Notes 6 Session 6

Participant Notes- Inventory Management & Audit 1

Participant Notes
Material Resource Planning:

IMPORTANCE
The quintessence of any Managers job is planning and control. Hence the materials
planning and budgeting function is given a prominent place in the integrated materials
management set-up. This is so because, planning for materials and working out a
realistic budget not only help motivate people but also serve as a control device.
Planning is done at all levels of the organization. This is illustrated in Exhibit 6.1

EXHIBIT 6.1










In the context of materials management, planning has to be done for highly
programmed decisions such as import policy, foreign exchange availability and credit
squeeze. In a similar manner, planning has also to be done for highly programmed
decisions such as hypothecating inventory for working capital, working out delivery
schedules, etc. The relationship between materials planning and other major
functions are shown in Exhibit 6.2

EXHIBIT 6.2









Material Requirements Planning
Material requirements planning (MRP) is the system used to avoid missing
parts. It establishes a schedule (priority plan) showing the components required at
each level of the assembly and, based on lead times, calculates the time when these
Top Management
Middle Management
Planning for non-
programmed
decisions
Planning for
programmed
decisions (routine)
Sales
Forecast
Production
Programme
Materials
Plan
Notes 6 Session 6
Participant Notes- Inventory Management & Audit 2
components will be needed.
This chapter will describe bills of material (the major building block of
material requirements planning), detail the MRP process, and explain how the
material requirements plan is used. But first, some details about the environment in
which MRP operates.
Nature of Demand
There are two types of demand: independent and dependent. Independent
demand is not related to the demand for any other product. For example, if a company
makes wooden tables, the demand for the tables is independent. Master production
schedule items are independent demand items. The demand for the sides, ends, legs,
and tops depends on the demand for the tables, and these are dependent demand
items.
Figure 6.1 is a product tree that shows the relationship between independent
and dependent demand items. The figures in parentheses show the required quantities
of each component.
Figure 6.1




Since independent demand is not related to the demand for any other assem-
blies or products, it must be forecast. However, since dependent demand is directly re-
lated to the demand for higher-level assemblies or products, it can be calculated.
Material requirements planning is designed to do this calculation.
An item can have both a dependent and an independent demand. A service or
replacement part has both. The manufacturer of vacuum cleaners uses flexible hose in
Table
Legs
(4)
Ends
(2)
Sides
(2)
Top
(1)
Hardware
Kit (1)
Independent
Demand (Forecast)
Dependent
Demand
(Calculated)
Notes 6 Session 6
Participant Notes- Inventory Management & Audit 3
the assembly of the units. In the assembly of the vacuums, the hose is a dependent
demand item. However, the hose has a nasty habit of breaking, and the manufacturer
must have replacement hoses available. Demand for replacement hoses is independent
since demand for them does not depend directly upon the number of vacuums
manufactured.
Dependency can be horizontal or vertical. The dependency of a component on
its parent is vertical. However, components also depend on each other (horizontal de-
pendency). If one component is going to be a week late then the final assembly is a
week late. The other components are not needed until later. This is also a dependency,
and is called horizontal dependency. Planners are concerned with horizontal depen-
dency when a part is delayed or there is a shortage, for then other parts will have to be
rescheduled.
Objectives of MRP
Material requirements planning has two major objectives: determine
requirements and keep priorities current.
Determine requirements. The main objective of any manufacturing planning and
control system is to have the right materials in the right quantities available at the
right time to meet the demand for the firm's products. The material requirements
plan's objective is to determine what components are needed to meet the master
production schedule and, based on lead time, to calculate the periods when the
components must be available. It must determine the following:
o What to order.
o How much to order.
o When to order.
o When to schedule delivery.
Keep priorities current. The demand for, and supply of, components change daily.
Customers enter or change orders. Components get used up, suppliers are late with
delivery, scrap occurs, orders are completed, and machines break down. In this ever-
changing world, a material requirements plan must be able to reorganize priorities to
Notes 6 Session 6
Participant Notes- Inventory Management & Audit 4
keep plans current. It must be able to add and delete, expedite, delay, and change
orders.
Linkages to Other MPC Functions
The master production schedule drives the~material requirements plan. The
MRP is a priority plan for the components needed to make the products in the MPS.
The plan is valid only if capacity is available when needed to make the components,
and the plan must be checked against available capacity. The process of doing so is
called capacity requirements planning and is discussed in the next chapter.
Material requirements planning drives, or is input to, production activity
control (PAC) and purchasing. MRP plans the release and receipt dates for orders.
PAC and purchasing must plan and control the performance of the orders to meet the
due dates.

Figure 6.2 shows a diagram of the production planning and control system
with its inputs and outputs.
Figure 6.2


















PRODUCTION
PLAN
MASTER
PRODUCTION
SCHEDULE
MATERIALS
REQUIREMENTS
PLAN
INPUT OUTPUT
Business Plan
Financial Plan
Market Plan
Capacity

Production Plan
Forecasts
Customer Orders
Inventory
Capacity

MPS
Bill of Materials
Inventory
Capacity
Aggregate Plan
o By product groups
o Inventory levels


Detailed Plan
o By Week
o By End Item


Time-Phased
Manufacturing and
Purchase Orders
o For Raw Materials
o For Components
PURCHASING PRODUCTION
ACTIVITY
CONTROL
Notes 6 Session 6
Participant Notes- Inventory Management & Audit 5
Techniques of Material Resource Planning
ABC Analysis
WHAT IS ABC ANALYSIS?
ABC Analysis is a basic analytical management tool, which enables top
management to place the effort where the results will be greatest. This technique,
popularly known as Always Better Control or the alphabetical approach, has universal
applications in many areas of human endeavour. The technique tries to analyse the
distribution of any characteristic by money value of importance in order to determine
its priority. In materials management, this technique has been applied in areas needing
selective control, such as inventory, criticality of items, obsolete stocks, and purchase
orders, receipt of materials, inspection, store keeping, and verification of bills.
The annual consumption analysis of any organisation would indicate that a
handful of top high value items-less than 10 per cent of the total number-will account
for a substantial portion of about 75 per cent of the total consumption value, and these
few vital items are called 'A' items which need careful attention of the materials
manager. Similarly, a large number of 'bottom' items-over 70 per cent of the total
number called the trivial many-account only for about 10 per cent of the consumption
value, and are known as the 'c' class. The items that lie between the top and bottom
are called the 'B' category items.
ADVANTAGES OF ABC ANALYSIS
This approach helps the materials manager to exercise selective control and
focus his attention only on a few items when he is confronted with lakhs of stores
items. By concentrating on 'A' class items, the materials manager is able to control
inventories and show 'visible' results in a short span of time. Controlling the A items
and doing a proper inventory analysis automatically pinpoint obsolete stocks. Many
organisations have claimed that ABC analysis has helped in reducing the clerical costs
and resulted in better planning and improved inventory turnover. ABC analysis has to
be resorted to because equal attention to 'A', 'B' and 'C' items will not be worthwhile
Notes 6 Session 6
Participant Notes- Inventory Management & Audit 6
and would be very expensive. Concentrating on all the items is likely to have a
diffused effect on all the items, irrespective of the priorities.
MECHANICS OF ABC ANALYSIS
The mechanics of classifying the items into 'A, 'B' and 'C' categories are
described in the following steps:
1. Calculate rupee annual issues for each item in inventory by multiplying the
unit cost by the number of units issued in a year. It is assumed that the issues
and consumption are the same.
2. Sort all items by rupee annual issues in descending sequence.
3. Prepare a list from these ranked items showing item no., unit cost, annual units
issued and annual rupee value of units issued.
4. Starting at the top of the list, compute a running total, item-by-item issue value
and the rupee consumption value.
5. Compute and print for each item the cumulative percentages for the item count
and cumulative annual issue value.
The normal items in most organisations show the following pattern:
5 per cent to 10 per cent of the top number of items account for about
70 per cent of the total consumption value. These items are called 'N
items.
15 per cent to 20 per cent of the number of items account for 20 per
cent of the total consumption value. These items are called 'B' items.
The remaining number of items account for the balance 15 per cent of
the total issue value. These items are called 'C' items.

Instead of doing ABC analysis, as discussed earlier, many firms classify items
as accounting for consumption value of above Rs. 10,000, 'B' items between Rs 1,000
and Rs 10,000 and 'c' items less than Rs 1,000 of annual consumption. These limits
vary depending upon the size of the firm:
The basic principles in ABC analysis are:
i. The analysis does not depend upon the unit cost of the items but only on its
annual consumption value;
ii. It does not depend on the importance of the item; and
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Participant Notes- Inventory Management & Audit 7
iii. The limits for ABC categorisation are not uniform but will depend upon the
size of the undertaking, its inventory as well as the number of items
controlled.
PURPOSE OF ABC ANALYSIS
The object of carrying out ABC analysis is to develop policy guidelines for
selective control.
Normally, once ABC analysis has been done, the following broad policy
guidelines can be established in respect of each category:
A-items: B-items: C-items:
High consumption value Moderate value
Low consumption
value
1. Very strict control Moderate control Loose control
2. No safety stocks
(or very low)
Low safety stocks High safety stocks
3. Frequent ordering or
weekly deliveries
Once in three months
Bulk ordering once in
6 months
4. Weekly control
statements
Monthly control reports
Quarterly control
reports
5. Maximum follow-up and
expediting
Periodic follow-up
Follow-up and
expediting in
exceptional cases
6. Rigorous value analysis Moderate value analysis
Minimum value
analysis
7. As many sources as
possible for each item
Two or more reliable
sources
Two reliable sources
for each item
8. Accurate forecasts in
materials planning
Estimates based on past
data on present plans
Rough estimates for
planning
9. Minimisation of waste,
obsolete and surplus
(review every 15 days)
Quarterly control over
surplus and obsolete items
Annual review over
surplus and obsolete
material
10. Individual postings Small group postings Group postings
11. Central purchasing and
storage
Combination purchasing
Decentralised
purchasing
12. Maximum efforts to
reduce lead time
Moderate
Minimum clerical
efforts
13. Must be handled by
senior officers
Can be handled by middle
management
Can be fully
delegated
Notes 6 Session 6
Participant Notes- Inventory Management & Audit 8
Colour coding can be used to identify A, Band C categories in stores. Usually
red is used for 'A' items, pink for 'B' items and blue for 'c' items.
'A' items merit a tightly controlled inventory system with constant attention by
the purchase and stores management. A large effort per item on only a few items can
cost only moderately, but the effort can result in large savings. 'B'items merit a
formalised inventory system with periodic attention by the purchase and stores
management. 'C' items use a simpler system designed to cause the least trouble for the
purchase and stores department, perhaps even at the cost of a little extra inventory
cost. It is also common to further subdivide 'A' items as Al and A2 or A +and A-and
similarly categories for 'B' and 'C' items exist for exercising finer control.
OBJECTIVE OF ABC ANALYSIS
As discussed earlier, the ABC analysis enables the materials manager to
exercise selective control when he is confronted with a large number of items. Tighter
and accurate procedures are essential for 'A' value items relating to materials
planning, forecasts, ordering, review, records, postings, revisions, lead time analysis,
safety stock, materials consumption control, purchase budget, delivery schedule,
value analysis, follow-up, clerical efforts, physical stock verification, receipts, issues,
stores accounting and inspection. The degree of control should be rigorous for 'A'
items and should be minimum for 'C' items.
ABC analysis is also helpful to rationalise the number of orders and reduce the
overall inventory. For instance, let us consider three items accounting for a
consumption of Rs 60,000, Rs. 4,000 and Rs 1,000 respectively, each being ordered
four times a year. The following pattern would then emerge:

EXHIBIT 6.3


Item no.
Annual consumption
value (Rs)
Number of
orders
Value per
order
Average
inventory
1 60,000 4 15,000 7,500
2 4,000 4 1,000 500
3 1,000 4 250 125
Total inventory Rs 8,125
Notes 6 Session 6
Participant Notes- Inventory Management & Audit 9
If A, B, C analysis has been done, then it implies that 'A' item should be
ordered more, say eight orders, three for 'B' and one for 'C' item. Then the pattern
given in Exhibit 6.4 emerges.

EXHIBIT 6.4


Item no.
Annual
consumption value
(Rs)
Number of
orders
Value per
order
Average
inventory
1 60,000 8 7,500 3,750
2 4,000 3 1,333 667
3 1,000 1 1,000 500
Total inventory Rs 4,917

It is thus noted that even though the total number of .orders is the same, the
average inventory has been reduced significantly by recognising that 'A' items should
be 'ordered more frequently. (The optimum number of orders can be arrived at by
formulae discussed under Inventory Systems.)
LIMITATIONS OF ABC ANALYSIS
ABC analysis, in order to be fully effective, should be carried out with
standardisation and codification. ABC analysis is based on grading the items
according to the importance of performance of an item, that is by V.E.D.-vital,
essential and desirable analysis discussed later. Some items, though negligible in
monetary value, may be vital for running the plant, and constant attention is needed. If
the inventory position is analysed according to the value, commonly known as XYZ
analysis, then results of ABC and XYZ analysis will be different, depending upon the
nature of obsolete items. The results of ABC analysis have to be reviewed
periodically and updated. It is a common experience that a 'C' item, like diesel oil in a
firm, will become the most high value item during power crisis. However, ABC
analysis is a powerful approach in the direction of cost reduction as it helps to control
items with a selective approach.

Notes 6 Session 6
Participant Notes- Inventory Management & Audit 10
Order Quantities
INTRODUCTION
The objectives of inventory management are to provide the required level of
customer service and to reduce the sum of all costs involved. To achieve these
objectives, two basic questions must be answered:
1. How much should be ordered at one time?
2. When should an order be placed?
Management must establish decision rules to answer these questions so inven-
tory management personnel know when to order and how much. Lacking any better
knowledge, decision rules are often made based on what seems reasonable.
Unfortunately, such rules do not always produce the best results. First, we must
decide what we are ordering and controlling.
Stock-Keeping Unit (SKU)
Control is exercised through individual items in a particular inventory. These
are called a stock-keeping unit (SKU). Two white shirts in the same inventory but of
different sizes or styles would be two different SKUs. The same shirt in two different
inventories would be two different SKUs.
Lot-Size Decision Rules
The eighth edition of the APICS Dictionary defines a lot, or batch, as a
quantity produced together and sharing the same production costs and specifications.
Following are some common decision rules for determining what lot size to order at
one time.
Lot-for-Lot. The Lot-for-Lot rule says to order exactly what is needed-no more-no
less. The order quantity changes whenever requirements change. This technique re-
quires time-phased information such as provided by a material requirements plan or a
master production schedule. Since items are ordered only when needed, this system
creates no unused lot-size inventory. Because of this, it is the best method for
planning "A" items and is also used in a just-in-time environment.
Notes 6 Session 6
Participant Notes- Inventory Management & Audit 11
Fixed-order quantity. Fixed-order quantity rules specify the number of units to be
ordered each time an order is placed for an individual item or SKU. The quantity is
usually arbitrary, such as 200 units at a time. The advantage to this type of rule is that
it is easily understood. The disadvantage is that it does not minimize the costs
involved.
A variation on the fixed-order quantity system is the min-max system. In this
system, an order is placed when the quantity available falls below the order point (dis-
cussed in the next chapter). The quantity ordered is the difference between the actual
quantity available at the time of order and the maximum. For example, if the order
point is 100 units, the maximum is 300 units, and the quantity actually available when
the order is placed is 75, the order quantity is 225 units. If the quantity actually avail-
able is 80 units, an order for 220 units is placed.
One commonly used method of calculating the quantity to order is the eco-
nomic-order quantity, which is discussed in the next section.
Order "n" periods supply. Rather than ordering a fixed quantity, inventory man-
agement can order enough to satisfy future demand for a given period of time. The
question is how many periods should be covered? The answer is given later in this
chapter in the discussion on the period-order quantity system.
Costs
As shown in the last chapter, the cost of ordering and the cost of carrying
inventory both depend on the quantity ordered. Ideally, the ordering decision rules
used will minimize the sum of these two costs. The best known system is the
economic-order quantity.
ECONOMIC-ORDER QUANTITY (EOQ)
Assumptions
The assumptions on which the EOQ is based are as follows:
Demand is relatively constant and is known.
The item is produced or purchased in lots or batches and not
continuously.
Notes 6 Session 6
Participant Notes- Inventory Management & Audit 12
Order preparation costs and inventory-carrying costs are constant and
known.
Replacement occurs all at once.
These assumptions are usually valid for finished goods whose demand is inde-
pendent and fairly uniform. However, there are many situations where the assump-
tions are not valid and the EOQ concept is of no use. For instance, there is no reason
to calculate the EOQ for made-to-order items in which the customer specifies the
order quantity, the shelf life of the product is short, or the length of the run is limited
by tool life or raw material batch size. In material requirements planning, the lot-for--
lot decision rule is often used, but there are also several rules used that are variations
of the economic-order quantity.
Development of the EOQ Formula
Under the assumptions given, the quantity of an item in inventory decreases at
a uniform rate. Suppose for a particular item, the order quantity is 200 units, and the
usage rate is 100 units a week, the quantity of units in inventory then increases
instantaneously by Q, the quantity ordered. This is an accurate representation of the
arrival of purchased parts or manufactured parts where all parts are received at once.
From the preceding,

Average lot size inventory =
Order quantity = 200
= 100 units
2 2


Number of orders per year =
annual demand = 100 x 52
=
26 times
per year order quantity 200

Relevant Costs. The relevant costs are as follows:
Annual cost of placing orders.
Annual cost of carrying inventory.
As the order quantity increases, the average inventory and the annual cost of
carrying inventory increase, but the number of orders per year and the ordering cost
decrease. It is a bit like a seesaw where one cost can be reduced only at the expense
of increasing the other. The trick is to find the particular order quantity in which the
Notes 6 Session 6
Participant Notes- Inventory Management & Audit 13
total cost of carrying inventory and the cost of ordering will be a minimum.
Let:
A =annual usage in units
S =ordering cost in dollars per order
I =annual carrying cost rate as a decimal of a percentage
C =unit cost in dollars
Q =order quantity in units
Then:
Annual ordering cost =number of orders x costs per order
=
A
X S
Q
Annual carrying cost =average inventory x cost of carrying one unit for one year
=average inventory x unit cost x carrying cost
=
Q
X c X i
2
Total annual costs =annual ordering costs +annual carrying costs
=
A
X S +
Q
X c X i
Q 2
Economic-Order Quantity Formula
EOQ occurs at an order quantity in which the ordering costs equal the carrying
costs. If these two costs are equal, the following formula can be derived:
Carrying costs =ordering costs

Qic = AS
2 Q
Solving for Q gives

Q
2
= 2AS
ic

Q = 2AS
ic
Notes 6 Session 6
Participant Notes- Inventory Management & Audit 14
Practical Considerations When Using the EOQ
Lumpy demand. The EOQ assumes that demand is uniform and replenishment
occurs all at once. When this is not true, the EOQ will not produce the best results. It
is better to use the period-order quantity.
Anticipation Inventory: Demand is not uniform, and stock must be built ahead.
It is better to plan a buildup of inventory based on capacity and future demand.
Minimum order. Some suppliers require a minimum order. This minimum may
be based on the total order rather than on individual items. Often these are C items
where the rule is to order plenty, not an EOQ.
Transportation inventory. As will be discussed in Chapter 13, carriers give rates
based on the amount shipped. A full load costs less per ton to ship than a part load.
This is similar to the price break given by suppliers for large quantities. The same
type of analysis can be used.
Multiples. Sometimes, order size is constrained by package size. For example, a
supplier may ship only in skid-load lots. In these cases, the unit used should be the
minimum package size.

IT & MATERIAL RESOURCE PLANNING
This is the first activity in materials management. The important input here is
the sales forecast. The sales forecast is converted into finished goods forecast, and the
bill of materials is used for exploding the requirements of finished goods into the
requirements of materials. The bill of materials is a document containing a detailed
list of all raw materials, components and sub-assemblies needed for manufacturing a
particular final product. It will be very exhaustive and will carry part numbers, store
locations, whether they are to be purchased or manufactured, and so on.
When the forecast of finished product A for a month is 1,000 units, the bill of
materials for A can be used to arrive at the forecast of the requirements of various
Notes 6 Session 6
Participant Notes- Inventory Management & Audit 15
parts and components which go into the manufacture of A. Bill of materials data is
sometimes kept in punched cards. As the bill of materials is formed from the
engineering drawings, any changes can be effected by replacing invalid cards with
new cards. However, when the number of parts that go into each finished product
becomes large (say 10,000 items or more as could be the case with Automobiles),
then the punched cards could become unwieldy. Hence, many computer systems
operate by storing the bill of materials internally in the machine.
Also, in computerized materials planning it is possible to send the exploded
requirements over the future. This is done by assigning levels, which is known as
product structuring. Programmes are available to assign a level. These kinds of levels
actually indicate the product structure, i.e., finished product, assemblies, sub-
assemblies, components and raw materials. Further, at each level a code may be
assigned to the items, which indicate the earliest time that the item must be made so
that it is ready for the next step. The levels and codes are the building blocks, which
enable the planner to project the requirements as well as timing in a systematic
manner. The lead times of various items as well as rejection rates for each part are
also taken into account for timing the requirements.