 to 8 weeks. The consumption of raw material units is 100kg to 450 kg / week. The average Consumption is 275 kg. The carrying cost inventory is 20% / annum. You are required to calculate:

1. Re-order quantity
2. Re-order Level
3. Maximum Level
4. Minimum Level
5. Average Stock Level                           (8 marks)

A8)

Annual Requirement of Material = 275×52 = 14300

EOQ =

2x 14,300 x 100

= 10 x 20%

= 1196 units

Re-order Level= Maximum weekly Consumption × Maximum Delivery Period.

= 450 ×8

=3600 Kg.

Maximum Level= Re-order Level + Re-order quantity- (Minimum weekly Consumption × Minimum Delivery period)

= 3600+1196 – (100×4)

= 4396kg

Average Delivery Period= (4+8)

2

= 6 weeks.

Minimum Level = Re-order Level - (Average Weekly consumption × Average Delivery period)

= 3600- (275×4)

=2500kg.

Average Stock Level = (Minimum Level + Maximum Level)/2

= (439+2500)/2

= 3448kg

Q17) Long life pharmacy produces Sanjivini tonic using two herbs H-1 and H-2. Each liter of tonic requires 35 centiliters of H-1 and 65 centiliters of H2. Weekly production varies from 500 liters to 600 liters averaging 550 liters. Delivery period for both the herbs is 2 to 6 weeks. The economic order quantity for H-1 is 800 liters and for H-2 is 1,500 liters

Compute:

1. Re-order level of H-1;
2. Maximum level of H-1;
3. Minimum Level of H-1.
4. Re-order level of H-2;
5. Maximum level of H-2;
6. Minimum level of H-2.                        (8 marks)

A9)

Re- order level of H-1

= (Maximum consumption ×Maximum re-order Period)

= (600 X 0.35) X 6 = 1,260 Litres

Maximum level of H-1:

= Re- order level + Re- order Quantity –

(Minimum consumption ×Minimum Re-order Period)

=1,260 + 800 – (500 X 0.35 X 2)

=1,260 + 800 -350 = 1,710 Litres

Minimum Level of H-1:

= Re-order level – (Average consumption × Average Re-order Period)

=1,260 - (550 × 0.35 × 4)

= 1,260 – 770 = 590 Litres

Re- order level of H-2

= (Maximum consumption × Maximum Re-order Period)

= (600 X 0.65) X 6 = 2,340 Litres

Maximum of Level of H-2:

= Re- order level + Re- order Quantity –(Minimum consumption × Minimum Re- order period)

= 2,340+1500 – (500 × 0.65 × 2)

= 2,340+1500 – 650 = 3190 Litres

Minimum Level of H-2:

= Re-order level – (Average consumption × Average Re-order Period)

=2,340 - (550 × 0.35 × 4)

= 2,340 – 770 = 1570 Litres

Q18) In manufacturing its product P, a company uses two types of raw materials, M-1 and M-2 in respect of which the following information is supplied:

One unit of P requires 16 Kg of M-1 and 6 Kg of M-2 materials. Price per Kg of M-1 is Rs.25 and that of M-2 is Rs.50. Re-order quantities of M-1 and M-2 are 16,000 kg and 7,600 kg. Re- order levels of M-1 and M-2 12,000 kg and 7,000 kg respectively. Weekly production varies from 200 units to 300 units averaging 250 units. Delivery period of M-1 is 1 to 3 weeks and that of M-2 is 3-5 weeks.

Compute:

1. Minimum Stock level ofM-1.
2. Maximum Stock level ofM-2.               (8 marks)

A10)

Minimum Stock level ofM-1 = Re-order level – (Normal Consumption X Normal Re-order Period)

=16,000 – [(250 × 16) × 2]

= 16,000 – 8,000 = 8,000 Kg.

Maximum Stock level of M-2:= Re- order Level + Re- order Quantity – (Minimum consumption

× Minimum Re- order Period)

=7,000 + 7,600 – [(200 × 6) × 3]

= 7,000 + 7,600 – 3,600 = 11,000 Kg

Q 11) Find out re-order quantity if consumption is 80-100 units per day, delivery period is 3- 5 days and maximum level is 660units.

A11)

Re-order level = (Maximum Consumption × Maximum Re- order Period)

= (100 × 5) = 500 units

Maximum Level:

= Re-order level + Re- order Quantity –(Minimum consumption ×Minimum re-order Period)

Therefore, Re-order Quantity

= Maximum level – Re- order level + (Minimum consumption × minimum re-order Period)

= 660 – 500 + (80 × 3)

= 660 – 500 + 240 = 400 units

Q19) The following data pertain to Material M-1: SupplyPeriod 4 to 8months Consumption Rate:

Maximum 600 units‟ per month Minimum 200 units‟ per month Average 400 units‟ per month Monthly 625 units‟

Storage cost is 40% of stock value, ordering costs are Rs.600 per order. Price per unit is Rs.250. Compute:

Re-order level; Maximum Stock Level; Minimum Stock Level; Average Stock Level.

(8 mark)

A12)

Re-order Quantity or Economic Order Quantity (EOQ):

= [(2AB)/C]

A = 625 X 12 = 7,500 units B = Rs.600

C= Rs. 100 i.e. (250 X 0.4)

= √ [(2 X 7,500 X 600)/100]

= 300 units

Re-order level = (Maximum consumption × Maximum Re-order Period)

= (600 X 8) =4,800 units

Minimum Stock level:

= Re-order level - (Normal Consumption X Normal Re-order Period)

= 4,800 – (400×6)

= 4,800 – 2,400 = 2,400 units

Maximum Stock Level:

= Re-order level + Re-order quantity – (Minimum consumption × Minimum Re-order Period)

= 4,800 + 300 – (200 × 4) = 4,300 units

Average Stock Level

= Minimum Level + 0.5 Re-order Quantity

=2,400 + 0.5 × 300

= 2,400 + 150 = 2,550 units OR

Average stock level = Minimum level + Maximum level

2

= (2,400 + 4,300) / 2

= 6,700 / 2 = 3,350 units

Q20) Prepare stores ledger account by simple Average Method and Weighted Average Method from following information: (8 marks)

A13)

Stores Ledger Account (Weighted Average Method)

Q21) From the following transaction prepares stores ledger account using FIFO: 2016(8 marks)             

Receipts 2016 Issues

A14)

Store ledger: