Inventory Management UNIT II

In any business or organization, all functions are interlinked and connected to each other and are often
overlapping. Some key aspects like supply chain management, logistics and inventory form the backbone of
the business delivery function. Therefore these functions are extremely important to marketing managers as
well as finance controllers.

Inventory management is a very important function that determines the health of the supply chain as
well as the impacts the financial health of the balance sheet. Every organization constantly strives to
maintain optimum inventory to be able to meet its requirements and avoid over or under inventory that can
impact the financial figures.

Inventory is always dynamic. Inventory management requires constant and careful evaluation of external and
internal factors and control through planning and review. Most of the organizations have a separate
department or job function called inventory planners who continuously monitor, control and review inventory
and interface with production, procurement and finance departments.

Defining Inventory

Inventory is an idle stock of physical goods that contain economic value, and are held in various forms by an
organization in its custody awaiting packing, processing, transformation, use or sale in a future point of time.

Any organization which is into production, trading, sale and service of a product will necessarily hold stock
of various physical resources to aid in future consumption and sale. While inventory is a necessary evil of any
such business, it may be noted that the organizations hold inventories for various reasons, which include
speculative purposes, functional purposes, physical necessities etc.

From the above definition the following points stand out with reference to inventory:

 All organizations engaged in production or sale of products hold inventory in one form or other.
 Inventory can be in complete state or incomplete state.
 Inventory is held to facilitate future consumption, sale or further processing/value addition.
 All inventoried resources have economic value and can be considered as assets of the organization.

Different Types of Inventory

Inventory of materials occurs at various stages and departments of an organization. A manufacturing

organization holds inventory of raw materials and consumables required for production. It also holds
inventory of semi-finished goods at various stages in the plant with various departments. Finished goods
inventory is held at plant, FG Stores, distribution centers etc. Further both raw materials and finished goods
those that are in transit at various locations also form a part of inventory depending upon who owns the
inventory at the particular juncture. Finished goods inventory is held by the organization at various stocking
points or with dealers and stockiest until it reaches the market and end customers.

Besides Raw materials and finished goods, organizations also hold inventories of spare parts to service the
products. Defective products, defective parts and scrap also forms a part of inventory as long as these items
are inventoried in the books of the company and have economic value.

Types of Inventory by Function

INPUT PROCESS OUTPUT

Raw Materials Work In Process Finished Goods

Consumables required for Semi Finished Production Finished Goods at

processing. Eg : Fuel, in various stages, lying Distribution Centers
Stationary, Bolts & Nuts with various departments through out Supply Chain
etc. required in like Production, WIP
manufacturing Stores, QC, Final
Assembly, Paint Shop,
Packing, Outbound Store
etc.

Maintenance Production Waste and Finished Goods in transit

Items/Consumables Scrap

Packing Materials Rejections and Defectives Finished Goods with

Stockiest and Dealers

Local purchased Items Spare Parts Stocks &

required for production Bought Out items

Defectives, Rejects and

Sales Returns

Repaired Stock and Parts

Sales Promotion & Sample

Stocks

Inventory Management Concepts

Inventory management and supply chain management are the backbone of any business operations. With the
development of technology and availability of process driven software applications, inventory management
has undergone revolutionary changes. In the last decade or so we have seen adaptation of enhanced customer
service concept on the part of the manufacturers agreeing to manage and hold inventories at their customers
end and thereby effect Just In Time deliveries. Though this concept is the same in essence different industries
have named the models differently. Manufacturing companies like computer manufacturing or mobile phone
manufacturers call the model by name VMI - Vendor Managed Industry while Automobile industry uses the
term JIT - Just In Time where as apparel industry calls such a model by name - ECR - Efficient consumer
response. The basic underlying model of inventory management remains the same.

Let us take the example of DELL, which has manufacturing facilities all over the world. They follow a
concept of Build to Order where in the manufacturing or assembly of laptop is done only when the customer
places a firm order on the web and confirms payment. Dell buys parts and accessories from various vendors.
DELL has taken the initiative to work with third party service providers to set up warehouses adjacent to their
plants and manage the inventories on behalf of DELL’s suppliers. The 3PL - third party service provider
receives the consignments and holds inventory of parts on behalf of Dell’s suppliers. The 3PL warehouse
houses inventories of all of DELL’s suppliers, which might number to more than two hundred suppliers.
When DELL receives a confirmed order for a Laptop, the system generates a Bill of material, which is
downloaded at the 3PL, processed and materials are arranged in the cage as per assembly process and
delivered to the manufacturing floor directly. At this point of transfer, the recognition of sale happens from
the Vendor to Dell. Until then the supplier himself at his expense holds the inventory.

Let us look at the benefits of this model for both Dell as well as Its Suppliers:
 1. With VMI model, Dell has reduced its in bound supply chain and thereby gets to reduce its logistics
and inventory management costs considerably.
2. DELL gets to postpone owning inventory until at the time of actual consumption. Thereby with no
inventories DELL has no need for working capital to be invested into holding inventories.
3. DELL does not have to set up inventory operations and employ teams for operations as well as
management of inventory functions.

Supplier Benefits

1. Supplier gets to establish better relationship and collaboration with DELL with long-term business
prospect.
2. By agreeing to hold inventories and effect JIT supplies at the door to DELL, supplier will be in a
better position to bargain and get more business from DELL.
3. With VMI model, supplier gets an opportunity to engage in better value proposition with his
customer DELL.
4. Supplier gets confirmed forecast for the entire year with commitments from DELL for the quantity
off take.
5. VMI managed is managed by 3PL and supplier does not have to engage himself in having to set up
and manage inventory operations at DELL’s premise.
6. 3PL Managed VMI holds inventories of all suppliers thereby charges each supplier on per pallet basis
or per sq.ft basis. Supplier thereby gets to pay on transaction basis without having to marry fixed
costs of inventory operations.

Today most of the Multi National companies have successfully managed to get their suppliers and 3PL
service providers to setup VMI through out their plants all over the world and this model has become the
order of the day.

Need for Inventory Management - Why do Companies hold Inventories ?

Inventory is a necessary evil that every organization would have to maintain for various purposes. Optimum
inventory management is the goal of every inventory planner. Over inventory or under inventory both cause
financial impact and health of the business as well as effect business opportunities.

Inventory holding is resorted to by organizations as hedge against various external and internal factors, as
precaution, as opportunity, as a need and for speculative purposes.

Reasons why organizations maintain Raw Material Inventory

Most of the organizations have raw material inventory warehouses attached to the production facilities where
raw materials, consumables and packing materials are stored and issue for production on JIT basis. The
reasons for holding inventories can vary from case to case basis.

1. Meet variation in Production Demand

Production plan changes in response to the sales, estimates, orders and stocking patterns. Accordingly
the demand for raw material supply for production varies with the product plan in terms of specific
SKU as well as batch quantities.

Holding inventories at a nearby warehouse helps issue the required quantity and item to production
just in time.

2. Cater to Cyclical and Seasonal Demand

Market demand and supplies are seasonal depending upon various factors like seasons; festivals etc
and past sales data help companies to anticipate a huge surge of demand in the market well in
advance. Accordingly they stock up raw materials and hold inventories to be able to increase
production and rush supplies to the market to meet the increased demand.

3. Economies of Scale in Procurement

 Buying raw materials in larger lot and holding inventory is found to be cheaper for the company than
buying frequent small lots. In such cases one buys in bulk and holds inventories at the plant
warehouse.

4. Take advantage of Price Increase and Quantity Discounts

If there is a price increase expected few months down the line due to changes in demand and supply
in the national or international market, impact of taxes and budgets etc, the company’s tend to buy
raw materials in advance and hold stocks as a hedge against increased costs.

Companies resort to buying in bulk and holding raw material inventories to take advantage of the
quantity discounts offered by the supplier. In such cases the savings on account of the discount
enjoyed would be substantially higher that of inventory carrying cost.

5. Reduce Transit Cost and Transit Times

In case of raw materials being imported from a foreign country or from a far away vendor within the
country, one can save a lot in terms of transportation cost buy buying in bulk and transporting as a
container load or a full truck load. Part shipments can be costlier.

In terms of transit time too, transit time for full container shipment or a full truck load is direct and
faster unlike part shipment load where the freight forwarder waits for other loads to fill the container
which can take several weeks.

There could be a lot of factors resulting in shipping delays and transportation too, which can hamper
the supply chain forcing companies to hold safety stock of raw material inventories.

6. Long Lead and High demand items need to be held in Inventory

Often raw material supplies from vendors have long lead running into several months. Coupled with
this if the particular item is in high demand and short supply one can expect disruption of supplies. In
such cases it is safer to hold inventories and have control.

Holding inventories help the companies remain independent and free from vendor dependencies.

Types of Inventories - Independent and Dependant Demand Inventories

Inventory Management deals essentially with balancing the inventory levels. Inventory is categorized into
two types based on the demand pattern, which creates the need for inventory. The two types of demand are
Independent Demand and Dependant Demand for inventories.

 Independent Demand

An inventory of an item is said to be falling into the category of independent demand when the
demand for such an item is not dependant upon the demand for another item.

Finished goods Items, which are ordered by External Customers or manufactured for stock and sale,
are called independent demand items.

Independent demands for inventories are based on confirmed Customer orders, forecasts, estimates
and past historical data.

 Dependant Demand

If the demand for inventory of an item is dependant upon another item, such demands are categorized
as dependant demand.

Raw materials and component inventories are dependant upon the demand for Finished Goods and
hence can be called as Dependant demand inventories.

Take the example of a Car. The car as finished goods is an held produced and held in inventory as
independent demand item, while the raw materials and components used in the manufacture of the
Finished Goods - Car derives its demand from the demand for the Car and hence is characterized as
dependant demand inventory.
 This differentiation is necessary because the inventory management systems and process are different
for both categories.

While Finished Goods inventories which is characterized by Independent demand, are managed with
sales order process and supply chain management processes and are based on sales forecasts, the
dependant demand for raw materials and components to manufacture the finished goods is managed
through MRP -Material Resources Planning or ERP - Enterprise Resource Planning using models
such as Just In Time, Kanban and other concepts. MRP as well as ERP planning depends upon the
sales forecast released for finished goods as the starting point for further action.

Managing Raw Material Inventories is far more complicated than managing Finished Goods Inventory. This
involves analyzing and co-coordinating delivery capacity, lead times and delivery schedules of all raw
material suppliers, coupled with the logistical processes and transit timelines involved in transportation and
warehousing of raw materials before they are ready to be supplied to the production shop floor. Raw material
management also involves periodic review of the inventory holding, inventory counting and audits, followed
by detailed analysis of the reports leading to financial and management decisions.

Inventory planners who are responsible for planning, managing and controlling Raw Material inventories
have to answer two fundamental questions, which can also be termed as two basic inventory decisions.

a. Inventory planners need to decide how much of Quantity of each Item is to be ordered from Raw
Material Suppliers or from other Production Departments within the Organization.
b. When should the orders be placed ?

Answering the above two questions will call for a lot of back end work and analysis involving inventory
classifications and EOQ determination coupled with Cost analysis. These decisions are always taken in co
ordination with procurement, logistics and finance departments.

Inventory Costs
Inventory procurement, storage and management is associated with huge costs associated with each these
functions.

Inventory costs are basically categorized into three headings:

1. Ordering Cost
2. Carrying Cost
3. Shortage or stock out Cost & Cost of Replenishment

a. Cost of Loss, pilferage, shrinkage and obsolescence etc.

b. Cost of Logistics
c. Sales Discounts, Volume discounts and other related costs.

1. Ordering Cost

Cost of procurement and inbound logistics costs form a part of Ordering Cost. Ordering Cost is
dependant and varies based on two factors - The cost of ordering excess and the Cost of ordering too
less.

Both these factors move in opposite directions to each other. Ordering excess quantity will result in
carrying cost of inventory. Where as ordering less will result in increase of replenishment cost and
ordering costs.

These two above costs together are called Total Stocking Cost. If you plot the order quantity vs the
TSC, you will see the graph declining gradually until a certain point after which with every increase
in quantity the TSC will proportionately show an increase.

This functional analysis and cost implications form the basis of determining the Inventory
Procurement decision by answering the two basic fundamental questions - How Much to Order and
When to Order.
 How much to order is determined by arriving at the Economic Order Quantity or EOQ.

2. Carrying Cost

Inventory storage and maintenance involves various types of costs namely:

 Inventory Storage Cost

 Cost of Capital

Inventory carrying involves Inventory storage and management either using in house facilities or
external warehouses owned and managed by third party vendors. In both cases, inventory
management and process involves extensive use of Building, Material Handling Equipments, IT
Software applications and Hardware Equipments coupled managed by Operations and Management
Staff resources.

c. Inventory Storage Cost

Inventory storage costs typically include Cost of Building Rental and facility maintenance
and related costs. Cost of Material Handling Equipments, IT Hardware and applications,
including cost of purchase, depreciation or rental or lease as the case may be. Further costs
include operational costs, consumables, communication costs and utilities, besides the cost of
human resources employed in operations as well as management.

d. Cost of Capital

Includes the costs of investments, interest on working capital, taxes on inventory paid,
insurance costs and other costs associate with legal liabilities.

The inventory storage costs as well as cost of capital is dependant upon and varies with the
decision of the management to manage inventory in house or through outsourced vendors
and third party service providers.

Current times, the trend is increasingly in favor of outsourcing the inventory management to third party
service provides. For one thing the organizations find that managing inventory operations requires certain
core competencies, which may not be inline with their business competencies. They would rather outsource
to a supplier who has the required competency than build them in house.

Secondly in case of large-scale warehouse operations, the scale of investments may be too huge in terms of
cost of building and material handling equipments etc. Besides the project may span over a longer period of
several years, thus blocking capital of the company, which can be utilized into more important areas such as
R & D, Expansion etc. than by staying invested into the project.

Inventory Classification - ABC Classification, Advantages & Disadvantages

Inventory is a necessary evil in any organization engaged in production, sale or trading of products. Inventory
is held in various forms including Raw Materials, Semi Finished Goods, Finished Goods and Spares.

Every unit of inventory has an economic value and is considered an asset of the organization irrespective of
where the inventory is located or in which form it is available. Even scrap has residual economic value
attached to it.

Depending upon the nature of business, the inventory holding patterns may vary. While in some cases the
inventory may be very high in value, in some other cases inventory may be very high in volumes and number
of SKU. Inventory may be help physically at the manufacturing locations or in a third party warehouse
location.

Inventory Controllers are engaged in managing Inventory. Inventory management involves several critical
areas. Primary focus of inventory controllers is to maintain optimum inventory levels and determine
order/replenishment schedules and quantities. They try to balance inventory all the time and maintain
optimum levels to avoid excess inventory or lower inventory, which can cause damage to the business.

ABC Classification

Inventory in any organization can run in thousands of part numbers or classifications and millions of part
numbers in quantity. Therefore inventory is required to be classified with some logic to be able to manage the
same.

In most of the organizations inventory is categorized according to ABC Classification Method, which is
based on pareto principle. Here the inventory is classified based on the value of the units. The principle
applied here is based on 80/20 principles. Accordingly the classification can be as under:

A Category Items Comprise 20% of SKU & Contribute to 80% of $ spend.

B Category Items Comprise 30% of SKU & Contribute to 15% of $ spend.
C Category Items Comprise 50% of SKU & Contribute to 5% of $ spend.

The above is only an illustration and the actual numbers as well as percentages can vary.

Example: Table of Inventory Listing by Dollar Usage Percentage.

Item Annual Usage in No. Units Unit Cost-$ Usage in Dollars Percentage of Total Dollar Usage

1 5,000 1.50 7,500 2.9%

2 1,500 8.00 12,000 4.7%

3 10,000 10.50 105,000 41.2%

4 6,000 2.00 12,000 4.7%

5 7,500 0.50 3,750 1.5%

6 6,000 13.60 81,000 32.0%

7 5,000 0.75 3,750 1.5%

8 4,500 1.25 5,625 2.2%

9 7,000 2.50 17,500 6.9%

10 3,000 2.00 6,000 2.4%

Total $254,725 100.0%

Advantages of ABC Classification

 This kind of categorization of inventory helps one manage the entire volume and assign relative
priority to the right category. For Example A Class items are the high value items. Hence one is able
to monitor the inventory of this category closely to ensure the inventory level is maintained at
optimum levels for any excess inventory can have huge adverse impact in terms of overall value.
  A Category Items: Helps one identify these stocks as high value items and ensure tight control in
terms of process control, physical security as well as audit frequency.
 It helps the managers and inventory planners to maintain accurate records and draw management’s
attention to the issue on hand to facilitate instant decision-making.
 B Category Items: These can be given second priority with lesser frequency of review and less
tightly controls with adequate documentation, audit controls in place.
 C Category Items: Can be managed with basic and simple records. Inventory quantities can be
larger with very few periodic reviews.

Example: Take the case of a Computer Manufacturing Plant; the various items of inventory can be broadly
classified as under:

SKU Description Classification of Remarks

Inventory

Processor Chips A Class Kept under High Value Storage/Asset Tracking /

Access Control required

Memory Chips A Class Kept under High Value Storage/Asset Tracking /

Access Control required

Hard Disk / Storage A Class Kept under High Value Storage/Asset Tracking /
Media Access Control required

Software License A Class Kept under High Value Storage/Asset Tracking /

Access Control required

Disk Drives A Class Normal Storage / Access Control Required

Cabinet / Case B Class Normal Procedures

Battery Pack B Class Normal Procedures

Monitor A Class Normal Storage / Access Control Required

Keyboard B Class Normal Procedures

Training Manuals C Class Minimal Procedures

Mouse B Class Normal Procedures

Stickers C Class Minimal Procedures

Screws & Nuts C Class Minimal Procedures

Power Cord C Class Minimal Procedures

Starter Assembly Pack- C Class Minimal Procedures
Instructions

Disadvantages

 Inventory Classification does not reflect the frequency of movement of SKU and hence can mislead
controllers.
 B & C Categories can often get neglected and pile in huge stocks or susceptible to loss, pilferage,
slackness in record control etc.

Factors affecting Inventory Operations

Inventory management operations are increasingly being outsourced to third party service providers, thereby
ensuring that the investments and costs in managing the inventories are reduced. This is a welcome trend
provided the companies focus on overseeing and reviewing both inventory management as well as inventory
operations periodically to ensure proper controls are maintained and processes followed.

Inventory management entails study of data on movement of inventory, its demand pattern, supply cycles,
sales cycles etc. Active management calls for continuous analysis and management of inventory items to
target at lean m inventory Management.

Inventory Management function is carried out by the inventory planners in the company in close co
ordination with procurement, supply chain logistics and finance, besides marketing departments.

The efficiencies of inventory management are largely dependent upon the skills and knowledge of the
inventory planners, the focus and involvement of management and the management policies coupled with the
inventory management system.

However inventory operations management is not under the control of the inventory management team but
rests with the third party service providers. In this section of the article we aim to uncover few of the critical
areas and action points on the part of operations that can impact the inventory of the company.

1. Unskilled Labor and Staff: Inventory operations management is a process-oriented operation. Every
task and action required to be carried out by the operatives will impact the inventory as well as the
delivery lead times and other parameters. Therefore knowledge of what one is required to do and the
effect of the action should be known to the operatives who are on the shop floor. For Example: If an
operative is given a put away task, he should know how and where he should put away the pallet,
how to scan the pallet ID and confirm it back to the system. Besides he should also know the impact
of not completing any of these actions or doing some thing wrong. The impact his action will have on
the system as well as physical inventory should be clear to the operative.

Secondly different inventory items would have to be handled differently. Operatives who are carrying
out the task should know why and what is required to be done. They should also know the
consequences of not following the process. A pallet might have to be scanned for the pallet id and put
away on a floor location, while a carton might have to be opened and scanned for individual boxes
inside and put away into a bin. The operatives should be trained on the entire process and understand
why and what he is doing.

The WMS systems are quite operational and task intensive. Where the warehouses are being
managed on RF based systems, the operatives should be able to manage the RF readers, understand
how to access and complete transactions through the RF Guns.

Often it is noticed that when the warehouse operations are being managed by a third party service
provider and the principle customer is not present at the location, the quality of staff and operatives is
compromised and people are not given adequate training before being allocated their responsibility.
Such situations can lead to inventory discrepancies.

2. In adequate SOP, Training and emphasis on processes compliance: When a inventory

management project kicks off at a third party warehouse location, both the principle customer as well
as the third party service provider work on the project and setup basic processes, document them in
 Standard Operating Procedures and conduct training as a part of the project management
methodology.

However over a period of time, the nature of business requirements changes, resulting in change in
the operating processes. These do not get documented in terms of amendments and the SOPs become
outdated. Thereafter one finds that the new comers who are introduced on the shop floor are required
to learn the processes by working along with others where as no training or SOP document is
provided to him for reference. With the result they often have half-baked knowledge of the processes
and carry on tasks not knowing why they are doing and what they are required to do.

This situation is very dangerous for the health of the inventory and it shows slackness in the attitude
of the third party service provider. Continuation of such a situation will lead to bad housekeeping,
inventory mismatches, discrepancies and also affect the service delivery. If left unchecked can lead to
theft, pilferage and misuse of inventory.

In any third party owned inventory operations warehouse, the principle client should ensure that
periodic review and training is conducted for all staff. Inventory operations should be periodically
reviewed and inventory counts and audits carried out regularly.

How Is the Economic Order Quantity Model Used in Inventory Management?

The economic order quantity (EOQ) model is used in inventory management by calculating the number of
units a company should add to its inventory with each batch order to reduce the total costs of its inventory.
The costs of its inventory include holding and setup costs.

The EOQ model seeks to ensure that the right amount of inventory is ordered per batch so a company does
not have to make orders too frequently and there is not an excess of inventory sitting on hand. It assumes that
there is a trade-off between inventory holding costs and inventory setup costs, and total inventory costs are
minimized when both setup costs and holding costs are minimized.

The Formula for Economic Order Quantity

\begin{aligned} &EOQ= \sqrt{\frac{2\times S\times D}{H}}\\ &\textbf{where:}\\ &S = \text{Setup costs
(per order, generally including}\\ &\text{shipping and handling)}\\ &D = \text{Demand rate (quantity sold
per year)}\\ &H = \text{Holding costs (per year, per unit)} \end{aligned}EOQ=H2×S×D
where:S=Setup costs (per order, generally includingshipping and handling)D=Demand rate (quantity sold per
year)H=Holding costs (per year, per unit)

How to Calculate the Economic Order Quantity

To calculate the economic order quantity for inventory you must know the setup costs, demand rate, and
holding costs.

Setup costs refer to all of the costs associated with actually ordering the inventory, such as the costs of
packaging, delivery, shipping, and handling.

Demand rate is the amount of inventory a company sells each year.

Holding costs refer to all the costs associated with holding additional inventory on hand. Those costs include
warehousing and logistical costs, insurance costs, material handling costs, inventory write-offs,
and depreciation.

Ordering a large amount of inventory increases a company's holding costs while ordering smaller amounts of
inventory more frequently increases a company's setup costs. The economic order quantity model finds the
quantity that minimizes both types of costs.

Example of How EOQ Works

EOQ considers the timing of reordering, the cost incurred to place an order, and costs to store merchandise. If
a company is constantly placing small orders to maintain a specific inventory level, the ordering costs are
higher, along with the need for additional storage space.
 For example, consider a retail clothing shop that carries a line of men’s shirts. The shop sells 1,000 shirts
each year. It costs the company $5 per year to hold a single shirt in inventory, and the fixed cost to place an
order is $2.

The EOQ formula is the square root of (2 x 1,000 shirts x $2 order cost) / ($5 holding cost) or 28.3 with
rounding. The ideal order size to minimize costs and meet customer demand is slightly more than 28 shirts. A
more complex portion of the EOQ formula provides the reorder point.

Drawbacks of Using EOQ

The EOQ formula inputs make an assumption that consumer demand is constant. The calculation also
assumes that both ordering and holding costs remain constant. These assumptions make it difficult or
impossible to account for unpredictable business events, such as changing consumer demand, seasonal
changes in inventory costs, lost sales revenue due to inventory shortages, or purchase discounts a company
might get for buying inventory in larger quantities.

ABC Analysis

ABC analysis helps set inventory management systems and processes based on the consumption value of
stocked items. However, it takes no account of consumption volatility. So two items with similarly high
consumption values but very different patterns of demand may be subject to the same inventory management
policies and process, which may not be appropriate. For example:

 Item 1001 costs $10,000 and demand is reliable at two per month throughout the year.
 Item 1002 costs $1,000 and demand is sporadic but typically 240 are drawn off each year.
Using ABC analysis, their consumption values would be identical ($240,000) and may be classed as A items.
It may be that item 1002 is typically drawn off twice per year, but it is impossible to predict when during the
year they will be drawn down.

The policies for A items in the company may be as follows:

Policy Implication item 1001 Implication item 1002

Automatically order annual
demand / 12 each month.
 Low or negligible  Stock levels will build up during
buffer. periods of no demand, tying up
 Take off equals reorder working capital.
quantity.  Item condition may deteriorate while
 Facility costs low (low languishing in inventory.
buffer).  High facility costs (buffer level
varies).

Perpetual stock count  Cost-benefit makes  Perpetual counting of stock that’s not
perpetual count needed is wasteful.
worthwhile.

On the other hand, applying XYZ analysis alone ignores consumption value, which in this example is
identical. Item 1001 may be classified as an X item and item 1002 may be classified as a Z item. Policy may
be that X item replenishment is fully automated and Z items are manually replenished only on customer
order.
 Policy Implication item 1001 Implication item 1002

Perpetual stock  The cost-benefit makes  Policy is pointless since there won’t be
count perpetual count worthwhile. any stock for most of the year.

Goods receiving  Receipted to inventory.  Receipted to production or logistics.

Facilities/security  Located in inventory.  Transient. So the facilities cost

 Security limits losses. implication is negligible.
 Value not considered. So opportunity for
losses are greater.

By combining ABC with XYZ approaches, stock management policies, systems and procedures can be better
tailored by taking into account both demand volatility and consumption value.

A B C

AX Class BX Class CX Class

 High consumption value.  Medium consumption  Low consumption value.

X
 Even demand. value.  Even demand.
 Reliable forecasts.  Even demand.  Reliable forecasts.
 Reliable forecasts.

AY Class BY Class CY Class

 High consumption value.  Medium consumption  Low consumption value.

Y  Predictably variable value.  Predictably variable
demand.  Predictably variable demand.
 Less reliable forecasts. demand.  Less reliable forecasts.
 Less reliable forecasts.

AZ Class BZ Class CZ Class

 High consumption value.  Medium consumption  Low consumption value.

Z  Sporadic, variable demand. value.  Sporadic, variable demand.
 Forecasting unreliable or  Sporadic, variable demand.  Forecasting unreliable or
impossible.  Forecasting unreliable or impossible.
impossible.

Accurate forecasts are of great potential benefit to a business. At one extreme, a company could “play it safe”
with its forecast demand by maintaining high inventory buffer levels to eliminate stock outs. The costs
avoided, or benefits reaped are:
 Eliminating the need for emergency replenishment. Emergency stock replenishment is usually costly due
to, for example, not buying the economic order quantity, off-contract buying, rush penalties and additional
transportation costs.
 Avoiding production disruption, which leads to lower capacity use, increased standby time and disruption
to shifts – driving overtime costs up.
 Avoiding loss of customer loyalty due to missed delivery commitments or longer lead times.
 Avoiding reputation impairment, leading to erosion of market share.
On the other hand, holding costs will go up as:

 More storage space will be needed to carry the higher buffer levels.
 More people will be required to manage the stock.
 More equipment will be needed to maintain, move, count and secure the stock.
 Insurance costs could be higher as the value at risk of loss is higher.
 There is a cost of capital tied up in unproductive working capital.
So, the management accountant needs to balance the costs associated with stock outs with the costs of
holding higher levels of stock. The sales manager will push for plentiful stocks to maximise customer
satisfaction and loyalty, and to beat competitors on lead times. The production manager will want to minimise
production disruption caused by stock outs. The CFO will want to reduce working capital and associated
holding costs. There’s also the cost of replenishment to consider – the more frequently replenishment occurs,
the higher the costs of replenishment. Replenishment costs include:

 The procurement function: the more orders that need to be placed, the more people are needed to do the
ordering.
 The goods receiving function: people, facilities and equipment are required to receive deliveries of goods.
The higher the number of orders, the more frequent goods deliveries will be – requiring more people,
facilities and equipment.
 Transportation: transportation costs for frequent small deliveries usually exceed those for larger, less
frequent deliveries.
In having an appreciation of all these factors, the management accountant can then work with key
stakeholders (CFO, production management, inventory management, logistics, procurement) to agree
inventory management policies and to develop systems and processes to implement them. Policies may
include, for example:

 Degree of automation of replenishment processes.

 Buffer stocks.
 Inventory control.
To illustrate by way of example:

A B C

AX Class BX Class

 Automated CX Class
X replenishment.
 Automated replenishment.  Low buffer – safety  Automated replenishment.
 Low buffer – JIT or first.  Low buffer – safety first.
consignment transfers the  Periodic count;  Free stock or periodic
 responsibility for security of medium security. estimation by inspection or
supply. weighing; low security.
 Perpetual inventory.

AY Class
 Automated with manual
Y intervention.
 Low buffer – accept stock out
risk.
 Perpetual inventory.
BY Class
CY Class
 Automated with
manual intervention.  Automated replenishment.
 Manually adjust  High buffer – safety first.
buffer for  Free stock or periodic
seasonality. estimation by inspection or
 Periodic count; weighing; low security.
medium security.

BZ Class
AZ Class
CZ Class
 Buy to order.
 Buy to order.  No buffer –
Z  Automated replenishment.
 No buffer – customer customer
 High buffer – safety first.
understands lead times. understands lead
times.  Free stock or periodic
 Not stocked.
estimation by inspection or
 Not stocked.
weighing; low security.

What benefits does the approach provide?

 Provides a scientific and transparent framework for developing and refining stock management policies.
 Optimises tensions between the costs, risks and benefits of stock holding.
 Stakeholder focused – the needs of all key stakeholders can be factored into policy.

XYZ inventory management

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:

1. Determine the items to be included in the analysis.

2. Calculate the variation coefficient for each item.

3. Sort the items by increasing variation coefficient and accumulate.

4. 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.

Purchasing: it’s Meaning, Definition, Importance and Objectives | Material Management

Meaning and Definition:

Purchasing is the first phase of Materials Management. Purchasing means procurement of goods and services
from some external agencies. The object of purchase department is to arrange the supply of materials, spare
parts and services or semi-finished goods, required by the organisation to produce the desired product, from
some agency or source outside the organisation.

The purchased items should be of specified quality in desired quantity available at the prescribed time at a
competitive price. In the words of Alford and Beatty, ”Purchasing is the procuring of materials, supplies,
machines, tools and services required for equipment, maintenance, and operation of a manufacturing plant”.

According to Walters, purchasing function means ‘the procurement by purchase of the proper materials,
machinery, equipment and supplies for stores used in the manufacture of a product adopted to marketing in
the proper quality and quantity at the proper time and at the lowest price, consistent with quality desired.”

Thus, purchasing is an operation of market exploration to procure goods and services of desired quality,
quantity at lowest price and at the desired time. Supplier who can provide standard items at the competitive
price are selected.
Purchasing in an enterprise has now become a specialised function. It was experienced that by giving the
purchase responsibility to a specialist, the firm can obtain greater economies in purchasing. Moreover
purchasing involves more than 50% of capital expenditure budgeted by the firm.

According to Westing, Fine and Zenz “Purchasing is a managerial activity that goes beyond the simple act of
buying. It includes research and development for the proper selection of materials and sources, follow-up to
ensure timely delivery; inspection to ensure both quantity and quality; to control traffic, receiving,
storekeeping and accounting operations related to purchases.” The modern thinking is that Purchasing is a
strategic managerial function and any negligence will ultimately result into decrease in profits.

Importance of Purchasing:
1. Purchasing function provides materials to the factory without which wheels of machines cannot move.

2. A one percent saving in materials cost is equivalent to a 10 percent increase in turnover. Efficient buying
can achieve this.

3. Purchasing manager is the custodian of his firm’s is purse as he spends more than 50 per cent of his
company’s earnings on purchases.

4. Increasing proportion of one’s requirements are now bought instead of being made as was the practice in
the earlier days. Buying, therefore, assumes significance.

5. Purchasing can contribute to import substitution and save foreign exchange.

6. Purchasing is the main factor in timely execution of industrial projects.

7. Materials management organisations that exist now have evolved out or purchasing departments.

ADVERTISEMENTS:

8. Other factors like:

(i) Post-war shortages,

(ii) Cyclical swings of surpluses and shortages and the fast rising materials costs,

(iii) heavy competition, and

ADVERTISEMENTS:

(iv) Growing worldwide markets have contributed to the importance of purchasing.

Objectives of Purchasing:
The purchasing objective is sometimes understood as buying materials of the right quality, in the right
quantity, at the right time, at the right price, and from the right source. This is a broad generalisation,
indicating the scope of purchasing function, which involves policy decisions and analysis of various
alternative possibilities prior to their act of purchase.

The specific objectives of purchasing are:

1. To pay reasonably low prices for the best values obtainable, negotiating and executing all company
commitments.

2. To keep inventories as low as is consistent with maintaining production.

3. To develop satisfactory sources of supply and maintain good relations with them.

4. To secure good vendor performance including prompt deliveries and acceptable quality.

5. To locate new materials or products as required.

6. To develop good procedures, together with adequate controls and purchasing policy.

7. To implement such programmes as value analysis, cost analysis, and make-or-buy to reduce cost of
purchases.

8. To secure high caliber personnel and allow each to develop to his maximum ability.

9. To maintain as economical a department as is possible, commensurate with good performance.

10. To keep top management informed of material development which could affect company profit or
performance.

11. To achieve a high degree of co-operation and co-ordination with other departments in the organisation.

Material requirements planning

Material requirements planning (MRP) is a production planning, scheduling, and inventory control system
used to manage manufacturing processes. Most MRP systems are software-based, but it is possible to conduct
MRP by hand as well.
An MRP system is intended to simultaneously meet three objectives:

 Ensure materials are available for production and products are available for delivery to customers.
 Maintain the lowest possible material and product levels in store
 Plan manufacturing activities, delivery schedules and purchasing activities.
Material Requirements Planning (MRP)
Material requirements planning (MRP) is a computer-based inventory management system designed to assist
production managers in scheduling and placing orders for items of dependent demand. Dependent demand
items are components of finished goods—such as raw materials, component parts, and subassemblies—for
which the amount of inventory needed depends on the level of production of the final product. For example,
in a plant that manufactured bicycles, dependent demand inventory items might include aluminum, tires,
seats, and bike chains.

The first MRP systems of inventory management evolved in the 1940s and 1950s. They used mainframe
computers to explode information from a bill of materials for a certain finished product into a production and
purchasing plan for components. Before long, MRP was expanded to include information feedback loops so
that production personnel could change and update the inputs into the system as needed. The next generation
of MRP, known as manufacturing resources planning or MRP II, also incorporated marketing, finance,
accounting, engineering, and human resources aspects into the planning process. A related concept that
expands on MRP is enterprise resources planning (ERP), which uses computer technology to link the various
functional areas across an entire business enterprise.

MRP works backward from a production plan for finished goods to develop requirements for components and
raw materials. MRP begins with a schedule for finished goods that is converted into a schedule of
requirements for the subassemblies, the component parts, and the raw materials needed to produce the final
product within the established schedule. MRP is designed to answer three questions: what is needed? how
much is needed? and when is it needed?"

MRP breaks down inventory requirements into planning periods so that production can be completed in a
timely manner while inventory levels—and related carrying costs—are kept to a minimum. Implemented and
used properly, it can help production managers plan for capacity needs and allocate production time. But
MRP systems can be time consuming and costly to implement, which may put them out of range for some
small businesses. In addition, the information that comes out of an MRP system is only as good as the
information that goes into it. Companies must maintain current and accurate bills of materials, part numbers,
and inventory records if they are to realize the potential benefits of MRP.

MRP INPUTS
The information input into MRP systems comes from three main sources: a bill of materials, a master
schedule, and an inventory records file. The bill of materials is a listing of all the raw materials, component
parts, subassemblies, and assemblies required to produce one unit of a specific finished product. Each
different product made by a given manufacturer will have its own separate bill of materials. The bill of
materials is arranged in a hierarchy, so that managers can see what materials are needed to complete each
level of production. MRP uses the bill of materials to determine the quantity of each component that is
needed to produce a certain number of finished products. From this quantity, the system subtracts the quantity
of that item already in inventory to determine order requirements.

ADVERTISING

The master schedule outlines the anticipated production activities of the plant. Developed using both internal
forecasts and external orders, it states the quantity of each product that will be manufactured and the time
frame in which they will be needed. The master schedule separates the planning horizon into time "buckets,"
which are usually calendar weeks. The schedule must cover a time frame long enough to produce the final
product. This total production time is equal to the sum of the lead times of all the related fabrication and
assembly operations. It is important to note that master schedules are often generated according to demand
and without regard to capacity. An MRP system cannot tell in advance if a schedule is not feasible, so
managers may have to run several possibilities through the system before they find one that works.

The inventory records file provides an accounting of how much inventory is already on hand or on order, and
thus should be subtracted from the material requirements. The inventory records file is used to track
information on the status of each item by time period. This includes gross requirements, scheduled receipts,
and the expected amount on hand. It includes other details for each item as well, like the supplier, the lead-
time, and the lot size.

MRP PROCESSING
Using information culled from the bill of materials, master schedule, and inventory records file, an MRP
system determines the net requirements for raw materials, component parts, and subassemblies for each
period on the planning horizon. MRP processing first determines gross material requirements, then subtracts
out the inventory on hand and adds back in the safety stock in order to compute the net requirements.

The main outputs from MRP include three primary reports and three secondary reports. The primary reports
consist of: planned order schedules, which outline the quantity and timing of future material orders; order
releases, which authorize orders to be made; and changes to planned orders, which might include
cancellations or revisions of the quantity or time frame. The secondary reports generated by MRP include:
performance control reports, which are used to track problems like missed delivery dates and stock outs in
order to evaluate system performance; planning reports, which can be used in forecasting future inventory
requirements; and exception reports, which call managers' attention to major problems like late orders or
excessive scrap rates.

Although working backward from the production plan for a finished product to determine the requirements
for components may seem like a simple process, it can actually be extremely complicated, especially when
some raw materials or parts are used in a number of different products. Frequent changes in product design,
order quantities, or production schedule also complicate matters. The importance of computer power is
evident when one considers the number of materials schedules that must be tracked.

BENEFITS AND DRAWBACKS OF MRP

MRP systems offer a number of potential benefits to manufacturing firms. Some of the main benefits include
helping production managers to minimize inventory levels and the associated carrying costs, track material
requirements, determine the most economical lot sizes for orders, compute quantities needed as safety stock,
allocate production time among various products, and plan for future capacity needs. The information
generated by MRP systems is useful in other areas as well. There is a large range of people in a
manufacturing company that may find the use of information provided by an MRP system very helpful.
Production planners are obvious users of MRP, as are production managers, who must balance workloads
across departments and make decisions about scheduling work. Plant foremen, responsible for issuing work
orders and maintaining production schedules, also rely heavily on MRP output. Other users include customer
service representatives, who need to be able to provide projected delivery dates, purchasing managers, and
inventory managers.
MRP systems also have several potential drawbacks. First, MRP relies upon accurate input information. If a
small business has not maintained good inventory records or has not updated its bills of materials with all
relevant changes, it may encounter serious problems with the outputs of its MRP system. The problems could
range from missing parts and excessive order quantities to schedule delays and missed delivery dates. At a
minimum, an MRP system must have an accurate master production schedule, good lead-time estimates, and
current inventory records in order to function effectively and produce useful information.

Another potential drawback associated with MRP is that the systems can be difficult, time consuming, and
costly to implement. Many businesses encounter resistance from employees when they try to implement
MRP. For example, employees who once got by with sloppy record keeping may resent the discipline MRP
requires. Or departments that became accustomed to hoarding parts in case of inventory shortages might find
it difficult to trust the system and let go of that habit.

The key to making MRP implementation work is to provide training and education for all affected
employees. It is important early on to identify the key personnel whose power base will be affected by a new
MRP system. These people must be among the first to be convinced of the merits of the new system so that
they may buy into the plan. Key personnel must be convinced that they personally will be better served by the
new system than by any alternate system. One way to improve employee acceptance of MRP systems is to
adjust reward systems to reflect production and inventory management goals.

MRP vs ERP: A Comprehensive Comparison of the Difference Between ERP and MRP Systems

What Is MRP?
MRP stands for material requirements planning. Its basic purpose is to measure what material you need, how
much of it you need and when you need it by, allowing you to ensure the highest rate of production in your
manufacturing center. MRP contains tools exclusively used to assist in manufacturing processes, though
companies that do more than just manufacturing are encouraged to use an MRP system to boost inventory
profitability. Businesses typically manage their production planning with these systems, using them to
forecast and order materials. This ensures that when those materials are needed for production, the right
amount is available on the correct date.

When using an MRP system, you need to be especially diligent about entering data accurately and punctually.
If the data is old or incorrect, material forecasts can become skewed, which could lead to having too many or
too few raw materials available for efficient business practice.

What Is ERP?
ERP stands for enterprise resource planning and is one of the more common categories of business software,
especially among large businesses. ERP systems, like MRP software, help you manage manufacturing
processes like production planning, scheduling and inventory management. However, the full range of ERP
capabilities is much more extensive than just manufacturing.

ERP at its core is an effective way of centralizing information and workflow processes through data
management. Because ERP keeps all of your workflow data in one place, all of your business processes draw
data from that location to inform insights. This helps ensure data quality, as it never gets duplicated between
systems. It also reduces the likelihood that numbers will get messed up or become difficult to access across
internal departments.

ERP software also comes equipped with modules for a range of business processes, including general
modules and industry-specific ones. For example, common ERP modules may include HR, customer
relationship management, supply chain management, financial management, inventory management,
warehouse management and manufacturing management. These functions include back-office workflows that
can be effectively connected to other systems. For example, a purchase order might come in, and the ERP
system could automatically pull that information to inform accounting practices.

Ultimately, ERP is a solution for a variety of tasks. By integrating these different components, ERP can
streamline and automate workflows and data collection to reduce human error and increase revenue.

MRP vs ERP: What are the Biggest Differences?

It can be hard to differentiate between ERP and MRP, largely because of their similar acronyms and their
mutual presence in the manufacturing industry. However, they have many distinctions that affect how exactly
they are used in a business. Let’s take a look at some of the most significant discrepancies between MRP vs
ERP:

Standalone vs Integrated
The biggest difference between MRP and ERP lies in the fact that MRP is more of a solo software, while
ERP is integrated. This means that ERP can easily connect to other software systems and modules. Some
MRP systems can be combined with other software, but it is a more difficult process than with an
ERP. Postmodern ERP is highly modular, so companies can pick and choose which aspects of the software
are the best fit and only reserve money and space for those features. They can support several modules for
total business control. On the other hand, MRP systems are standalone and function by themselves with only
manufacturing-related tools.

Due to the potentially overwhelming nature of so many departments and workflows coming together in an
ERP program, enterprise resource planning is often a good solution for large businesses. However, ERP
software for small businesses is becoming more and more prominent. MRP systems are suitable for any size
of company, as long as the company requires a tool to assist with manufacturing needs and isn’t looking for
intense integration with other processes. It should also be noted that a company doesn’t have to be in the
manufacturing industry specifically to benefit from an MRP solution.

Users
The type of people who use each system often varies drastically as well. Because an ERP is standard among
many industries and is handled by many departments, there isn’t a limit on who ERP software users are.
Users could include someone in HR who’s checking on payroll, a sales rep checking the status of a lead or a
data analyst creating a business intelligence report.

Because MRP systems are exclusive to manufacturing operations, people that use it are generally in that
department of a business. This could include a warehouse manager checking on the inventory of necessary
raw materials, a warehouse worker checking on lead times or a production planning specialist overseeing the
entire operation.

The point is that the types of people who use MRP are much more limited because the included services are
only related to manufacturing. A more diverse group of users might benefit from ERP because of its range of
provided workflows.

Cost
One significant and essential difference between ERP and MRP systems is that ERP is a more expensive
option. When you consider the fact that ERP can perform functions for multiple facets of a business rather
than just manufacturing, it makes sense that it’s more costly of a solution. This is not said with the intention
of discounting the fact that effective MRP systems come with a cost as well, but it should be noted that ERP
is typically pricier.

Depending on your company’s needs, the initial cost of investment in ERP may be worth it due to the wide
range of functions available. However, if the expense of ERP makes it an unsustainable option for your
company, MRP systems are available as a less comprehensive but more cost-effective option.
Scope
As mentioned before, ERP and MRP are different because of the range of features that they offer. MRP is a
simpler solution than the complex ERP. Material requirements planning software only focuses on
manufacturing, whereas ERP contains a range of solutions meant to ease diverse business processes such
as accounting and HR. MRP is a crucial component of ERP, but depending on a company’s needs, it might
not be the most critical process in the suite.

If a company is looking for a solution that encompasses a range of business processes, then ERP is definitely
the choice to go with. However, it might be overkill for companies that merely need a manufacturing
solution.

Material Requirements Planning is primarily related to the inventory of raw materials and
components which are required to produce the products in a facility. Their demand is
usually termed as secondary demand that totally depends upon the demand of finished
product. The demand for the finished products is known as primary demand. This primary
demand is ascertained mainly by aggregating the demand from sales orders and forecasted
demand. Then, keeping in view the product structure, secondary demand that is the
demand for the various components and raw materials is ascertained. There are various
techniques which may be used to determine the order lot size for components and raw
materials. MRP is a time phased priority-planning technique that estimates material
requirements and schedules supply to meet demand across all products and parts in one or
more plants. Now- a- days, information technology plays a major role in designing and
implementing Material Requirements Planning systems and processes as it provides
information about manufacturing needs (linked with customer demand) as well as
information about inventory levels. MRP techniques focus on optimizing inventory.

Concept of Material Requirement Planning

Material Requirements Planning is basically concerned with the inventory of raw materials
and components which are required to produce the products in a facility. The demand for
raw materials and components is termed as secondary demand which is essentially
depending upon the demand for the finished products. At current, globalization of the
economy and the liberalization of the trade markets have created new conditions in the
market place which are characterized by turbulence and intensive competition in the
business environment. Competition is continuously growing with respect to price, quality
and selection, service and promptness of delivery. Removal of barriers, international
cooperation, technological innovations naturally cause competition to Intensify. In terms
of manufacturing emphasis is placed on reducing cost while improving quality. In
addition, other factors such as timely delivery of the product become critical (this is
captured by emphasis in Just in Time or JIT in short) techniques.

It is a time phased priority-planning technique that estimates material requirements and

schedules supply to meet demand across all products and parts in one or more plants. MRP
techniques are used to explode bills of material, to compute net material requirements and
plan future production.
Information Technology plays a major role in designing and implementing Material
Requirements Planning systems and processes as it provides information about
manufacturing needs (linked with customer demand) as well as information about
inventory levels. MRP techniques focus on optimizing inventory.

MRP systems mainly use following information to determine what material should be
ordered and when:-
 The master production schedule, which describes when each product is scheduled to be
manufactured;
 Bill of materials, which lists exactly the parts or materials required to make each
product;
 Production cycle times and material needs at each stage of the production cycle time;
 Supplier lead -times.

In figure 1, you can see the overall view of the Inputs to a Standard Material Requirements
system and the various reports generated by the system which are of immense importance
for the production managers.

The master schedule and bill of materials indicate what materials should be ordered; the
master schedule, production cycle times and supplier lead times then jointly determine
when orders need to be placed.
 Figure 1: MRP System

The Master Production Schedule includes quantities of products to be produced at a given

time period. Quantities are included both at aggregate and detailed levels. Aggregate may
refer to monthly production and detailed may refer to weekly or daily production. The
master production schedule is a tabular form in which rows represent products and
columns represent time components.

Bill of Materials gives information about the product structure, i.e., parts and raw material
units necessary to manufacture one unit of the product of interest (discussed in next
section of this chapter). MRP was pioneered in the 1970‘s with the work of Orlicky. Later
evolved or became part of integrated to Manufacturing Resource Planning systems (or
MRPII). MRPII is a computer based planning and scheduling system designed to improve
management‘s control of manufacturing and its support functions.

Classes of MRP User/ Companies:

MRP systems fall into four categories, often identified as ABCD, in terms of use and
organizational implementation.

I. Class A represents full implementation of MRP. MRP system is tied up with

company ―financial system and includes capacity planning, shop floor dispatching,
and vendor scheduling as well as links with human resource planning. There exists
continuous monitoring of performance and inventory records and master production
schedules are accurate;
II. Class B represents a little less than full implementation. MRP system is confined in
the manufacturing area; however, it includes master production scheduling;
III. Class C represents a classical MRP approach in which the system is confined to
management of inventories;
IV. Class D represents a data processing application of MRP. System is used for keeping
track of data rather than as decision making tool.

Conditions for the successful implementation of MRP:

MRP is most valuable to companies involved in assembly operations and least valuable to
those in fabrication. For the success of MRP in an organization, some conditions need to
be fulfilled as followings:

 Availability of a computer based manufacturing system is a must. Although it is

possible to obtain material requirements plan manually, it would be impossible to keep
it up to date because of the highly dynamic nature of manufacturing environments;
 A feasible master production schedule must be drawn up, or else the accumulated
planned orders of components might ―bump‖ into the resource restrictions and become
infeasible;
 The bills of material should be accurate. It is essential to update them promptly to
reflect any engineering changes brought to the product. If a component part is omitted
from the bill of material it will never be ordered by the system;
 Inventory records should be a precise representation of reality, or else the netting
process and the generation of planned orders become meaningless;
 Lead times for all inventory items should be known and given to the MRP system;
 Shop floor discipline is necessary to ensure that orders are processed in conformity
with the established priorities. Otherwise, the lead times passed to MRP will not
materialize.

Inputs and outputs in MRP System

Inputs to MRP Programme:

Product Demand- Product demand for end items stems from two main reasons. The first
is known customers who have placed specific orders, such as those generated by sales
personnel, or from interdepartmental transactions. The second source is forecast demand.
Demand from known customers and demand forecast are combined and become the input
to the master production schedule.

Bill of Materials (BOM) File- BOM file is a document which tells us about an items
product structure and also it tells us about the sequence in which components are
assembled and their required number. It also tells us about the workstations in which it is
assembled. Bill of Materials gives information about the product structure, i.e., parts and
raw material units necessary to manufacture one unit of the product of interest
Product structure

Product structure shows a product build up. Its shows diagrammatically the components
required to assemble it, their numbers, and the sequence of assembly. Example: A sub
assembly A is made by joining one unit of components B and two units of components C
(shown below). Therefore, if 100 units of sub assembly A are to be manufactured 100
units of component B and 200 units of components of C are required.

A
Sub assembly

B (1) C (2)
Components

Product structure of sub-assembly A

From the above figure, we see that the requirement of components B and C depends on the
requirements of sub assembly A. The requirement of sub assembly A, in turn may depends
on the requirement of the finished products X.

Product Structure of Product X

Finished product Level 0

X

Sub assembly

Components Level 1

A (2) Y (1)

pg. 41

B (1) C (2)
Components Level 2

Now if 100 units of products X are to be manufactured, the following would be required

Sub assemblies/components Number of units

Y 1 x no. of units of X =1x100=100
A 2x no. of units of X =2x100 =200
B 1x no. of units of A =1x200 =200
C 2x no. of units of A = 2x200=400

The BOM file is often called the product structure file or product tree because it shows
how a product is put together. It contains the information to identify each item and the
quantity used per unit of the item of which it is a part.
For example, the product structure of product M has been shown below. The sub assembly
N appears at level 1 as well as level 2 of the product structure .when a computer program
reads a bill of material of a product, it starts from the top level which is level 0 as it moves
downward, it counts down the product structure tree .If an item appears in more than one
level, its number of units cannot be determined unless the computer scan reaches the
lowest level. This results in inefficiency of the program.

Product structure of product M

Finished product

Level 0
M

Level 1

Sub assemblies
O (1)
Components N (3)

Level 2

N (2)
pg. 42
P (1) Q (2)
Components

Master Production Schedule- The master schedule and bill of materials indicate what
materials should be ordered; the master schedule, production cycle times and supplier lead
times then jointly determine when orders need to be placed. The Master Production
Schedule includes quantities of products to be produced at a given time period. Quantities
are included both at aggregate and detailed levels. Aggregate may refer to monthly
production and detailed may refer to weekly or daily production. The master production
schedule takes the form of a table in which rows represent products and columns represent
time components.
Let me explain it with the help of example:

Numbers of cars to be produced by Nissan India in upcoming months:

Months Number of Cars

Jan 10000
Feb 12000
Mar 8000
Apr 11000
May 7000
June 12000

The above table reveals the production plan of Nissan India. Master Production Schedule
(MPS) tell us that how much amount of a particular model is to be manufactured in a
given period of time, if the aggregate plan is given in months, MPS may be divided further
into weeks. Let‘s take an example: Master production schedule of month January is shown
below:

Weeks of 1st 2nd 3rd 4th Total

January
Model-A 1200 2000 2700 750 6650
Model-B 700 950 1100 200 2950
Model-C 100 50 200 50 400
Total 2000 3000 4000 1000 10000
Further, the above MPS can also contain information on sub models of a model, e.g., in a
given week how many Model-1 will be produced with power steering and how many with
power windows and so on.

Inventory Records File- Inventory record file contains the status of all the items in the
inventory; it includes scheduled receipts of units of item in that interval of time as a result
of orders placed in the recent past to suppliers. This necessarily contains 1) details of the
suppliers of the items, 2) time taken by him to supply the item and 3) size of each order to
be placed to him.

Inventory records file under a computerized system can be quite lengthy. Each item in
inventory is carried as a separate file and the range of details carried about an item is
almost limitless. The MRP program accesses the status segment of the file according to
specific time periods. These files are accessed as needed during the program run.

Working of MRP program:

 A list of end items needed by time periods is specified by the master production
schedule.
 A description of the materials and parts needed to make each item is specified in the
bill of materials file.
 The number of units of each item and material currently on hand and on order are
contained in the inventory file
 The MRP program ―works ―on the inventory file in addition, it continuously refers to
the bill of materials file to compute quantities of each item needed.
 The number of units of each item required is then corrected for on hand amounts, and
the net requirement is ―offset‖ to allow for the lead time needed to obtain the material.

Outputs in materials requirement planning

MRP programme generates different reports as the output which is very important for the
production managers for taking different decisions. The various outputs of MRP
programme have been summarized as hereunder:
(1) Primary Reports - Primary reports are the main or normal reports used for the
inventory and production control. These report consist of
(a) Planned orders to be released at a future time;
(b) Order release notices to execute the planned orders;
(c) Changes in due dates of open orders due to rescheduling;
(d) Cancellations or suspensions of open orders due to cancellation or suspension of
orders on the master production schedule;
(e) Inventory status data.
(2) Secondary Reports - Additional reports, which are optional under the MRP system,
fall into three main categories:
(a) Planned Order Report- Planned order report tells us about the planned orders
that would be released in future date or during a given interval of time. This report
helps in preparing the funds required for payments to the suppliers in the future
according to the dates and order sizes.
For instance, April is the current month and the finance manager wants to see
what quantities of raw material have to be made available in the month of May.
This report helps him very much in preparing report that what amount of fund is
required in May for making payments to the suppliers.

(b) Order Release Report- Order release report is that which gives information
about planned orders which would be released on the present date .IT helps the
purchase managers to release purchase orders purchase orders to the suppliers.

This report helps the purchase manager to keep track of the purchase order that
have to be sent on a particular day. The material requirement planning logic
makers use of the lead time of items in determining the release date of orders, so
that goods are supplied by the time the items are required for production.

(c) Order Changes Report- These refer to the orders which have been placed in the
past and the supplier of these items is preparing for these supplies to be made to
the company. During the lead time the material requirement planning may
fluctuate because some customers cancel their orders leading to revision of the
mps because of this change in demand open orders have to revise.

In this case: Suppliers are told either to cancel the order s placed earlier by the company or
to postpone them for some time or to reduce the order size to suit the current requirement.
The order change report provides information to purchase manager about all such changes
to be made in the open orders with the suppliers.
Calculation of Order Size in MRP

There are 4 methods of calculating the order size in MRP

 Lot for lot method

 Economic Order Quantity (EOQ) method
 Least total cost method
 Least unit cost method

Let us take an example to understand all these methods. For an item the following
information is given:

Ordering cost (OC) = Rs 50 per order

Carrying cost (CC) per unit per week = 0 .5% of unit cost price
Unit cost price = Rs 20
CC per week =20 X .5% =Rs 0.1
Week Net requirement
1 80
2 100
3 90
4 60
5 110
6 50
Total 490

Let us calculate order size using four methods as follows

Lot for Lot Method:

In this the order size or the lot size is the same as the requirements at a point of time.
In the above example, at the beginning of every week the planned order receipts (order
size) exactly match the requirements of the item in that week. As shown in the excel
sheet 1 below, the ending inventory as well as the CC of inventory is zero .There is no
accumulation of inventory at any point of time, every week an order is placed, leading
to an OC of Rs 50. The total cost is Rs 300 for this method.
 Given that ANNUAL DEMAN D 4248.67
ORDER COST =RS 50 PER ORDER ANNUAL CARRYING COST =5.2/WEEK
Carrying cost per week (EOQ)2 = 81666.667
UNIT COST PRICE= RS 20 EOQ =285.7738
Carrying cost per unit per week = 20x0.5% =rs 0.1

WEEK Net requirement lotsize ending inventor carrying cost order cost total cost
1 80 80 0 0 50 50
2 100 100 0 0 50 50
3 90 90 0 0 50 50
4 60 60 0 0 50 50
5 110 110 0 0 50 50
6 50 50 0 0 50 50
total 490 grand total 490

LOT FOR LOT METHOD

WEEK Net requirement lotsize ending inventor carrying cost order cost total cost
1 80 286 206 20.6 50 70.6
2 100 0 106 10.6 0 10.6
3 90 0 16 1.6 0 1.6
4 60 288 242 24.2 50 74.2
5 110 0 0 13.2 0 13.2
6 50 0 0 8.2 0 8.2
grand tota 178.4

EOQ METHOD
Excel Sheet 1

Economic Order Quantity (EOQ) Method:

In this method, the annual demand is determined by assuming that the next
requirements as given in the six weeks will continue with the same pattern for the
whole year. A year contains 52 weeks and in given six weeks the total demand is 490.

Annual demand = 492 X 52

Annual Demand (A0) = 4246.667

The CC per unit per week has been calculated earlier as Rs 0.1

Annual cc for 52 weeks = 0.1 x 52= Rs 5.2 per unit

Now, the EOQ can be easily calculated

Q= 2Ao

C
2 X 4246.667 X50 = 285.773 = 28

5.2
This implies that an order of 286 units only must be placed every time. In above figure the
first planned order receipt of 286 units is in week 1.the net requirements in week 1 is only
80 units .Hence, the excess of 206 units forms the closing inventory, for which the CC will
be Rs 20.6(206 X .1). The OC in week 1 is Rs 50 .The inventory keeps on decreasing and
in week 3 it reduces to just 16 units .Thus , at the beginning of week 4, an order of 286
units is again placed to receive these immediately (assuming zero lead time).

The total cost in this method is Rs 178.4.

Least Total Cost Method:

In this method, the lot size is determined by extending the time horizon from the smallest
unit of time to the largest. In excel sheet 2, the upper table shows that for the time horizon
of week 1, the lot size of 80 units will suffice to meet the requirements with zero CC and
OC of Rs 50, resulting in the total cost also of Rs 50. When the time horizon is extended
from week 1 to week 2, a total of 180 units are required .The lot size to satisfy the
requirements of this time horizon is, thus, 180 units .Therefore there is a single order of
size 180 units resulting an OC of Rs 50 .The CC for this time horizon is equal to the CC of
100 units to be stored for one week .Thus, the CC is 100 X 0.1 =Rs10.

Similarly, for the time horizon of weeks 1-3, the CC = cost of carrying 100 units for one
week + cost of carrying 90 units for two weeks

=100 X 0.1 + 90 X 0.1 X 2 = 10 +18 = Rs 28

The calculations of the total cost in the time horizon of weeks 1-6 are shown in excel sheet
2. Note that the CC and OC are most close to each other in value for the time horizon of
weeks 1-4 .Thus, this time horizon has the least total cost .Therefore, lot size for this
interval from week 1 to 4 will be taken as 330 units .For the remaining duration, i.e.,
weeks 5 and 6, we will perform the calculations in a way similar to what has been done
earlier.
weeks lot size carrying cost order cost total cost
1 60 0 50 50
1 to 2 180 10 50 60
1 to 3 270 29 50 78
1to 4 330 46 50 96 least total cost
1 to 5 440 90 50 140
1 to6 490 115 50 165
5 110 0 50 50
5to 6 160 5 50 55 least total cost

week net req. lot size encoding inventory carrying cost order cost total cost
1 80 330 250 25 50 75
2 100 0 150 15 0 15
3 90 0 60 6 0 6
4 60 0 0 0 0 0
5 110 160 50 5 50 55
6 90 0 0 0 0 0
total 151

last total cost method

Excel Sheet 2

First, consider only weeks 5-6, for which the CC and OC are Rs 5 and Rs 50, respectively.
Clearly for weeks 5-6, the CC and OC values are nearer to each other compared to week 5
alone. Therefore, the least cost lot size is 160.

In excel sheet 2, the second table shows the usual total cost calculations, when the second
order of 160 units is placed at the beginning of week 1, while the second order of 160 units
is placed at the beginning of week 5, the total cost of this method is Rs 151.

Least Unit Cost Method:

This method is just an extension of the least cost method, as shown in excel sheet 3 below
,the only difference is that after calculating the total cost for each time horizon, it is
divided by the lot size to get the unit cost. Note that the unit cost is lowest for the time
horizon of week 1-3. Thus, the first lot size will be 270 units. We now do the calculations
for time horizons beyond week 3 i.e., week 3, week 4, week 4-5, and week 4-6. The least
unit cost is for week 4-6.

Thus the next size is 220 units. The total cost for this method has been calculated as Rs
149. The lot for lot and EOQ methods is called fixed period methods, while the least total
cost and least unit cost methods are called part period methods, as various parts of the
duration are considered for minimizing the cost .The least total cost and least unit cost
methods are based on dynamic lot sizing techniques. Both these methods result in lower
values of total cost compared to the lot for lot and EOQ methods. At the same time, they
are more complicated to the lot for lot and EOQ methods.

weeks lot size carrying cost order cost total cost unit cost
1 80 0 50 50 0.625
1 to 2 180 10 50 60 0.3333333
1 to 3 270 28 50 78 0.2888889 least unit cost
1to 4 330 46 50 96 0.2909091
1 to 5 440 90 50 140 0.3181818
1 to 6 490 115 50 165 0.3367347
4 60 0 50 50 0.8333333
4 to 5 170 11 50 61 0.3588235
4 to 6 220 21 50 71 0.3227273 least unit cost
weeks net requirements lots size Ending inventory carrying cost order cost total cost
1 80 270 190 19 50 69
2 100 0 90 9 0 9
3 90 0 0 0 0 0
4 60 220 160 16 50 66
5 110 0 50 5 0 5
6 50 0 0 0 0 0
total 149
least unit cost method

Excel sheet 3

Just- in-Time Manufacturing System

According to Schonberger, ―Just-in-Time (JIT) is a system to produce and deliver finished

goods just in time to be sold, sub assemblies just-in-time to be assembled into finished
goods, and purchase materials just in time to be transformed into fabricated parts.‖

The idea of just in time was originally developed by the Toyota motor company in Japan
.The idea was formalized into a management system when Toyota sought to meet the
precise demand of customers for different models and colors of cars with minimum
delays. JIT is being used in wide variety of industries such as automobiles, consumer
electronics, office equipments etc.

JIT may be understood as the continuous improvement of material flow in either factory or
a combination of factories.

There are four techniques in JIT for improving material flow which are as follows
 Factory layout revision
 Set up time reduction
 Pull system implementation
 Better coordination with suppliers

Factory Layout Revision

The layout of factories can be revised to introduce assembly lines and manufacturing cells
.sometimes called continuous flow manufacturing, the purpose of these layout
modifications is to minimize material handling activities and their associated transactions
and to provide faster quality feedback .Assembly lines are typically dedicated to a
particular product type, although they may be able to produce multiple models.
Manufacturing cells produce a variety of completed parts and the cells are developed using
group technology .often in order to have the capability to handle certain surges in demand,
excess capacity is built into the system.

Set-up Time Reduction

Factories can reduce set up times in order to reduce lot sizes and smooth production.
Reduced set up times enables a factory to produce smaller lot sizes economically. Smaller
lot sizes enable a factory to produce a broader variety of products, assemblies and parts
each day .However, preventive maintenance and lowering defects rates are also needed to
achieve these lower safety stock sizes.

Pull System Implementation

In a pull system, final assembly lines only produce actual orders and kanban cards are
used to signal sub assembly and part deliveries, and production.MRP may be used and
smooth production facilitates the use of a pull system.

Better coordination with suppliers

Factories can work with suppliers to reduce raw material inventories and solve quality
problems. The first three techniques are applicable to the suppliers as well, for improving
the material flow between a firm and its supplier‘s. The goal is to make the supplier an
extension of the internal material flows, to avoid the problems associated with shifting of
inventories from customers to suppliers.

Kanban Visual Systems

Kanban is a Japanese word that means flag or signal, and is a visual aid to convey the
message that action is required. The kanban inventory control system was originally
introduced by the Toyota motor company in Japan. On a visit to the USA, Toyota‘s Vice
President Taiichi Ohno noticed the technique, adapted by American supermarkets for
replenishing empty shelves in racks .Whenever a shelf was found drained of a product, it
triggered the replenishment of the product to the shelf. It was so simple because an empty
shelf was easily visible among the other shelves full of products. Ohno thought of
implementing the same idea for replenishment at his assembly lines. He adapted this
simple but effective method by using a trigger or kanban, to alert the manufacturing area
that the assembly area was running low on components. Every component must have its
own kanban to signal when it needs to be replenished.

The kanban system can be explained in the following stages:

Stage 1

When a worker needs components, he goes to the racks placed opposite his workstation.
These racks contain bins of components required by a workstation, which from the work
in process inventory. Every bin has the requisition kanban card affixed on it, which is
removable .This card contains the component name, its identification number, and the rack
number and shelf on the rack in the store where more bins of the component are stored.

The workers from the assembly line remove the kanban card from the bin, hang it on a
hook on the rack, and take away the bin to their workstation for using the components in
assembly operations. These hanging kanban cards are thus clearly visible from
everywhere, signaling replenishment of components from the store.

Stage 2

A supply worker called ―Mizosomashi” in Japanese keeps on moving in the aisle or the
passage way across the racks his trolley. When he reaches the racks opposite the assembly
line, he removes all the hanging requisition kanban cards and the empty bins from the
racks. He then takes these along with him through the aisle to the racks in the store
opposite the manufacturing cells.

Stage 3

Mizosomashi looks at the information on each requisition kanban card and locates the
position of the rack and the shelf on the rack containing the bins full of a particular
component .Every bin in the store has the production kanban card affixed on it, which is
removable. The production kanban card contains the name and identification number of
the component to be manufactured in the cell. Mizosomashi takes off the bins from the
racks corresponding to the requisition kanban card he had bought with him, and removes
the production kanban card from these. He hangs these on the hooks on the corresponding
racks in the store, attaches the requisition kanban cards on the bins, and puts the bins in the
trolley to the racks opposite the assembly line and places the bins in the appropriate racks.
Thus, the replenishment of the bins at the assembly line has taken place. Mizosomashi
repeats this process at regular intervals of time.

Stage 4

One worker from each of the manufacturing cells goes to the rack placed opposite his cell
with his trolley. He removes the hanging production kanban cards and places the empty
bins from the rack in his trolley. He takes these to his manufacturing cell, where the
different components mentioned on the production kanban cards are manufactured in exact
quantities so as to fill the empty bins completely. The filled in bins with the production
kanban cards attached to them are then taken from the manufacturing cell to the rack
opposite the cell and placed on the appropriate shelf mentioned in the production kanban
card.

JIT is a pull system, as opposed to the western norm of making bulk components and
storing them just in case they are needed. The obvious benefits of using the kanban system
are reduced inventory and less storage space required; however, the hidden benefit is the
high quality of components. Production of components in small batches makes it easier to
immediately detect defects in them. Thus reduced inventory acts as a buffer against bad
quality.

Benefits of MRP System

MRP system is of immense importance in manufacturing organizations. The key benefits

have been summarized as below:

 Reduced inventories without reduced customer

service
 Ability to track material requirements
 Ability to evaluate capacity requirements
 Means of allocating production time
 Increased customer satisfaction due to meeting
delivery schedules
 Faster response to market changes
 Improved labor and equipment utilization
 Better inventory planning and scheduling

In addition to above, the key outputs of MRP system are

very helpful in:

 Calculating demand for component items

 Determining requirements for subassemblies,
components, and raw material
 Determining when they are needed
 Generating work orders and purchase order
 Considering lead time

Summary

Material requirement planning is a system for determining order quantities and the time
intervals for placing orders of dependent demand items e.f. components and raw materials
etc. It requires three inputs, namely, master production schedule, bill of materials and
inventory status. It generates three output reports – planned order reports, order release
report, and order change report. Just in time is a manufacturing system in which work in
process inventories are reduced to minimum levels. Small quantities of materials are
supplied by the suppliers to the assembly line directly with the aid of visual kanban cards.
In MRP, order size can be determined using four techniques namely, 1) Lot for lot
method, 2) Economic Order Quantity (EOQ) method, 3) Least total cost method and 4)
Least unit cost method.

MRP and JIT can be used together simultaneously as a hybrid MRP –JIT system, where
MRP is used for planning materials requirement only, and the purchase orders sent to the
suppliers act only as an indication of the probable requirements of the buyer company. The
supplier supplies the goods only according to the JIT system of kanban cards.

Keywords
Bill of materials: is a document which tells us about the structure of a product,
showing the sequence in which components sub assemblies are assembled and their
required numbers. It also contains details about the workstations at which the item is
assembled.

Just in time system: is defined as produce and deliver finished goods just in time to be
sold, subassemblies just in time to be assembled into finished goods and purchased
materials just in time to be transformed into fabricated parts.

Kanban: is a Japanese word meaning flag or signal, and is a visual aid to convey
the message that action is required.

Master production schedule: is an extension of the aggregate production plan. It tells

us the number of units of different models of a product to be manufactured on a weekly
or monthly basis in the coming 6-18 months.

Material requirement planning: is a system for planning the future requirements of

dependent demand items.

Product structure: shows a product build up. It shows diagrammatically the components
required to assemble it, their numbers, and the sequence of assembly.

Purchasing: refers to the actual buying materials and the activities associated with it.