CHAPTER -ONE

Introduction
1.1 Meaning and Significance of Materials Management
Learning objectives
At the end of this chapter, learners will understand
 The meaning & importance of materials management
 Materials management objectives and functions
 Systems approach to materials management
 Buy or make decision factors
 Equipment repurchase us lease decisions
The significance of materials to the efficient operation of organizations is increasing more
than ever. Shortages of raw materials, components, and products have been experienced on a
global scale with demand exceeding supply, the price of many materials has increased
significantly.

Every organization requires materials for its operation, and there will always be the necessity
for some stores and stocks to be maintained either for immediate consumption, conversion, or
re-use. Manufacturing organizations require a variety of raw and other materials that must be
acquired, stored, and handled. Similarly, service organizations need materials, equipment, and
some stores to run their operations. In both cases enough stocks of materials and equipment
have to be maintained to meet at least short-run requirements. These stocks or inventory are
cash in kind that need at most care. Therefore, their safe custody, upkeep, and maintenance,
handing and proper supply are of great importance.

Almost all organizations, regardless of their nature, are demanding proper and efficient
management of materials. Furthermore, both real and contrieved shortage of materials,
including food stuffs, metals, and energy resources, have made materials management an

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important and difficult organizational function. The reason is that materials, specially
components and sub-assemblies, have specific uses and have low flexibility. And they need
more care in procurement, storage, handling, and distribution.

What is Materials Management?

Materials management is concerned with the flow of materials from suppliers to production
and the subsequent flow of products through distribution centers to the user. Materials
management is, thus, an activity that involves planning, acquisition, storage, control and
disposition of inputs like raw materials and in-process goods which go into the production
process directly and also capital equipment., tools and accessories, spare parts and other in-
direct materials which are required for everyday operations. It is designed to ensure supply of
materials of the right quality, in the right quantity, at the right time, at the right price, and at
the right place acquired from the right source in order to ensure economy, efficiency, and smooth
operation of an organization.

1.2 The Objectives of Materials Management

Poor materials performance may jeopardize any plant's capacity to provide the goods and
services that the society so urgently requires. The primary objective of materials management
is thus to provide service and support to operating functions, mainly to production and
operations, Accordingly, materials management is established to achieve the following objectives.

1. Purchasing and Procurement

Materials should be purchased in required quality, at a minimum cost, and to be made
available in time. However, as purchasing objectives vary in relative importance from one
organization to other, one may concentrate efforts more on one rather than the other. When
raw materials are available at a low price, price objective is paramount. Here the key
objective is to procure raw materials at a minimum price and much depends on intelligent
timing of purchases. When the materials to be procured for the manufacture of some
components and parts that are to be used in complex machines are scarce, timely

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 availability is dominant; and cost factor does not dominate. Still in others, such as aircraft
and ship building industries, consistency in quality and reliability may be the sole criterion
because of the complexity of the end-products.

2. Stores and Inventory Management

Although inventory function is more complex, more subtle, and the balance of costs and
gains is much more difficult to find out, one of the objectives of materials management is
to have the correct quantity and right quality of material on hand at the time required
keeping the right balance of inventory is important because when inventory turn-over is
high, storage and carrying costs are low. Sometimes, however, inventory turnover may be
the turning point because we stock not because thousands of spares and parts go to make
complicated machine, but because we keep them ready for after-sale customer service.
Here, striking a balance between stock-outs and built-in-inventory becomes the most
important materials management objective. The objective of stores and inventory
management is achieved by proper receipt and inspection of materials, issue and
dispatch, storage and storekeeping, stock records and stores accounting, identification
and coding, materials control, materials handling and traffic, and disposals of surpluses,
wastes and obsolete materials.

3. Continuity of Supply
In automated processes, where costs are rigid and are not easily amendable to reduction
due to lack of production materials, continuity of supply is of paramount importance. This
foreshadows all other objectives, because idle time costs of men and machines push up
overall costs of production and expediting supply means additional transport costs.
4. Quality of Materials
Where quality materials presents cost plus production engineering problems it may well
become one of the prime objectives of materials management, where other objectives are
sacrificed at quality – cost.

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5. Good Supplier Relations
Good supplier relations greatly depend on the product or service reputation of the
company. However, suppliers respond favorably to fair treatment; they are uncooperative
and unwilling if indifferently treated. The materials management can thus improve
relations by providing the required stimuli for their better performance.

6. Product Development and New Product

The discovery and improvement of materials frequently leads to a new product
development and lower costs on existing products. Materials management can suggest
materials and components that will do better or equivalent jobs at a lower cost. Product
efficiency is basically a compromise between engineering design and economic means of
utilizing the by - products or wastes product development is always profitable and
materials management can render substantial help by adding new products to the
existing product - line. Besides materials management can also help in price, demand, and
requirements forecasting. Materials management has intimate knowledge of the market
conditions through daily contacts with suppliers. Therefore, by analyzing and interpreting
data of past sales, seasonal variations in prices, availability and demand for materials, it
helps to forecast the future trends and plan material requirement accordingly.

1.3 System Approach to Materials Management

Materials management is a management activity which is primarily concerned with the
efficient flow of materials to, through, and out of an organization for optimum use of
materials. Materials required for manufacturing have to match the production schedules that
must be related to marketing possibilities.The function, therefore, covers maximum
utilization, conservation; elimination of waste, avoidance of unnecessary delays, and
assurance of right quality and needed quantity at an economic cost.

There is a good deal of misunderstanding with regard to its scope. Some emphasize the
acquisition aspect, some refer to it as inventory control and stores management, some again

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attach great importance only to materials logistics and movement control and handling
aspects. However, as the term, materials management has now been universally accepted, and
is being widely used, the only thing that has to be answered is the question of integration. The
general trend is, therefore, towards an integrated systems approach which covers the
availability, flow, conservation, utilization, quality and cost of materials.
Materials management is responsible for planning, acquisition, storage, movement and control
of materials and finally goods so as to optimize personnel and physical facilities and capital
while providing better customer service in its perfect harmony with the organizational goals, it
involves the provision of the right quantity, at the right time, and from the right source. It is,
therefore, a systematic and dynamic approach for the control of materials to, through and out
of an organization throughout its flow cycle.
Seen in this light materials management is an integrated activity that starts functioning with
the designing, planning, sourcing and procurement of materials and then getting the materials
through successive stages of operations for the final embodiment into an end-product,
awaiting final distribution so as to be of service to human needs. An objective analysis of
materials management reveals that it does not start with purchasing and end with production,
but it concerns itself with total flow of materials from forecasting of future demands down to
final distribution of end products. All the sub-functions are individually important, but at the
same time it has to be realized that they are not isolated phenomena.
Materials management is, therefore the systematic integration of the following functions or
activities.
1. Materials forecasting, budgeting, planning, and programming.
2. Scheduling, purchasing and procurement.
3. Receiving and inspection as to quantity and quality
4. Inventory control, storage and warehousing.
5. Material handling, movement control and traffic etc.
6. Despatch, shipping and disposals (including wastes, scraps and reclaimed and surplus
products.)

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 Organization for Materials Management
Organizing may be defined as a process of identifying, classifying, and grouping various
activities establishing authority-responsibility relationships to create a structure capable to
accomplish predetermined objective. organization structure is thus an established pattern in
which various parts of an organization are interrelated and interconnected. The activities of
materials management are similarly grouped and integrated to form the organization structure.
The underlying purpose of organization, logically, is to facilitate efficient operation of each
work group.
General Manager

Materials Department

Procurement S U P P LY Handling and

Maintenance

Receiving Stores Traffic

Material planning Scrap and

and surplus
Inventory control disposal

Organization structure for materials management

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 1.5 Functions Included in Materials Management

1. Purchasing
Purchasing department has the responsibility of acquiring the kinds and quantities of the
right quality materials authorized by the requisitions issued by production scheduling,
inventory control, engineering, maintenance and any other department or function
requiring materials.
2. Receiving
The receiving department is responsible for the physical handling of incoming shipments,
the identification of such material, the verification of quantities, the preparation of reports,
and the routing of the materials to the place of use or storage.
3. Materials Planning and Inventory Control
This is the aggregate planning of material requirements to meet the broad, overall
production plan. It also involves keeping detailed records or parts and production
inventories, and non-production materials-such as expendable tools, office supplies and
maintenance, repair, and operating supplies. It further includes maintenance of physical
stocks, and issuing requisitions to the purchasing department. Material requirements
determined by production control are checked against the inventory records before
requisitions are sent to the purchasing department.
4. Stores
This function physically controls and maintains all inventory items. Appropriate physical
safeguards must be established to protect items from damage, unnecessary obsolescence
due to poor stock rotation procedures, theft etc. Records must be maintained which enable
immediate location of items.
5. Traffic
Transportation costs have had an increasing influence on material costs in recent years.
Traffic is responsible for transporting various materials from suppliers stores to a firm's
stores. It also includes the transportation of materials from their point of receipt or storage
to the point of usage.

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6. Scrap and surplus disposal
Material managers are concerned with the effective, efficient, and profitable disposal of
scrap, surpluses, obsolete, and waste materials generated within the firm. In addition to the
desire to obtain good value for disposals, materials management is responsible to protect
the environment from pollution.

7. Material handling and maintenance

Materials management concerns itself with the physical movement of materials from their
original source to their point of use. More efficient distribution and smoother work flow
are some of the results of efficient handling and maintenance of materials. Maintenance
department must keep its equipment in good operating condition long beyond what could
be considered "beyond economical repair"

1.5 Make or Buy Decisions

An organization may be in need of different raw materials, parts, components or products
which are processed and/or assembled into a finished product. In sourcing a part or product, it
either purchases from an outside source or the firm may seek to undertake production within
the firm's own plant for reasons of costs, convenience, and control, which outside supply
source does not always provide. Accordingly any firm has the following three basic
alternatives.
1. Buy the parts or products completely from an outside source
2. Make all the parts or products within the firm
3. Buy some components, parts, materials or products and make the remaining and
assemble others.

Any manufacturing concern may be confronted with the problem of choosing one of these
alternatives. The decision problem often arises when a new product is added to the production
line or existing products are redesigned. It also arises when the firm notices that other firms
are manufacturing the same part more economically, or it may also arise when the supplier

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fails to supply satisfactorily. Still in other cases the issue may come up as a planned solution
to the problem of idle production capacity.

Practically, a manufacturing enterprise can neither buy not make all the products or
components completely. As a general rule therefore, a manufacturing firm will make some of
its parts or components and buy others from outside sources, either in a semi-finished or
finished state. Cost considerations and conditions in the supply market may suggest a change
even when the part was formerly purchased.

Although it is not the sole factor, cost comparison is the most important consideration in
deciding whether to make or buy. The estimated total cost of production must be compared
with the total cost of purchase to know the pay-off. The policy of never make what you can
buy may serve no purpose unless it is justified by economic analysis. It is apparent, therefore,
that when a make-or-buy decision has to be made, what matters is not the purchasing policy or
source of supply but the consultation and cooperation of production, cost, quality, and other
technical departments. A simple ‘make or buy' decision may have such economic
complications as that may affect the total organization interest on a much wider scale which
can even overthrow a product or threaten product stability in a highly competitive market.

However, as cost comparision is not the sole factor, it will be found that there are certain
factors on which make or buy decisions can be based. Quantity, quality, availability and
flexibility of supply, control of trade secrets, patents, research and development, and
alternative sources of supply are the important factors which enter into considerations to reach
a decision, either to ''make or buy'.

1. Quantity: Requirements of too large quantity would lead to 'make' rather than 'buy while
too small quantity does not justify such a decision. But quantity alone may not prove to be
the best and most economical solution to the problem.

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2. Quality: If the quality of the bought-out components does not differ widely from the
made-out ones, the quality factor may not make the decision in favor of making. However,
if there is a marked quality difference between the bought-out and made-out components
and if the out-side supplier cannot ensure the required quality and when the company
cannot allow even a slight difference in the quality due to technical complexity, then the
decision is in favor of making. To the contrary, when the slight differences do not affect
the final product significantly, the decision may be in favor of buying.

3. Reliability: It refers to the capacity of outside suppliers, in terms of time and state of
delivery, to assure a regular and steady supply in large quantities and of the right quality.
If suppliers cannot assure a ready supply and fail to keep up the delivery schedules, the
balance usually swings to buying because this adversely affects production plans.

4. Availability and flexibility of supply: This is another factor that has to be considered in
the decision of making or buying. The presence of many sellers and the flexibility of
buyers often provide a strong stimulus to buy rather than to make and vice versa.

5. Control of trade secrets and patents: If the company wants to protect the unpatented
processes and does not wish any outside supplier to have any knowledge of the designs,
the case for making is obvious. On the other hand, if the company feels that the design and
patent of the components concerned are not so important as the design and the patent of
the final product, it may be desirable to follow a policy of buying.

6. Technical factors: When special expertise is not available within and around the
organization, the decision may be in favor of buying. Besides when the time allowed is
short and where there is shortage of space and skilled human resource, the decision still
favors buying.

1.6 Equipment Purchase Versus Leasing

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Besides to making or buying, companies have another third option with regard to capital
equipment. This alternative is leasing. The decision to purchase or lease concerns both
manufacturing and materials activities, but it is more common in buildings and capital
equipments.

To purchase or lease is a firm's choice and before a final decision is made several factors have
to be considered. A typical lease is simply a device for shifting the risks of ownership from
the lesee to the lessor. If a company owns equipment, then it bears the risk of obsolescence
and deterioration. If the manufacturer owns the equipment and the company leases it, then the
manufacturer may lose. Recognizing this, the manufacturer must set his lease rates high
enough to cover this possibility in the average.

Management’s problem, therefore, is to decide whether its case is above or below average -
weighing carefully such factors as probable rate of obsolescence. A final decision for leasing
should only be taken when management can state with fair certainty that it is the least costly
or the most desirable means of securing the use of new equipment.

Whether lease is short-term or long-term, it is classified as either service lease or finance

lease. Thus the cost of any repairs, maintenance, taxes, licencing and so on must be borne-by
the lessee and the rents must be paid during the period of lease even if the equipment becomes
obsolete or does not function properly. In a service lease, however, all repairs maintenance,
taxes and so on are borne by the lessor (owner of the equipment.)
Advantages
Probably, the most important aspect of leasing is that production facilities can be increased by
using an equipment without paying the full purchase price that results in disproportionate
financial burden. To put in another way leasing enables manufacturers to get new equipment
through leasing contracts without disturbing their financial position. Actually it is suitable for
and more commonly used by small companies having limited financial resource.

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If the equipment is highly automated and complex so that expert maintenance is necessary,
then service type leases avoids such problems.

Another significant advantage of leasing is that the equipment can be returned when necessity
ceases, when it is technologically suppressed or is inadequate for the job. In this case, leasing
is used to avoid the risk or obsolescence and deterioration.
Also leasing enables a manufacturer (lessee) to try out a new equipment for a given period of
time before the company decides to purchase it.
Finally, leasing gives the lessee a 'package' of advantages, administrative, legal, tax and other
expenses as part of the price of the lease.

Disadvantages
Despite the above mentioned advantages, leasing has certain drawbacks. Many highly technical pieces
of specialized equipment may not be available on lease basis. In some other instances, the specific
uses stipulated by the lessor limit its flexibility and thus hamper the lease in its economic uses.

Leasing is often costly than owning. Any firm which rents or leases equipments to another
does so for profit. It is obvious, therefore, that the rental cost must cover the risks involved in
such a transaction that would not be involved in sales contract.

A further disadvantage is that the lessee develops no equity in the machine or equipment.
Rental money is totally an expense which lasts with no assets or salvage value. Thus although
the cost of the equipment may have been out in rent the company ends up with nothing.

CHAPTER TWO

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 MATERIALS PLANNING AND BUDGETING
Learning Objectives: At the end of this chapter, learners will understand:
- The importance of materials planning
- Steps in the material planning process
- Techniques used in materials planning,
- Guidelines for materials planning and
- Budgeting process

2.1 Definition and Importance

Materials planning is the scientific way of determining the requirements of all
materials (raw materials, components, spare parts and other items) that enter into
meeting production needs within the economic investment policies. Thus, by
definition, it follows that the materials planning function is a sub-system in the
overall planning activity.

Factors Affecting Materials Planning Decisions

The factors which affect materials planning decision can be classified in the
following two categories:
1) Macro-Factors:- some of the macro factors which affect materials
planning are price trends, business cycles, government import policy,
credit policy, etc.. No materials manger (planner) can afford to ignore
these guidelines, as banks extend credit one, as per these guidelines.
Such Macro level policy changes are found to take place in future as well
and should be considered while evolving the materials plan.
2) Macro Factors:- Materials planner also has to take into account various
factors at micro level. They include corporate objectives, plant capacity
utilization, rejection rates, lead time, inventory levels, working capital,
seasonality, delegation of powers, and communication systems.

IMPORTANCE OF PLANNING

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The duty (responsibility) of any mangers job is planning (preparing today for
tomorrow) and control (checking whether the plans are achieved or not). Hence the
materials planning and budgeting function is given a permanent place in the
integrated materials management setup. This is so because, planning for materials
and working out a realistic budget not only help motivate people but also serve as a
control device.

In the context of materials management, planning has to be done for highly non-
programmed decision (decisions made on the basic of contingencies) such as
import policy, foreign exchange availability and credit squeeze (ie restrictions of
borrowing money). In a similar manner, planning has also to be done for highly
programmed decisions (decisions made on scheduled time) such as hypothecating
inventory for working capital, working out delivery, schedules, etc..

Materials planning must be done in cross – functional with other functional

departments such as finance, Marketing and production (manufacturing). The
relationship between materials planning and other function as shown below.

Sales Forecast Production Program Materials Plan

Feedback information and review

The emergency of world war II is the remarkable event that give rise for
materials (logistics) planning, linear programming, production scheduling,
operations research and other disciplines. This change calls for both
manufacturing and service enterprise managers to take as an assignment of a
need to improve production efficiency and customer service. The increased
emphasis on planning has been accompanied by a formalized approach as a
constant methodology is need to determine the labor, capital, equipment and

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 materials required by materials management and other functions to produce a
desired output. The nature of the output or organization does not violate the
importance of planning, because manufacturing or service enterprises,
government or private, profit or non-for-profit organization need to plan.
2.2 The Features of Materials Planning Process
Future is always uncertain and planning is predicting and preparing for future
course of action. Here lies the contradiction between planning and uncertainty. But
make sure that no plan does not only mean no goal, objective, target, vision or
strategy but also no control.
Planning is the only way that we can minimize the degree of uncertainty if not
eliminated. This means planning basis itself on the historical data (the impact of
past on today) and scientific and systematic approach to future (the possible
impact of today on tomorrow). Today’s dynamic and competitive business
environment survival depends on proactive approach of forecasting anticipating
needs and meeting customer requirements (tastes, preferences, income level,
demographic structure etc) Materials management planning process is a
mechanism for setting overall operating levels. To meet its goal, materials planning
process should apply different strategies, policies procedures and techniques that
add value and decrease cost (material handling, materials damage, obsolescence
etc.. ). In addition to these, material planners must be aware of inputs analysis (the
analysis of labor, facilities, and equipment) as a basis for ascertaining future
requirements based on an organizations overall objectives and goals.

Not all plans meet the objectives for which they stand. In order to meet the goals
for which plans are set, they must be in a form of formal document that considers
capacities and priorities, and components for the fulfillment of corporate objectives.

Materials manager is responsible to prepare a formal and logical plan to

management and the top management is going to take an integrated decision for

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marketing, production or manufacturing, engineering, quality assurance as well as
finance.
To be specific, plans must be formal, descriptive, measurable, and possible and
time bound.
2.3 Steps of Materials Planning Process
Planning is not an activity of one event or chance rather it is a series of concurrent
activities arranged in logical and simultaneous order relationships.

Planning is the foundation for any management activities and this is true for
materials manager.

Planning must play a basic role in the management of a firms activities, as a

necessary first step in the management process. Through effective planning, the
materials manager offsets the uncertainty of change, focus on objectives, improves
productivity, and facilitates control. These effects make planning a necessity for
managers at all levels, especially for the materials managers
The major steps in the materials planning process include the following.
i) Planning Period:- The planning period may extend from a weak to a number of
years. At any given time, the materials manager will be planning a variety of
activities for different planning periods. Planning must encompass a period of
time during which management can foresee the fulfillment of its current
decisions; the materials manager must plan for enough ahead to anticipate a
recovery of his or her decision. The recovery of the decision may involve cost
(product, job cost…) or capital equipment. Because of the various lengths of
time required for assessing each of these variables, one can plan for a year, five
years, or even ten years; it depends on the characteristics of the activity
concerned. Sufficient planning period enables materials manager to look upon
the uncertainty of decisions and if there is doubt about the feasibility of plan,
flexibility of plan at measurable cost can be accommodated.

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 This may be accomplished by recovering cost over a shorter period, particularly
those involving capital expenditures where the investment factor can be written
off. Other alternative may be leasing capital facilities, rather than purchasing
them or constructing materials handling facilities designed to handle a wide
variety of products so that when the company’s product line changes, the
facilities will be able to handle different products
ii) Forecasting:- An essential input of any level of the planning process is a
forecast that describes the future. Forecasting is determining what will happen
in the future, and includes anticipated business conditions, sales volumes, the
political environment, and so on. Planning involves deciding how to cope up
with these expectations. This shows that planning and forecasting are different
managerial functions. A forecast lay ground on which a manager should develop
a plan.
In a forecast, attention is given to economic and demographic factor of
environment, technological, social, and political and other factors that might
affect future operations.

Forecasting is concerned with very specific information and this specific

information is needed to develop a realistic plan. Because materials
management is anticipating the environment in which it will operate, the
forecast must include those elements that affect operations.

iii) Considering alternatives: Materials manager should utilize every possible

opportunity clearly and completely and to analyze its consequences, problems
and expected gains.
iv) Establishing Management objectives
There is always the danger that the objectives chosen for materials management
will be inconsistent with those of the units or the organization. For example, the
objective of always having materials available for production might contradict

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 the objective of achieving lower costs for the organization. The organization, as a
whole, is a unit; objectives must be interconnected and mutually supportive.
v) Developing plans:- Materials management objectives and plans specifies the
results expected from the action taken; where major emphasis will be placed;
what will be accomplished; and the strategies, policies, procedures rules,
budgets and programs that must be implemented by the materials manager to
produce the desired results. A company’s objectives give direction to its over all,
which should reflect the objectives of each major units. These, in turn, becomes
the plans for the units.
vi) Follow-up and Revision:- All forecasts are subject to some degree of error; the
best analysis cannot guarantee complete accuracy. However, even though guess
work never can be omitted from forecasts, it must be reduced to a minimum.
The more experience a company has in making forecasts and plans, the more
quickly it will develop a consistent record of accuracy.

2.4 Forecasting
One of the major planning elements for the materials manager is the company’s
sales forecast. To a considerable extent, it provides a based for materials
management programs. The sales forecast provides the foundation on which
internal plans can be developed by all the groups in the company.

The sales forecast is a prediction of expected sales of a firm, by both products and
prices, for a specified number of months or years. By using the forecasts for a
certain period time, with a degree of confidence, management can forecast and plan
the various activities of the organization to achieve the predicted sales. With a valid
sales outlook, management can decide what must be produced, what materials
must be handled, and what funds are available for operations and for capital
improvements

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The company must make every effort to develop the most accurate forecast
possible. In practice, however, there are many reasons given for not developing a
forecast; these may include a large sales backlog, the small size of the firm, a lack
of information, unique product lines, inability to devote the time and resources
required for an accurate forecast, and so forth.

Forecasting Information
Very reliable economic forecasts are prepared regularly for the nation’s equipment,
productivity, income, and gross national product, by the president’s council of
economic advisors, the federal reserve system, banks, and other economic groups.

A forecast is the link between the external uncontrollable environment and the
internal controllable affairs of an organization.

Requirements of successful Forecasting

In spite of the use of sophisticated models, forecasting is inexact, i.e. absolute

accuracy in predicting events and activity levels are unachievable. Successful
forecasting often requires a skillful blending of the art and science of forecasting. In
forecasting experience, judgment and technical expertise play their own respective
roles.

Common Features of Forecasting

Regardless of the availability of various forecasting techniques, the following are
common features of forecast.
1. Forecasting techniques generally assumes that some underline casual system
that existed in the part will continue to exist in the future without major
variations.
2. Forecasts are rarely perfect i.e actual result will vary from predicted values.

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3. Forecasts for groups of items tend to be more accurate than forecasts for
individual items because errors among items in a group usually have similar
effect
4. Forecast accuracy decreases as the time period covered by the forecast
increases.
Generally short rang forecasts involve less uncertainty than long rang forecasts, so
they tend to be more accurate.

Steps in the Process of Forecasting

There are five basic steps in the forecasting process.
1) Determine the purpose of the forecast that will provide an indication of:
a) the level of details required,
b) The amount of resources and
c) the desired level of accuracy.
2) Establish a time horizon that the forecast must cover, keeping in mind that
accuracy decreases as the length of the forecast period increases.
3) Select an appropriate forecasting technique particularly the quantitative
models.
4) Gather and analyze the appropriate historical data and prepare the forecast.
This requires identifying all major assumptions that are made in conjunction
with preparing and using the forecast.
5) Monitor the forecast to check its validity. If it is unsatisfactory, reexamine the
methods or techniques, assumptions, validity of data, and make necessary
adjustments to prepare a revised forecast

Approaches to Forecasting
i) Qualitative Approaches
Qualitative forecasting consists using subjective inputs as human factors and
personal opinion. It is based on experience, judgments, opinion, or intuition of
individuals. Thus it is also called judgmental or subjective forecasting because

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 the outcomes may vary from individuals to individuals. Forecasts based on
judgment, experience or opinion are appropriate when:
a) Forecasts must be prepared quickly in a short period of time,
b)Available data may be obsolete or up to date information might not be
available because of rapid and continuous changes in the external
environment such as economic and political conditions,
c) Historical data cannot be available like demand for a newly introduced
product, and
d)The forecasting period is long range that past events will not repeat
themselves in a similar fashion.
The following are the major methods of qualitative forecasting:
i) Collective opinion or consensus forecasts
This refers to soliciting opinions from a large number of people such as customers,
wholesalers, retailers or employees
ii) Delphi Technique: This uses group knowledge through discussion where
individuals’ responses are collected (through brain storming)
iii) Expert Opinion: Qualitative opinion may also be solicited from people who
are related to the subject matter such as experts, managers, sales people,
purchasers etc.
iv) Market Survey: Interviews, questionnaires, panel discussion and other
data collection techniques may be used to gather information from
randomly selected respondents.
2) Quantitative Approach
Qualitative techniques consist of mainly analyzing objective or hard dat. This
usually avoids personnel biases that sometimes contaminate qualitative methods.
It is based on actual historical statistical data using mathematical and statistical
methods to forecast demand. Thus, it is objective and is also called statistical
forecasting. Quantitative techniques imply two things:
a) The existence of historical data

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b) Development of associate models that attempt to utilize causal variable to
make a forecast. The major quantitative techniques include:
 Time series analysis,
 Trend analysis,
 Regression analysis,
 Economic indicators and
 Econometric models,
1) Time series Analysis:- This is a set of observations of some variable over
time. It involves observed values for a sequentially ordered set of time
periods. It is a set of time ordered observations.

COMPONENTS OF TIME SERIES ANALYSIS

a) Secular trend or trend components (T)
This indicates that demand and time show some relationship when the value of
a variable tends to increase or decrease over a long period of time in the time
series.
b) Cyclical fluctuation (C):- Shows recurrent up and down
movements with respect to secular tend over duration of several years, or may
not be periodic. It is often the result of business cycles or expansion a
contradiction of economic activity over a long period of time. eg Business cycle
and product life cycle
c) Seasonal Components (S):- shows patterns of change within a year and tends
to repeat periodically. This is usually shown on the basis of months or seasons.
Examples include harvest season for agricultural products. It consists of
similar periodic patterns that occur within each year.
d) Random Component (R):- it is also called irregular movement because it
shows erratic variations from secular trend which cannot be ascribed the
cyclical or seasonal influences. These variations are sporadic movements
related to chance events that often last for a short period of time. It is
unpredictable and completely changing.

22
 The underlying assumption in the time series analysis is that for any
designated period in the time series the value of the variable is determined by
the influence of the four components defined above. Thus,
Y=TxSxCxR

Techniques of Time Series Forecasting Analysis

i) Last Period Demand (LPD) Forecasts for the next period are taken from the
actual demands of the previous period. It is applied when the future is likely to
occur in a way similar to its latest previous period. This responds fairly well to
trends but over reacts to random influences.
Mathematically, Yt = Yt - 1
Yt = Forecasted value of period t
Y t – 1 = actual demand for the immediate previous period, which before Y t
ii) Arithmetic Average (AA – mean)
This takes the average of all previous actual demand as a forecast for next period.
Unlike LPD AA smoothes out random (average) fluctuation. But doesn’t adequately
respond to trends in demand and it doesn’t give sufficient attention to recent data.
This works well for stable and constant situation of demand.

Yt = Y1 + Y2 + Y3 ……………. Yn =

iii) Moving average (MA): MA generates the next periods forecast an averaging
the actual demand for the last predetermined “n” time periods. “n” is
determined based on experience and often between 3 and 8 in a way it reflects
the pattern of change. It makes use of recent data to show trends and changes
in pattern of demand. Thus it is a compromise of last period demand and
arithmetic average that it focuses on the advantage of both methods.
iv) Weighted Moving Average (WMA): It is a modification of Moving average. In
this method weights are given to the data which sum up one and recent data

23
 are heavily weighted than older data. Mathematically it given by the following
formula.

X= No of observations

W= Weights assigned to each observations

2) Trend Analysis: Trend analysis is a mathematical model which fits a trend
line to a historical data of past observation and then projects this line into the
future for the purpose of forecasting. It deals in the long term direction of the
movement in the time series. The method of least squares is the most frequent
basis used for identifying the trend component of the time series by determining
the equation for the best fitting trend line.
When the long term increases or decreases appear to follow a trend. The equation
for the forecasted trend line is given by

Yi = a+bx
X= Time period or number of observation (1…………..n)
Yt= Forecasted demand for period t
A= Constant value when X=0
B= slope used to measure the degree of change in demand in responding to time

or

a=

The simultaneous equation from which the values of a and b are derived are

24
Example
Measures of Seasonal Variation
The influence of seasonal variation of seasonal components on the demand of a
material over a time series values is identified by deter mining
the seasonal index (number associated in each time period within a year). Seasonal
indices are used adjust observed trend (time series data) values to forecasted
values. The adjusted data are called de seasonally data (seasonally adjusted data)
seasonal indexes are calculated by averaging ratios of actual periodic (month,
week… ) demand to trend line value for each month.
Based on the previous example
1. Six months moving average

2. Arithmetic average

3. Given

Required: Formulate the trend line equation

Y= a + bx

Y= 114.32 + 1.22X
3) Regression Analysis

25
Is an algebraic formula through which the value of dependable variable is
forecasted. The primary objective of the regression analysis is to predict the value
of dependent variable given that the value of an independent variable is known.
It is represented by the following equation
Yx = a + b
or

The regression equation shows how any dependent variable changes as a result of
changes in the independent variable. In using regression analysis as a tool of
forecasting, there are two important considerations
a) Estimation can be made only for dependent variable within the range of
originally sampled number of observations of the independent variable. This is
because there is no adequate statistical basis for the validly of the regression
line outside the range.
b) The regression equation provides the basis for detr5mining only a point
estimate, Q, not a complete predication interval. This required the computation
of the standard error of estimated and prediction intervals. The standard error
of estimate is a conditional deviation that indicates the standard deviation of
dependent variable, which gives specific value of the independent variable. It is
used to establish a prediction intervals for the dependent variable. The standard
error of estimate based on a sample data it represented by the following formula

or

n= number of sample observation

CHAPTER THREE

26
 PURCHASING AND PROCUREMENT

Purchasing can be defined as ensuring right – price, quality, contractual term, time, source,
material, mode of transportation and attitude for all organizations (big or small, business or non
business, public or private) depend on varying degrees for materials and sources acquired through a
group of activities known as procurement.
Goods and services may be acquired through purchasing that involves exchange or transaction or
other means of procurement such as gift, aid etc.

Objectives (Goals) of Purchasing

The basic objective of purchasing function in material management is to ensure continuity of supply
of raw materials, sub contracted items and spare parts and at the same time reduce the ultimate
cost of finished goods.
The standard statement of the overall objectives of purchasing function is obtaining the right
material (meeting quality requirements), in the right quality, for delivery at the right time and to the
right place, from the right source at a right condition.
More specifically the overall objectives of purchasing can be described as follows:
1. To support company operations by providing with an uninterrupted flow of materials supply
& service.
2. To buy competitively and wisely
3. To keep inventory investment and losses at a practical minimum
4. To find or develop reliable and competent alternative sources of supply.
5. To develop faster good vendor relations
6. To maintain the organizations competitive position.
7. To achieve maximum integration with other firms.
8. To develop policies and procedures which permit accomplishment of the stated objectives.

Purchasing Strategies
Purchasing strategic role has tagged behind that of other departments. There are
several reasons for this :
1. Purchasing is seen only as clerical function;
2. Day – to day operating pressures leave little time for strategic thinking; and
3. Management views purchasing as a supportive function, not as a profit
contributor.

27
There are substantial risks of not having the purchasing function included in a
strategic planning process these include it
 Treat to supply assurance;
 Improper supplier selection for new products;
 Problem with environmental or regulatory constraints;
 Improper protection against potential company liability.
 Lead time uncertainty &
 Price uncertainty

For these and other reasons it is important to include purchasing in strategic

management.

Essentially environmental analysis (Internal & External) will lend to the

formulation of commodity strategic plans.
Several issues pertaining to environmental analysis that must be studied are:
a. consideration of supply; both input side and market side (out put)
b. determination of which trends are relevant to cooperation, monitor and
evaluation
c. development of supply alternatives

Purchasing Policies
Purchasing policies are general statements of understanding which guide or
channel thinking and action in carrying out purchasing transactions and objectives
in an optional manner. Policies are area within which a decision is to be made and
assure that the decision will be consistent and contribute to objectives clarity and
improve relationship with other functions. Clear – cut policies promote supplier
understanding and cooperation to full fill management and/or government
requirements. Purchasing policy areas are framed around centralization Vs
decentralization, back orders, big evaluations, buyer’s assignment, cancellation &

28
claims, capital purchase, cash discount, change orders, competitive bidding,
conflict of interest consignment purchase etc.
Centralization Vs Decentralization
When a firm uses a decentralized purchasing policy individual departments handle
their own purchasing activities. That is, they decide, Use their own source of
supply, negotiate with vendors directly or perform other functions of purchasing,
Decentralized purchasing is adopted to secure the following advantages.
1. Users know their departmental needs better than anyone else.
2. It may also be faster because departments directly place order.
On the other hand the demerits are duplication of the same activities in different
departments that increase cost and decrease efficiency (specialization).
Centralization of purchasing refers to the degree of delegation of purchasing
authority rather than to the location of buying personnel. Centralization exists
when the entire purchasing function is made under the responsibility of a single
department or person.
The advantages of centralized purchasing are so great in comparison with
decentralized purchasing that almost all large firms are centralized, if used
properly, centralized purchasing results in the following benefits.
1. Duplication of effort and haphazard practices are minimized by central
coordination of firm’s purchases.
2. Quantity discounts are made possible by combining the requirements of
different department for the same and similar materials. It also results in
unified procurement policy.
3. full load transportation can be realized by consolidation of orders and
delivery schedules.
4. Suppliers are able to offer better prices and better services because their
expenses are reduced. Duplication of selling effort is minimized.
5. Responsibility for the performance of purchasing function is fixed with a
single department hands there by facilitating management control.

29
 6. More effective management control is possible because of the company’s wide
knowledge of stock levels, materials usage lead time & price.
7. It reduces record keeping and at the same time record keeping is made
significantly more effective.
8. It enables line department manager to devote full time and effort to their
basic responsibilities.
9. Specialization.
Purchase Systems
In an organization, depending on the size and nature of operation, the quantum of
purchase varies anywhere between a few amount of money to hundreds of
thousands naturally, this necessitates formalized systems and procedures for ease
of operation and accountability. Formal procedures have to be laid down in
initiating purchase, selecting suppliers, placing purchase orders, follow up,
receiving materials and so on.
We can classify the systems in the following manner.
1. Pre- purchase system,
2. Ordering system;
3. Post – purchase system.
1. Pre – Purchasing System
Initiating the purchasing through requisitions, requirements programs, selection of
suppliers, obtaining quotations & evaluating them, are broadly the pre- purchase
system
a. Requisitions:- the department, division or unit concerned in need of a
material, usually presents a completed written requisition form which has
the following form
b.
ABC Organization
Materials Requisition Form
Description Quantity Suggested Purpose Delivery
of material required supplier date

30
 Requested by Checked by Approved By
Name Name Name Sign
Sign Sign
Note that the department requiring the material and requisition reference
number must be mentioned.’
c. Traveling requisitions:- This document is widely used for requisitioning items
that are required frequently in bulk quantities over a long period.
d. Enquires:- Many organizations often invite suppliers to quote rates for supply of
materials. For this purpose a standard format is used which is similar to a
purchase order in all aspects except the words such as “this only a request for
quotation ” or “This is not a purchasing order” are printed so as to assure that
the supplier does not consider the request for quotation as a firm order.
2. Ordering Systems
Having selected the supplier and the rates agreed, the buyer places the
purchase order to the supplier, expressing the terms and conditions. The
purchase order, once accepted, becomes a binding contract. The details that are
normally furnished in the purchase order are listed below.
a. purchase order reference number (which will be quoted in all subsequence
follow up measures pertaining to the order);
b. description of the materials and detailed specification;
c. quantity required and delivery schedule;
d. price and discounts;
e. shipping instructions;
f. location where the materials are to be shipped (usually the name and
address of the buyer);

31
 g. signature of the materials manager who can authorize the purchase order;
and
h. Detailed terms and conditions (as a common practice these are printed at the
back of the purchase order).
3. Post – Purchase System
These include follow- up procedures, receipt and checking invoices.
a. Follow-up Procedures: follow- up implies commitment of time and money and,
therefore, it has to be selective. Certain practices could be established for follow
up only Critical” items require continuous follow up. Depending up on the
movement, items can be classified in to fast moving and slow moving,

For fast moving items, follow up can be initiated whenever the stock level
depletes to one month’s consumption. For slow moving items also similar norms
can be established. ‘
b. Receipt:- a systematic record of the consignments received carrier details and
descriptions are to be maintained in chronological sequence, to help in quick
identification of materials so that inspection can be arranged prior to
acceptance. Many organizations have a separate central receiving section for
this purpose. Usually a copy of purchase order is sent to the central receiving
section for reconciling purposes.

c. Invoice checking:- the supplier normally sends the invoice for the materials
supplied for payment. It is essential that this invoice is matched against the
receipt details, quantity accepted and rejected so that payment can be made
within the discount period or provisions be made which will keep in funds
planning. Normally, invoices are sent to the buyers finance department. A close
coordination between the finance and materials management is necessary.

Sources for materials and/or services can broadly be classified in to two; domestic
and foreign, depending on the nature, quantity and other pertinent factors like

32
quality, price purchased either from domestic or international market. Policy
preferences, socio- economic and political concerns can have their own influence
on the degree of operations of the two. Both systems have their respective features
and importance when examined from different corners that include economic,
social and political factors.

3.1 Local Purchasing

Availability of suppliers domestically can be justified based on many considerations
and interdependencies of various economic and social activities reinforce each
other as they feed each other as supplier and buyers. Their developments can be
realized through progresses. The substitution effect that takes place as the result of
the linkage contributes to the improvement of the macroeconomic aspects.

Similarly, dependence on local sources, as long as the items needed are available,
has various socio- economic importance. Organizations can win the support of local
people if they use local sources that strengthen the relationships. From economic
point of view, too, local suppliers often can furnish smaller quantities of material at
lower prices than could be obtained from distant place. Local suppliers also can
maintain and finance a well- balanced inventory of materials for continuing local
users. Working with local sources of supply and encouraging them to be capable
suppliers is a part of progressive purchasing. In summary, local buying has the
following advantages.
 Closer cooperation between buyer and seller is possible because of
geographical proximity;
 Delivery dates are more certain since transportation is only a minor
factor in delivery;
 Lower prices can result from consolidated transportation and
insurance charges;
 A local supplier brings in many local buyers orders in the same
shipment;

33
  Shorter lead times frequently can permit reductions or elimination of
inventory. In effect, the seller produces just – in – time;
 Rush orders are likely to be filled faster;
 Disputes usually are more easily resolved;
 Implied social responsibilities to the community are fulfilled.

On the other hand, the size of purchase and other factors may force sources to be
in some other localities and in national central areas. Other national sources can
be more advantageous as compared to local sources. Some of the advantages of
national buying include;:
- national sources, as a result of the economies of scale, can in some stations
be more efficient than local suppliers and other higher quality or better
service at lower price;
- national companies often can provide superior technical assistance;
- large national companies have greater production capacity and therefore,
greater production flexibility to handle fluctuating demand;
- shortages are less likely with national companies because of their broader
markets.
Countries establish policies by which the sources for items to be purchased by
their societies and by organization required for various purposes (consumption,
production service, etc) are guided. Policies are shaped considering social,
economic and political factors prevailing with in respective countries and the globe.
Nevertheless the current global situation has brought the world closer. Particularly,
developing countries highly depend on imported materials for the functioning of
their many undertakings, whether operated by government or privately owned. As
the developing countries cannot compete with the developed countries, their
economic gains from the international trade is minimal. Nevertheless, they cannot
escape from the globalization process and hence they are highly involved in foreign
purchasing activities.

34
3.2 Foreign purchase
Although strengthening domestic sources can be justified from its multi- effect on
national socio- economic aspects, it is difficult, and nowadays seems even
impossible to be a closed economy, to become self- supporting in all requirements.
Particularly the poor countries like ours are highly dependent on international
sources.

As the consequence of the only being poor, but also the globalization has further
strengthened the inter- dependence of countries of the world where the issue of
self- sufficiency became almost a far cry, particularly in the poor countries.

Importing should not, however, understood from the pressures it creates on

balance of payments only. It has to be recognized as an essential economic function
since many of the technological output and industrial products required in the
production systems are missing in many of the developing countries. Such
imported materials would be fundamental in the endeavors made for self-
sufficiency including from the long – term perspective. Infect though the exchange
may not be in a balanced manner where developing countries who depend on only
very few export items of mostly raw nature, with less value added and mainly
agricultural products are at a disadvantaged position, the developed countries also
are not self- sufficient. So the industrially advanced countries also import items
from other countries.
As stated above, importing is an essential economic function which cannot be
completely eliminated.

In connection with this, Ricardo’s principle of comparative advantage states that it

would be beneficial for an economy to concentrate on the production of items in
which it specializes, export these items and import its requirement of other items.
The principle, though not totally practical, cannot be dismissed. International trade
is undoubtedly governed by political motives and, as such, a country cannot totally

35
rely on another country for its requirements of specific items. Accounting various
parameters, countries have their respective policies on imports. These days import
policies are liberated in many countries as possessed the import substitution
policies that were common practices and procedures are very important to
industries which depend on import for their production. Policies consider, among
others, the impact of imports on indigenous production and its influences on
foreign exchange resources. Generally, policies need to be neither liberalized nor
restrictive, but with a balance between the need for import and export production.

In relation to the classification of the purchasing process as to the possible source,

the points highlighted above suffice to indicate that foreign purchase is one
important source. But the detail aspects of the international purchasing are looked
in to the following chapter.

3.2.1 The Need For International Purchasing

In connection with the flow of goods and services in the international market, as
stated by R.Jerry Bake(1993 p.2), “boundaries are shrinking and disappearing, and
what’s becoming apparent is that global purchasing and domestic purchasing are
flowing, blending, and converging in to one stream.” The inter dependence of
countries is increasingly growing, however, their advantages may not be of equal
terms, and in fact with big gaps, particularly, between the developed and
developing countries.

Developing countries are highly dependent on technological and industrial product

imports for the progresses they endeavor especially in the industrial sector. Not
only they have to import machineries but the spare parts for their maintenances as
well as other inputs for their continuous production.

The reason for sourcing abroad are many and actually vary with the specific
commodity needed, however, the underlying principal and governing reason for

36
using foreign vendor is that better value is perceived to be available from that
source than from a domestic vendor.

Purchasing goods and services of foreign origin can be highly challenging.

International sourcing requires additional efforts when compared with domestic
sourcing, though may be with higher rewards. One of the complexities of buying
goods and services of foreign origin is the wide variability among the production
countries in characteristics such as quality, service, and dependability. With this
perception in mind, however, there are common reasons for purchasing goods and
services from international sources as highlighted below.

a. Quality
Although the issue of quality is argumentative, for there can be practices when
foreign items are purchased while their quality may not be better than
domestic products, the key reason forwarded by purchasing managers for
international sourcing is to obtain the required level of quality. This is not to
imply infect there are no higher quality products in the international market
than in domestic markets. Especially in developing countries like Ethiopia,
there may not be domestic sources for many industrial products and hence
this may eventually lead to developing lack of confidence one’s own products.
Such understanding impedes their progresses and domestic industrial
development potential.

b. Price
It may seem surprising to see a foreign vendor producing and transport an item
several miles at the lower cost than domestic supplier (producer). But, it
actually is observed in the international trade through additional costs, import
duties, and transportation expenses are required on international sourcing.
Several factors can influence the issue and be reasons for the specific
commodity, such as:

37
 I. The labor costs in the producing country may be substantially lower
than the costs incurred domestically.
II. The exchange rate may favor buying foreign.
III. The equipment and processes used by the foreign vendor may be more
efficient than those used by domestic vendors.
IV. The foreign vendor may be concentrating on certain products and pricing
export products at particularly attractive levels to gain volume.

c. Product and Process Technologies

International sources in some industrial products are more advanced
technologically than their domestic counter parts. So importing may be
advisable than an attempt to produce an item.
d. Unavailability Of Items Domestically
Some items may only be available in foreign sources. In such situations there
may not be option than depending on foreign purchase.
e. Faster delivery and continuity of supply
Because of limited capacity of the domestic sources, foreign vendor can deliver
faster than the domestic supplier. The foreign supplier may even maintain an
inventory of products. In related connection professional buyers want to
develop and maintain an adequate supply base for required materials. It may
be necessary to develop international suppliers in order to have a completive
supply base.
f. Better Technical Service
If the foreign vendor has a well – organized distribution network in various
areas; better supply of parts, warranty service, and technical advice may be
available than from domestic suppliers.

g. Counter Trade
The term “counter trade” refers to any transaction in which payment is made
partially or fully with goods instead of many. Counter trade links two normally
unrelated transactions; the sale of a product in to a foreign country and the

38
 sale of goods out of that country. Under such arrangement countries require
their domestic suppliers to purchase materials in their country as part of the
sales transactions, which commonly are called barter, offsets, or counter trade.
h. Tie – in with Foreign Subsidiaries
Firms can consciously be made to operate in foreign countries to support the
local, foreign economy by purchasing there and for export to own country.
Having stated as above, the reasons for the need to undertake international
purchasing, the process is with many challenges and problems. Such problems
include:
I. Source location and evaluation – this refers to the costs required to
have adequate information and evaluation on suppliers located abroad,
which may be thousands of miles away.
II. Lead/Deliver Time – there can be uncertainties on the lead – time
required since transporting the materials may demand longer period.
III. Expediting – additional efforts and resources in terms of financial and
personnel may be needed to know suppliers personnel and assuring
that they are responsive.

IV. Political and labor problems.

There can be a risk of supply interruption due to governmental problems, say
change in government or labor strikes. So the buyer may need to establish
some systems to monitor such concerns.

V. Currency fluctuation
Changes in the exchange rates can take place while the purchasing process in
undergoing and payments are incomplete. There can be a need to be
conscious and make arrangements to reduce the effects to the fluctuation.

VI. Payment terms and conditions

39
Terms of payments and conditions may substantially differ from those made
with domestic sources. The arrangement may not be easy and can be with
many affecting consequences.
VII. Culture and communication
Cultural differences can impede purchasing processes and language difference
poses difficulties in communication process.

VIII. Quality
Because locations being distant, it may not be easy to reconcile
understandings on the quality specifications.

IX. Tariffs and duties

A tariff is a schedule of duties (changes) imposed on the value of the good
imported in to a country, where the rates can differ from country to country
and depending on the type of commodity. The buyer should therefore have the
knowledge on all the different aspects linked with tariffs and duties.

X. Higher costs of doing business

The need for translators, communication problems, the distances involved in
making distant sit visits, and others expenses add to the costs of doing
business with international suppliers.

XI. Legal problems

How to settle disputes in case of failure of either of the parties to comply to
agreements is one problem. The law to be applied should be clearly specified a
head. Different arrangements may be needed and clauses included in the
agreements. Performance bond may be required; or, a bank guaranty
providing for payment in case of failure to perform according to specified
agreements.

40
Elements of International Purchasing
Procurement
In the earlier periods, industrial development strategy of developing countries was
mainly based on import substitution. The policy of import substitution had been
enshrined as major national objectives, assumed as a tool to achieve the goal of self
– reliance. Different complementary national policy instruments were designed and
practically aimed at achieving self- reliance and a favorable balance of payment
positions. Many restrictive policies that allow the procurement of selective items
only were under operation.

Nevertheless, import substitution strategy could not enable developing countries to

achieve the goal(s) that were presumed.
Eventually, the trend had shifted to a more opened economic systems parallel with
the upper hand of the western economy. The globalization process has brought the
world in to nearly one system where interactions and inter- dependencies are
facilitated. Hence, the import substitution systems are liberalized where the flow
and procurement of goods and services from one country to another have
Increased. Of course, it is quite obvious that the share of the developing countries
in the international trade is almost insignificant. As they have to depend for
technological, and industrially produced materials on the developed countries, it is
unlikely to keep the balance of importation and exportation. So, developing
countries like Ethiopia depend on the procurement of many goods and services
from the international market while their export supply is negligible compared to
flow of goods and services in the international market. Importation is so necessary,
since most developing countries have to depend upon the advanced nations for
their industrial growth and therefore, need to import equipment and materials.

It should, however, be underscored the importance of strengthening the domestic

(national) procurement as much as possible. This can be justified from different

41
 corners. Developing preferences on nationally produced materials have multi-effect
on driving the national economy. The principle of comparative advantage might be
acceptable, but the gains that can go to the developing countries as the result do
not seem feasible as there are also restrictive policies in the advanced countries to
protect their economy while the technological gap is quite beyond imagination. So,
a wise approach on the application of the comparative advantage principle would
be quite advisable.

Whatever the case, the procurement from the international market is unavoidable,
even in the advanced countries. The principles of purchasing and the procedures
that should be applied in the process are similar in the procurement of materials
and services from the national and international markets. But there are differences
in the requirements that need to be fulfilled and the documents necessary to
complete the procurement process.

ocumentation
Countries have their specific policy on imports. Policies can specify the items that
can be imported and the requirements that should be fulfilled in the whole
purchasing process. Hence, having adequate knowledge on the context of policy
and the requirements should be the first step in initiating international
purchasing.

There are certain steps the international purchasing process has to pass through
and special documents are required different from what are needed in indigenous
(domestic) purchases.

Items to be imported must pass through and be cleared from port and customs
before they are handed to the buyer and be used. These agencies have established
procedure(s) that need to be followed. Various documents are required to practice
the procedures and clear purchased items from ports and customs. To clear the

42
goods from customs, a bill of entry should be filed accompanied with different
documents that include, a) bill of lading, b) signed commercial invoice , C) packing
list,
d) specification/test certificate, e) country of origin certificate, f) insurance
certificate, g) indent and acceptance , h) catalogue or write up, i) Valid import
license, j) markings of packing, k) commercial invoice from seller to buyer
indicating conditions of sale and description of good, rates of exchange, I) export
and import permit numbers.

After scrutiny of the documents, the customs appraiser assess the consignment
and fix the duty to be paid. On payment of the duty, the consignment is released.
The port dues have to be cleared before the goods can be removed by the importer.

Some of the commonly practiced documents are further explained below for more
clarity purpose.

Bill of Lading
The bill of lading is the most important document which accompanies bills of
exchange drawn under letter s of credit. This is signed by the master of the ship
and indicates that the goods have been dispatched by the supplier and gives the
importer title to the goods and enables him/her to claim them on arrival at the
destination.

The bill specifies the port of shipment, the destination and the condition under
which the goods are received for carriage. It is at the same time i) a receipt for
goods delivered to carrier for transportation, ii) a contract between the shipper and
the carrier for transportation of the goods and then delivery to the consignee or his
order, and iii) a document of title to the goods, giving the holder title to the goods
mentioned.

43
Normally, a bill of lading shows the date and place of shipment, the name of the
carrying vessel, the name of the consigner and the consignee, the post of
destination, the number, contents, and identification mark of the goods shipped,
and the amount of freight paid or top pay. The detailed particulars of the number of
packages, the mark they bear, their contents and the amount of the freight on
them are entered in the space provided for them in the bill.
Commercial Invoice
The commercial invoice describes the merchandize, indicates the price and other
details of the transaction. The name and address of the buyer and the seller, the
vessel of shipment, port of discharge, shipment export and import permit number,
the number of contract and invoice and other essential details of transaction are
recorded on the invoice. The financial terms of the sale, such as whether under
letter of credit, sight drays, etc are given. The number of packages and identifying
marks and numbers on them are clearly indicated. The goods contained in the
packages are detailed and prices are given item by item, the trade discount is
deducted from the gross aggregate price of the goods and the total net value is
shown.

Package List
A packing list to indicate the exact nature, quantity, and quality of the contents of
each package in a shipment. The list helps the importer to identify the goods and
check them against his own order.

Certificate of Origin
The laws of some countries require a certificate of origin of imported goods to be
produced before clearance of goods by customs and assessment of duty. The
certificate is usually required where goods from certain countries receive
preferential treatment or the import of goods from some countries is partially or
wholly prohibited.

44
Insurance Certificate
This contract between the insurer and the insured where by the former agrees to
indemnity and the latter against loss incurred on which a premium paid by the
insured to the insurer.

Markings of Packages
This refers that the packages should be suitably marked with address, dimensions,
weight and other particulars
Letter of Credit (LC)
Importers need to communicate different organizations concerned with policies and
financial transactions like banks. Banks are involved particularly, in the activities
of payments. Documents involved in connection with payment arrangements
include; i) Letter of credit, ii) Terms of payment, iii) Rate of exchange, iv) payments
under various credits and trade agreements.

A letter of credit is an arrangement whereby the obligation to pay to an exporter is

undertaken by a bank. A letter of credit is therefore, an instrument issued by a
bank at the request of a buyer. The bank promises to pay a specified amount of
money upon presentation of documents stipulated in the letter. The letter of credit
is not a means of payments, but merely a promise to pay.

The letter of credit indicates the name of the bank issuing the letter so that the
exporter sees whether the bank is acceptable or not to him, states the name and
full address of the beneficiary (i.e the seller) the amount for which the credit is
issued, the name of the importer, etc. The letter of credit has expiry date. A time or
an exact date is mentioned by which the whole operation should be completed.

45
Custom Clearance
Imported goods need to be cleared as soon as possible. Clearing goods
expeditiously should not be understood only from the individuals interest and
benefit, but it is also a national concern. The time delay increases the cost of
goods. Ports can be occupied and free movement is prevented, unless goods are
cleared on time. In order to clear goods as soon as they arrived at ports, the
importer should make ready all documents required by the custom duty. Necessary
documents can be organized even before goods reached ports and all pre-
conditions can be finalized a head. Damages on goods can encounter, because of
various factors even after their arrival at port. So, delay in clearing may lead to
unnecessary losses.

Purchasing Procedure
Purchasing procedures refer to the way in which a purchase transaction is carried
through from its inception to its conclusion. i.e this purchasing activity begins with
the determination that the product/ service is needed and ends when an
organization has consumed or disposed the item and post evaluate its effect. But,
the steps vary as per to the type of organization, products (items) and personnel.
Some of the common procedures in purchasing are:

1. Need identification
Any purchasing activity starts with the recognition of the need for an item by any
responsible body. This need identified, usually emanates from forecasting of
material’s demand using different techniques. It estimates the level of demand for
materials expected for some period of time in the future.

Once the need has been recognized, it must be so accurately described that all
parties will know exactly what is wanted. The quantity and performance, price
characteristics, standard model, date when it is required, etc, should be described
clearly. Because an improperly or poorly described need can be costly.

46
An individual or using unit (department) that recognized the need for the item
originate formal purchase requisition; and provide it to the purchasing department.
The system of developing purchase requisition may vary. For example, for stock
items, purchase requisition can be originated by the store when materials are not
available or when the level of materials required reaches the pre- determined level-
reorder level. For non – stock items, the user prepares a material requisition to the
store and fills purchase requisition then after. This purchase requisition has to be
verified by the purchasing department. It should ask:
 Is the requisition authorized to make such a requisite?
 Is there sufficient budget for the requested material?
2. Sourcing
The next step is the selection of the source for requisitioned items. A firm has two
categories of suppliers: it could be either the firm itself or outside suppliers
according to the nature of the item (competency) and capability of the firm(finance).

After verifying the purchase requisitions, the purchasing department considers

whether quotations value and routinely purchased may not require bidding. At
such situations, a direct order can be made, but, items, which have high
purchasing value, complex and not purchased with regularity require bidding.
Hence, a purchase manager may conduct surveys and detailed analysis, I.e, if a
purchaser need to use competitive bidding as a bases, the following situations
should prevail.

 When the monetary value of a specific purchase is large.

 When the specifications for an item or service to be purchased is clearly
understandable to both buyers and sellers; and the seller can accurately
estimate the production cost of the item.
 When there are large an adequate number of suppliers.
 When there is mutually agreeable contracts between a buyer and a seller.

47
 When there is sufficient time availability for preparing mailing, opening and
evaluating bids.
 When certain and accurate estimation of costs for items is impossible.
 When price is not the only determinant factor; and other variables like quality
and services are to be negotiable
 When there is a trend and anticipation of changes in the specifications or
other aspects of the purchase contract.
If bidding is required, it must be determined the type of bidding whether it should
be open bid or closed bid and prepare bid document.
In open bid a purchaser invites all possible potential suppliers usually through
mass media, such as TV, radio, newspapers, etc. Here the purchaser shall have
enough choice but with high screening cost. Where as in closed bid, limited
number of selected suppliers are invited either in telephone or through Performa
invoices.

Bid document shall be prepared, if the purchasing department decided for open
bid. A bid document includes information required by suppliers, such as
a. eligibility of the supplier:- whether the supplier has license, has paid tax,
etc.
b. general conditions: - amendments - big bond (grant)
- language - opening date
- bid form - closing date
- bid price(currency) - etc.’
c. other requirements: - samples - terms of shipment
- warranty - inspection and taste
- applicable law -specifications and standard
- Notice -other related information
- patent right
3.Analysis

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After the provision of a comprehensive bid document and inviting all possible
potential suppliers to bid, purchaser starts to evaluate and select them based on
criteria set by the organization. The depth of the analysis depend up on the nature
of the item. In technical items the criterion used for technical evaluation may be
given higher percentile while in non- technical ones the financial aspect might have
higher consideration. Generally, technical and financial aspects are major
categories usually considered in the evaluation process. Each category can have its
own sub- criterion. To be more specific some of the factors for the evaluation and
selection could be:

i) Pricing Factor
pricing is one of the important factors on which the final choice is based. For many
items it is possible to keep current price information in the form of suppliers
catalogue, price list and discount schedules. Such source of information must be
kept undated. Or a purchaser may secure price information by negotiating with the
seller until agreement is reached. The third method is using competitive bid. In
many cases, the purchaser should obtain materials at the lowest price considering
other requirements.

ii) Quality factor

If the prospective supplier’s items are less than the buying firm’s quality
requirements, the supplier is not worthy to be selected. Suppliers having items of
high quality to fit to the manufacturing and operations requirements are likely to
be selected.

iii) Financial conditions

A review of financial statements (balance sheet and income statement) and credit
ratings can reveal whether a supplier is clearly incapable of performing
satisfactorily. Financial stability is essential for suppliers to assure continuity of
supply and reliability of product quality.

49
iv) Service factor
Good service always means delivering on time, treating special orders specially,
filling back orders prompting, setting disputes quickly and fairly, and informing
buyers in advance of possible price changes or developing shortage. On the other
hand, service also can include actions such as stocking spare parts for immediate
delivery, extending suitable credit arrangements or warranty the purchased items
quality and performance to a degree beyond that normally required. In general, by
the suppliers ability to comply with promised specifications, technical assistance
and delivery dates and other actions to ensure the smooth flow of purchase
materials to the buying firms. Here, supplier good at this service provision will have
better possibility to be selected.
v) Time factor
Purchasers always prefer suppliers who can deliver items on time for use so that
production or operation does not run out of time, and at the same time that
inventory will not be over stocked. i.e the just- in – time capability of suppliers
result in increased quality reduced scrap and rework, and obsolescence.
There are different methods that are used for evaluation and selection of suppliers.
Among these weighted – point method and cost ratio methods are common.’

5. Making contract and Follow-up

At this step, the purchaser creates a legal and binding commitments with selected
supplier. A contract is made when quotations (bid prices) are submitted to the
buyer and purchase order is sent in response to the quotation within the specified
period of time. Unless there is as offer and acceptance, no legal purchase contract
can arise. The purchase order can be made on several copies. Two copies for the
supplier in which he/she signs one copy and returns it back to the purchaser as a
means of acknowledgement of the receipt of the purchase order. One copy to
finance, one copy for store, one copy to receiving an inspection, one copy for
purchaser, and one copy for pad.

50
6. Negotiations
Negotiation is the appropriate means of purchasing when competitive bidding is
impractical, or if criteria for bidding are missing and when a contract made fails to
be acted. In the second case negotiation is nothing but, discussing or bargaining to
reach agreement in business transaction with the selected supplier. Doing this,
buyer and seller can reach at acceptable agreements or compromises in all aspects
of a transaction. Negotiation has the objectives of:

1. obtaining quality specified,

2. obtained fair and reasonable price,
3. getting the supplier to perform the contract on time,
4. controlling all activities as specified in the contract while deficiencies
arise, and
5. To develop sound and continuing relationship with competent supplier.
But sometimes, cancellation of contract may arise for reasons of default, force,
major and / or mutual agreements. At such condition, negotiation is taken as a
remedy.
Generally there are three types of contracts in relation to price.

a. Fixed Price Contracts

Here, the supplier is obliged to deliver the product required as to the contract for a
fixed price regardless of the change in delivery cost, the supplier is obliged to
provide the item. And, the supplier will receive no more than the previously agreed
– on –time amount. There is no maximum or minimum profit limitation in fixed
price contracts. This contract, type is common in situations where specific
specifications are well defined and cost risk is relatively low.

b. Cost type contracts

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Under a cost – type arrangement, the buyer’s obligation is to reimburse the
supplier for all allowable, reasonable and allocable costs incurred, and to pay a
fixed fee. For the supplier, the obligation is only to provide its ‘best effort’ usually;
either performance or delivery is guaranteed. This type of contract is normally used
when:
 Procurement of research and development involve high technical risk.
 Some doubt exists that the project can be successfully completed.
 Product specifications are incomplete

c. Incentive contracts
In an incentive contract, both parties share the delivery cost responsibility when
high uncertainty is present that inflates the contract price.
After the purchase order is made (contract is made) the purchaser need to follow
up the orders that the supplier will send the material on the agreed delivery time as
per to contract. Because, sellers may not receive order even though it has been
mailed, or fail to perform its duties a supplier to his promise of delivery.

7. Shipment (Transportation)
Transportation is a process concerned with obtaining items purchased from the
suppliers to the purchasers as specified in the contract. This transportation system
should be managed carefully and efficiently. Because, it significantly influence the
efficiency of the production and, ultimately, the firm’s ability to compete in the
market place. For example, if shipments fail to arrive when scheduled, production
may delay and the firm will be out of competition. The general efficiency of
transportation can be affected by the selection of carriers and type of relations
(shipping terms) made with them.
Shipping terms made in a contract determine three things:
1. The point where legal title passes from the seller to the purchaser
2. Who is responsible for payment of transportation (freight charges) and
selecting carriers.

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 3. Who has the right to claim in case of damage or loss.

The most common types of domestic shipment terms are:

a. FOB buyers place (destination)
In this arrangement, ownership title to the material passes from the seller to the
buyer when a carrier delivers the material at the buyer’s plant. i.e the supplier
retains ownership of he material during transit, it has the legal right to select the
carrier as well as the responsibility for paying the freight charges. This system is
better preferable for the purchaser,
b. When the buyer need to shift the burden of selecting effective carrier to
the suppliers.
c. To save time in time consuming negotiations at the time of damages.
d. When the risk during transportation is expected to be high
e. When the cost of transportation is high and the seller or the carrier
can do it with more efficiency and less cost.

b. FOB sellers place (origin) – shipping point

Under these arrangements, the buyer takes ownership title when the carrier
accepts the material for shipment at the sellers plant. In this case, the buyer
assumes responsibility for carrier selection and payment of freight charges. This
system may be helpful for purchasers:
 When the shippers are small in size and simply are not properly staffed to
give such services for all their geographically dispersed customers.
 When purchaser need to develop long- term relationships with carriers.
 When risk during transportation is low and the buyer can transport the
materials with high efficiency and less cost.

53
There are also international shipping terms, which are commonly called in terms
that involve in global trading. In terms describes the obligations of suppliers and
buyers with respect to packing materials for shipment, obtaining import or export
licenses, delivery, payment for carriage and insurance, and the risk of loss.

8. Receiving and Storing

Most big organizations have receiving and storage departments to control the
transported materials until they are ready for use. These activities continue the
final link in the materials supply chain.

A receiving department is responsible for the receipt, identification and general

inspection of most incoming materials. It also notifies the arrival and condition of
the material (if external damage) for any responsible body. The copy of purchase
order helps to check the incoming materials when arrive and inspected. The quality
shortage, damaged materials, incorrect items shipped, and all other details on the
item actually received are pointed – out by this department. Is to prepare a
receiving report as a purchasing control document. After the material shipped are
received and inspected carefully, they will be sent to storage.

A store department is also responsible to develop a system for classifying, marking,

and locating all materials so that they are readily accessible and, at the same time,
protect them against unnecessary damage, unauthorized usage and wastages.

Finally, post – purchase evaluation has to be made to check whether the materials
bought have resolved the problem of the users and whether the suppliers can also
be considered in future purchases.
3.3 Special Purchases
Purchasing Capital Equipment

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The purpose of capital equipment differs substantially from the purchase of
production materials and supplies. There are general-purpose capital equipments
(like pianos, pump, standard electric motors, microcomputers, materials-handling
trucks, and office furniture), and special-purpose capital equipment (that include
power-generating equipment). For accounting purpose most firms classify both
categories of equipment as noncurrent assets, which are capitalized and
depreciated over the course of their economic lives.

Some of the differences in the procurement of capital equipment as opposed to

purchase of production materials and supplies include the following aspects.

i) Non recurring purchases

The purchase of a particular piece of capital equipment typically occurs only once
in a certain period, say every three to five years or so.

A unique feature of most capital equipment purchases is the lead-time

requirement. While some types of capital equipments are standard off-the-shelf
products, many are not. Many production machinery and prime moving equipment
are built based on the peculiarities to each purchasers operation. Consequently,
manufacturing lead-time is usually a matter of months or perhaps years.

ii) Nature and Size of Expenditure

An expenditure incurred for the purchase of capital equipment is an investment. If
purchased wisely and operated efficiency, capital equipment generates profits for
its owner.

Although capital equipment prices cover a wide range, the purchase of most major
equipment involves the expenditure of a substantial sum of money. Since capital
equipment is often used for longer period, total cost of operation and maintenance
during its lifetime may far exceed its initial cost. Hence, the total life cost of

55
machine, relative to its productivity, is the cost factor of primary importance. In
looking for alterative machines in the process of purchasing, therefore, it has to
take into account the costs to be incurred in the life time of the item.

iii) Considerations in Sources Selection

When purchasing capital equipment, selection of a suppler is governed largely by
four general considerations: (a) operating characteristics of the equipment, (b)
engineering features of the equipment, including compatibility with existing
equipment, (c) a total economic analysis, and (d) various qualitative considerations

(a) Operating Characteristics

Design and operating features for a given type of equipment can differ markedly
among the machines available from different suppliers. For this reason, the
number of suppliers willing to produce a machine capable of meeting every
expectation of purchasers operating requirements is frequently limited. This is
more likely to be the case for specialized equipment than for general-purpose
equipment.
b) Engineering Features
Characteristics closely related to the equipments operation are its engineering
features. These features must be compatible with the buyers existing equipment,
process, and plant layout. The major engineering considerations include;
 Specific process capabilities: This concerns whether the performance of the
equipment is compatible with the existing machines, whether it has problems
in producing the appropriate capacity;
 Physical size and mounting dimensions: This refers to whether size of the
equipment can be accommodated with available space.
 Flexibility: This is about the possibility to easily be move and relocated.
 Power requirement: This concern whether it is possible to use the existing
power supplies.

56
  Maintenance: refers to the requirement of maintenance and availability of
capacity to maintain or if it needs special maintenance.
 Safety features: whether the machine have any unsafe features, whether it
meets existing standards, if its safety level is comparable with that of existing
equipment.
 Pollution characteristics: refers to the possible pollution consequences,
whether the equipment performance is in accordance with EPA
(Environmental Power Authority) requirements concerning pollution and
contamination discharge levels.
Organizations do not buy only new machines. Rather they may find it economical
to buy a used equipment. So, a firm may not necessarily buy new for different
reasons such as;
 The cost of used machinery may be found substantially less than that of new
equipment while the required performance can achieved by both.
 Analysis of payback or return on investment may well reveal that a piece of
used equipment is a better buy than a new machine
 A firm’s financial position may dictate the purchase of a lower-priced
machine.
 Used equipment frequently is more readily available than new equipment and
hence there can be situations where availability may override all other
considerations.
 There can be situations where used equipment may adequately satisfy
buyers needs
 In events that equipment is needed for standby or peak-capacity operation,
or for use on a short-lived project, more often than not used equipment can
satisfy the need very well.
But the problems in purchasing used equipment should be well understood. It is
difficult to determine the true condition of a used machine and to estimate the type
and length of service it will provide. So to have an experienced specialist in
appraising the purchase of used equipment is essential. To have information on the

57
reputation of used supplier is important. It may be necessary also to check or
inspect several machines before making a purchase. Age of the machine be
determined that can be traced through the manufacturers serial number
identification put for the machine.

In general the broad questions to be answered are; How does this piece of
equipment fit in with the existing operation? Will many costly modifications be
involved in adapting the equipment to the existing system?

The economic analysis issues and other qualitative considerations that have to be
examined in purchasing equipment and hence, in the selection of supplier and
dealt with separately in more detail as below.
3.4 Economic Analysis:
One of the most important considerations is not simply to compare the cost of the
equipment that is involved at the time of the purchase, but to consider also the
cost of modifications or additional fittings required, the total operating cost
involved in the total plan of the equipments economic life, and an estimation of cost
of maintenance. Hence, in the economic analysis the total cost that is involved over
the whole life of the equipment and the return it brings in the form of revenue of
profit over its life span are considered.

After having adequate information on several acceptable machines, an analysis of

the major operating alternatives is made that include a comparative economic
analysis of the machines against each other and against the existing equipment
under operation. The economic analysis must relate the total expected life cost to
total expected productivity of each machine.

Different methods are used to undertake the economic analysis such as the life-
cycle sorting technique, payback period net present value or discounted cash flow

58
method, Internal rate of return, return on investment and other measures of
profitability.

a) Life Cycle Costing

Lifecycle costing concerns that total cost that is born by the owner of the machine
that include, on top of the original cost, such cost factors as those associated with
installation, ongoing adjustment and calibration, energy and labor for operation,
routine maintenance, major overhauls, downtime, and eventual disposition of the
machine (net cost or salvage value).

b) Discounted Cash Flow Method

This method gives a true picture of the return on investment as it takes care of the
difference in times at which revenues are generated from an investment. It uses the
“present value” concept in the evaluation of investments. All future revenues
resulting from the investment are discounted so as to find the total present value of
all these future earnings and compared with the value of the investment. If the
total present value of the future revenues is more than the present investment
then, it is worth going in for the investment. This method based on the
understanding that “ a Birr earned today is worth more than a Birr earned years
later”. The following simple example is given to exemplify the method.

Assume a project requires 10,000 Birr capital cost and 4000 birr operating cost
each year in the subsequent years. Since the start of its operation, that is year one,
8000 Birr revenue generates yearly in its life time. Life span of the project is four
years and the discount rate is 8 percent. The net present value can be calculated
as follows.
Total Discount Present Total Discount Present
Year Cost Factor Value Revenue Factor Value
0 10,000 1.00 10,000 - - -
1 4,000 .926 3704 8000 .962 7408
2 4,000 .875 3428 8000 .857 6858

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3 4,000 .794 3176 8000 .794 6352
20,308 20,616
The NPV of the project is = PV of revenues – PV of cost, i.e 20616-20308 = 308

C) Internal Rate of Return (IRR)

This method can be defined as the procedure to find a rate of interest that will
make the present value of the cash proceeds expected form an investment equal to
the present value of the investment. It is the rate discount which when applied to
the future cash flows will equate their sum to the original price of the investment. It
is usually a trial and error method. The formula applied is:

IRR = R1 +
Where r1 = the higher discount rate
R2 =

Using the same as that of NPV above, the calculation of IRR will be as follows. But
we have to get first the discount rate that makes the NPV to have a negative value.
As shown above NPV is positive at 8 percent discount rate. If we use 10 percent
discount rate, NPV becomes negative 56. Then the IRR is found between the two
discount rates (8 and 10 percent). Applying the above formula IRR becomes:

The discussion rule in appraising a project is, accept all projects with an IRR above
the opportunity cost of capital (i.e. the discount rate). This is an arithmetical
approach, but IRR can also be calculated graphically.

IRR gives the net result in percentage terms but, it does not show the absolute
figure. In case of fund constraint, the discount rate can be uplifted up to a level
where only those projects of which total fund requirement is equal to the available
fund. In the selection process, it is those with higher IRR taken first.

60
d) Payback Period
This approach is the simplest and most widely used methods for evaluation of
investment.
Payback period refers to the analysis made to determine the number of years a
machine requires to pay for itself from additional earning generated by its
increased level of operating efficiency. This is mainly used in the case of purchase
of equipments that have a short economic life and the organization is of view that
the equipment should pay for itself. Hence, the shorter the pay-back period the
better is the investment.

The formula for pay-back can be given as t=C/I where t is the pay-back period in
number of years, C is the initial capital out lay of the investment, and I is the
average annual cash inflow expected from the investment. Depreciation should be
included, as depreciation by itself is a measure of capital recovery in the estimation
of cash inflow.

But this method has limitations in that;

i) It tends always to choose investment which result in higher cash inflows
in the beginning rather than those which give less inflows in the
beginning and more later. It ignores profits earned after the recovery of
the initial investment
ii) It assumes uniform cash inflow each year and it cannot handle varying
annual cash inflows.
e) Return on Investment (ROI)
Return on investment is just a reciprocal of the pay-back period, expressed as
ROI+I/C where I is the average cash inflow after taxes, and C is the original cash
outlay. This method also has limitation in that it gives only the approximate rate of
return and does not take into account the differences in the times at which
investments generate their revenue.
Qualitative Considerations

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Qualitative factors concerning potential suppliers are important in making any
purchase. But more important than in other purchases, there can be factors that
should be given higher weight in selecting sources for capital equipment. Capital
equipment purchases require a different type of cooperative relationship between
the buyer and the seller. It is important, initially, that a supplier be willing to work
with buyers technical personnel to ensure a good fit of equipment to operating
need. After a purchase, the buyer may need help with installation, start up,
adjustment, and so on. Not only that, adjustment or calibration may be a
continuing need, depending on the type of equipment and the buyers in house
capability.

Suppliers ability to produce reliable equipment that performs in accordance with

specifications is another consideration which may have to be supported by, among
others, plant visits of the producer and technical discussions with suppliers
personnel

Generally speaking, qualitative considerations do not play a primary role in the

selection of a supplier for capital equipment. They are usually considered in the
final analysis, after the major factors have been weighed.

3.4.2 Purchasing Vs Leasing

Leasing an equipment is a third alternative for a buyer on top of the possibilities of
purchasing new or used capital equipment. There are different factors that favor
leasing. The primary ones include;

- Operating and managerial convenience;

Under this arrangement the leasing organization has the responsibility of
continuously financing the maintenance of the equipment, renders special service
and other administrative tasks associated with equipment ownership. The lessee
has full use of the equipment and concentrates on its regular business operations.

62
In the case of complex equipment requiring highly specialized technical support
this can become a benefit of major importance.
- operating flexibility;
Equipment leasing may not be for long-term commitments and the lessee may not
fie large capital investment. Therefore, it can maintain maximum flexibility in its
operations to respond to changing business conditions and subsequent production
requirements. It can use a leasing arrangement to meet temporary operating needs
with relative ease, and in the same manner it can test new equipment prior to
making a longer term purchasing decision.
- Obsolescence protection:-
Leasing substantially reduces the risk of equipment obsolescence. Particularly for
those frequently used items that show rapid change like in the high-tech
equipment, leasing may be more advisable than purchasing for the machines
become technologically obsolete in a very short period.

- Financial Leverage
A major advantage of leasing expensive equipment stems from the fact that a
leasing decision typically replaces a large capital out-lay with much smaller,
regularly timed payments. This frees working capital for use in meeting expanded
operating cost or for investment in other segments of the business operations

- Income tax considerations

If a lease fulfills the Internal Revenue service requirements for a “true lease” from
an accounting point of view lease payments are recorded as an operating expenses.
When the depreciation cost that would have been incurred had the item been
purchased is less than the amount paid for lease the tax payment will be lesser,
than the payment if equipment was purchased.

3.4.3 Purchasing Services

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Purchased services play key roles in the successful operations of some
organizations. In some cases, services procurement represents more than 25
percent of the organizations expenditures.

Different types of services can be purchased. Services range from architectural

engineering, promotion and advertising, and the development of software, to the
maintenance and repair of production equipment which may be of critical
importance to the operation of the organization. Nowadays “out sourcing” of
services is taking place in different organizations in the world. Services of cafeteria
and janitorial operations that have impact on the morale of employees can be
purchased. Other services on which organization have less competences such as
management information systems, payroll, travel services, delivery services, etc.
Can be outsourced to service renders. Services on utilities, disposal services,
insurance, guard services, fire protection and the like could be also purchased.
These suppliers have the expertise and economies of scale to allow them to provide
the services at the same or higher quality level than the purchasing firm and at
lower total cost.

Like in the procurement of production requirements and capital equipment, the

most critical ingredient to a successful procurement of services is the development
and documentation of the requirement, therefore, the statement of work is
abbreviated as S.O.W. Similarly, the involvement of qualified purchasing personnel
is one of the keys to success alike its importance in the process of purchasing the
production requirements and capital equipment.

The statement work identifies what the contractor is to accomplish. The clarity,
accuracy, and completeness of thus S.O.W determine, to a large degree, whether
the objectives of the contract will be achieved. Satisfactory performance under the
contract is a direct function of the quality, clarity and completeness of its
statement of work.

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A well written statement of work enhances the contractors performance in pursuit
of S.O.W. objectives. Before writing it, those responsible must develop a thorough
understanding of all the factors that best bear on the project and that are reflected
in the S.O.W.

CHAPTER 4
STORAGE AND MATERIALS HANDLING
Determination of Storage Needs And Storage Cost
The Storage System
Once materials are acquired they do not directly enter in to production nor are
provided to user departments immediately. They should be stored until time of
requirement, for storage guarantees continuity of supply or uninterrupted service
to user departments. The main objective behind the stores functions is to render
service to user departments. The very nature of the storage system is thus to act as
a buffer between acquisition and other various consuming department.

The stores function is responsible for receipt, physical upkeep and maintenance,
and distribution of larger sums of moneys in the form of stocks. The management
of inputs and output flow will require a good deal characteristics and volume of
transaction the reporting, accounting, and verifying system should be devised. The
stores function must be managed and operated in a highly efficient way.

The stores should be considered as a temporary location for materials needed for
operational purposes, and should be planned, organized and operated in such a
way that the life – time of each stock item is as short as possible consistent with
economic operation. The only good reason for carrying operating stocks is that the

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material needed is obsolete redundant or surplus material is simply money sitting
on a shelf requiring more money to be spent on its custody. In general depending
on the nature of the materials if demand is steady or highly predictable then we
should store for very short periods, when demand is not highly predictable then
storage for longer periods may be required.

In a mass production unit, vast quantities of materials and component parts have
to be provided every day large sums of money are involved and it is essential to
organize the stores functions so that the investment is kept to the minimum. A big
automobile factory can use hundreds of thousands worth of material each week.
From the stores point of view the most important thing to keep the quantities of
incoming goods as near as possible to the departments and the machine shops and
assembly shops and assembly shops will use them daily. Shortages must be
avoided or production lines will have to stop. At the same time too much must not
be delivered or/it will close up the warehouse and perhaps also the production are,
apart from the fact that excess deliveries will tie up more capital. So the emphasis
is on the manufacturing schedule and everything is governed by that fact. For
bulky or expensive materials or components, the flow will have to be managed hour
by hour and this demands a vary high degree of cooperation and efficiency.

Storage is thus established with the following objectives:

1. Prevention of waster and/or miss appropriation of materials.
2. Reduced need for material handling equipment.
3. Provision of better storage facilities.
4. Ready accessibility of major materials permitting efficient service to
users.
5. Awareness of limited shelf-life items with a view to stock turnover in
time to prevent deterioration.
6. Efficient space utilization and flexibility of arrangement.

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Any managerial function is exercised to achieve a specific objective for which it is
set. Similarly in achieving the above mentioned objectives, storage performs the
following functions.
1. Receive the material, check quantities and quality against purchase order,
invoices and specification, certifies deliveries and reports shortages,
deficiencies in quality and partial deliveries, and prepares receiving
reports.
2. Provide adequate and proper storage and preservation.
3. Prepare and maintain bin, cards, periodically checks inventory records
against actual stock.
4. Minimize obsolescence, surplus, and scrap through proper codification,
standardization and preservation.
5. Highlight stock accumulation discrepancies and abnormal consumption
and effect control measures.
6. Ensure good house keeping so that material preservation, and stock
receipt and issue can be done accurately.
7. Assist in verification and provide supporting information for effective
purchase action.
8. Keep and maintain store areas in a clean and orderly condition so as to
facilitate handling and preserve all safety regulation and security
measures.

4.2 Materials Handling

4.2.1 Definition and Scope
Why is a material handling important to total materials management? That
question can be answered by asking another question. Why are the veins and
arteries essential to the human body? The answer to this question is fairly simple.
All the vital elements of the human system depend upon the proper flow of blood
through the body. Similarly, total material management system depends upon well-

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organized and integrated materials handling to provide the proper flow of materials
to all essential parts of the business.

Progress in current modern facilities is evident in the use of both mechanized

operations. Peter F. Druker states that in the United States and Europe,
automation still is seen as something for the “big boys”. However, in Japan
automation has been found advantageous for both large and small companies.
Drucker believes that the payoff from automation is both fast and high. Automation
builds quality standards and quality control into every step in the process. Quality
savings outweigh the savings in payroll and manpower and are likely to repay the
costs of automation within two or three years. Other economic benefits and derived
from a reduction in downtime of people and facilities. When production is changed,
from one model or part to another. Reduction of downtime means less constant for
“not doing” and provides additional capacity to generate revenues. Materials
handling has been defined in many ways, but the activity is rather neatly
summarized by the British Standards institution as: Techniques employed to move,
transport, and store or distribute materials with or without the aid of mechanical
appliances. The scope of this chapter is rather narrower than the definition; the
emphasis is on the movement of materials.

Handling materials, which is a major activity in storehouses and stockyards, is a

costly operation and therefore the methods and equipment should be efficient. As
in many other aspects of storekeeping, at the approach depends on the nature of
the business, the kind or stock carried and the since of the accommodation. In
small storerooms dealing with comparatively light materials (eg. A tool store) all the
handling may, in face, be done by hand. At the other end of the scale, in a large
storehouse catering for a wide range of mixed goods with a weekly output
measured in hundreds of tons, while there will be some manual handling, there
will certainly be mechanical equipment for moving the heavy items and this
equipment will probably be of more than ont type. In such a store it is not unusual

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to find overhead cranes, forklifts trucks and conveyors all in operation, with mobile
road cranes and dumpers in the stockyard.

Materials handling is of major importance not only in the stores but also
throughout the production processes. We must not lose sight of the fact that the
handling facilities controlled by the stores department in a manufacturing concern
may have to be correlated the methods employed in the production shops. For the
purposes of this chapter, however, materials handling will be considered from the
stores angle only, that is, from the point of unloading goods on arrival to the point
where why are issued for use.

4.2.2 Materials handling Objectives

Materials handling does not manufacture a product, using operations such as
shaping, cutting, or assembly. It does not improve the quality of raw materials,
work-in-process, or finished goods inventories. However, over the years, as
companies performed various work-related tasks, it become necessary to develop or
find suitable equipment to handle materials. Initially, this equipment provided
solutions to various individual problems, such as movement of heavy loads, storage
of large quantities of materials, and use of available building space. As company
operations become more complicated and business volume increased, the need
developed for materials handling systems. These systems had to satisfy objectives
related to the total materials management program: providing integrated systems,
minimizing total costs, improving integrated systems, minimizing total costs,
improving working conditions, and improving productivity.

Provide Integrated Materials Handling Systems

Materials handling is common to all types of businesses, both in the office and in
operations. Manufacturing, distribution, service, government, and transportation
are just a few of the areas that require materials handling activities to channel on
enormous volume of materials. Materials handling activities can be found at all

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levels of a business. Handling starts with individual work areas, involving one
person. A work center requires movement between various employees. Materials
then flow within individual work centers. Movement continues through various
locations. The overall flow network involves material movement among the
segments of a cycle that starts with suppliers and ends with the ultimate
consumer.

Considering the numerous and diverse business activities that requires material
handlings, it is logical to have an objective that considers integrating all these
facets. Significant gains in cost savings, productivity, customer service, and
reduction of bottlenecks can result from an integrated materials flow system. It is
critical that all individuals involved in materials handling and plant layout have an
integration orientation. They must recognize that changes in one part significantly
affect other elements of the over all flow network.

The cause-and-effect relationships created by changes in the flow net work levels of
the business. For example, one electronics manufacturer discovered that their
customers were receiving damaged products. Assemblies were being packaged on
the assembly line, and the final solution was to use a different configuration for
inner protective packaging, which required enlarging the packaged, which required
enlarging the package size. However, this change on the assembly line affected
storage in the physical distribution areas; the larger packages did not fit into the
flow rack that previously was used to store and pick these units.

Another example of the need to think in terms of multiple network elements

concerns a food distributor. Pails were originally stacked individually in a truck for
shipment to customers. A unit load program was instituted to provide for wrapping
and strapping individual pails into one large unit load. This change permitted
higher storage of materials and faster loading of trucks. However, the
“improvement” brought immediate customer complaints. Some customers did not

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have equipment capable of handling the lads, and faced the new problem of
disposal of scrap utilizing materials.

Minimize Total Costs

Material handling represents a major portion of total costs for every type of
business. Depending upon the nature of the industry, materials handling may
account for 20 to 35 percent of product costs. This activity is an obvious target for
any materials management, cost containment or reduction program. Reducing its
total materials handling cost allows a profit-oriented business to maintain a
competitive edge over its competitors. Non profit businesses can channel these
savings to other segments of the organization that have justifiable, perhaps urgent,
needs for additional funds.

Total materials handling costs can be minimized by various approaches. The most
common method is to directly reduce an existing expense item. For example, a mid
western company that used electric lift trucks to move materials through its facility
was able to reduce its total trucking costs by replacing older units, which were slow
and required frequent maintenance, with new, highly productive units. Another
approach is to invest in equipment that will reduce materials handling activities by
individual employees. For instance, an electronics company purchased a new
assembly conveyor that reduced handling time for each employee, and achieved a
labor savings of $ 12,000 per year, so that the new materials handling equipment
was paid for in less than two years.

To control materials handling costs, analyst first must identify general sources of
potential savings. All company operations should be reviewed to target possible
cost reduction projects. The major sources of material handling costs are space,
labor, inventory, equipment, and waste.

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Space Improvement in space be utilization can reduce costs. Often, the first
solution to apparent overcrowding is to construct an addition or build another
facility. A more positive approach is to look for alternative solutions that would
involve more efficient use of the existing building. One of the most effective options
is to make use of air right or cube space. By increasing the storage height form 12
feet to 16 feet, one company increased its space utilization by 33 percent.

Space costs also can be controlled by changing the size of storage aisles. Changing
from a counterbalanced truck to a side-loader truck could permit a reduction in
aisle width from 10 feet 5 ½ to 6 feet (a 40 percent savings). Frequently, the empty
space above operational areas can be given new uses, such as conveying waste
materials or production parts and assemblies.

Labor. There are many opportunities to reduce handling costs in labor intensive
operations. This is true for both manual labor employees and more highly paid,
skilled employees. The use of mechanized system can be an effective means of cost
reduction. For example, a Chicago electronics company originally required
incoming inspection personnel to transport loads of materials to and from their
workbenches. A conveyor system was installed to perform this materials handling
activity, which resulted in a 15 percent labor cost reduction.

Automated systems can considerably reduce labor costs. Many applications exist in
manufacturing, government, distribution, and transportation. For example, the
United States Postal Service installed automatic mail handling and processing
equipment to reduce labor costs and improve flow. The Yamazaki machinery works
in Nagoya, Japan, operates 18 machining strive to minimize inventories, as
inventory reduction offers tremendous cost-reduction opportunities. Materials
management programs that have been instituted to accomplish this objective
include Kanbn, Just-In-Time, and material requirements planning (MRP). These

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programs all depend on having an optimum flow of materials for successful results.
Dependable materials handling systems can provide the required materials flow.

Dramatic reductions in inventory have been achieved by installing new materials

handling systems. The Schweizer Turbochargers Company implemented an MRP
system that called for installation of two automated storage retrieval systems
(AS/RS). The equipment was justified by a 30 percent inventory reduction. The
General Electric Company uses a mini-computer in one facility to direct a truck
operator. The truck is equipped with a terminal that provides instant
communication. The total system has resulted in a 50 percent reduction in work-
in-process inventory as well as other benefits

Equipment. Improvements in materials handling equipment can reduce cost.

Numerous illustrations can be found in the transportation industry. For example,
in cargo ship loading and unloading, every day that a ship is in port means
increased cost for the operating company; so it is critical that loading and
unloading be performed expeditiously. Vessels called container ships, designed to
transport containers that hold large amounts of materials, are being used because
they can be loaded and unloaded in record time.

An AS/RS unit installed by Bethlehem Steel Corporation exemplifies the many cost
effective features of materials handling equipment. It is 105 feet high, and allows
storage of 6200 coils in less than 90,000 square feet. Manual effort has been
virtually eliminated in this unit. The use of a computer in conjunction with the
AS/RS has reduced order picking time and eliminated product damage. Power and
free conveyors are use to carry coils form production. Coils can go directly to
storage, bypass the AS/RS, and continue to a processing area, or they can move
directly to shipping.

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Product Quality. Successful material management systems required good-quality
materials. To avoid the negative effects of product damage, quality control systems
of the future increasingly will depends upon properly selected and designed
materials handling methods. One of the most common ways to reduce cost is to
decrease damage to materials. Concentrated efforts to eliminate the waste of
damaged materials through better handling techniques and practices will yield
substantial results. Damage control should start with initial layout design of the
materials handling system. Another detergent to materials damage is an effective
personnel-training program.

Some material are more susceptible to spoilage than others; so materials items. For
example, flow racks provide FIFO (first in, first out) rotation of stock, ensuring early
dispersal of the older stock. Another method of reducing waste costs relates to
scrap materials. Selective handling of scrap, where values and volume warrant it,
will result in higher scrap revenues. Separation of scrap can be beneficial with
different types of material, including metals and corrugated box materials.

Improve Working Condition

Improving employee working conditions is a basic objective of total materials
management. There is excellent justification for directing attention to this area,
involving human considerations as well as the profit motive. Good employee
working conditions contribute to the general success of an organization.
Companies that have instituted productivity improvement programs have found
that focusing on areas related to material handling, such as providing safe work
areas, reducing employee fatigue, and enhancing the quality or the work life, is an
extremely effective means of improving productivity.

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Safety. Mechanization of materials handling reduces the possibility of accidents.
Manual handling is a common cause of feet and back injuries, as well as hernia,
and takes a toll in medical expenses, lost productivity, and reduced customer
services. For example, back injuries associated with industrial jobs account for
about 25 percent of all lost job time and result in an annual expenditure of more
than one billion dollars for compensation payments, according to one insurance
company study.

The primary way to reduce materials handling accidents is to develop and

implement a safety program, which can be part of a general safety program. Some
safety requirements are stipulated in occupational Safety and Health
Administration (OSHA) standards. Rules and producers for safe handling should be
developed and monitored. These regulations will cover areas such as
housekeeping , use and maintenance of mechanical handling equipment,
unionization, and storage. Training programs should be conducted to instruct
employees. Posters, booklets, safety committees, meetings and articles in company
newsletters are among the many ways of stimulating employee safety
consciousness.

Quality of Work Life There are numerous ways to improve the work
environment. One goal of this effort is to increase the level of employee satisfaction.
Most workers devote a high percentage of their total productive hours to their firm’s
activities; so it is important that the hours spent at work be as pleasing as
possible.

The materials handling function can do much to improve the quality of the
individual’s work life. Volvo, the Swedish automobile manufacturer, has become
well known for its success in this area. The key to its most publicized achievement,
at the Kalmar assembly plant, was a mechanized materials handling system. A
“Kalmar wagon” was developed to carry the auto body frorm one assembly area to

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another. This assembly wagon made it possible to replace the conventional fixed-
speed assembly line’s rigid control with a much looser manufacturing process, in
which the auto stops at various assembly station during long periods, creating new
possibilities for humanization to the workplace are endless, and that monotonous
jobs can be improved to provide employees with a better work environment. The
materials handling system enhanced the quality of the work life in many ways; it
reduced fatigue improved job satisfaction, provided flexibility in work organization
within assembly groups, and created a small workshop atmosphere in a large
manufacturing facility.

Improve Productivity
Business publications refer continually to “productivity”. Productivity can be
defined as:
1. The ratio of effective or useful output to the total output in any system
2. The relationship between the amount of work accomplished and the
amount of labor necessary to accomplish it
3. the efficiency of people/machines

Productivity is important to all countries as they compete in world markets.

Increase in productivity can significantly affect the average citizen’s standard of
living. At the individuals company level, productivity is a means for minimizing
costs and providing positive benefits in competition with other firms. The output
per person-hour for minimizing costs and providing positive benefits in competition
with other firms. The output per person-hour for U.S. manufacturing has been
climbing steadily, rising between 1981 and 1987 to equal West Germany, but it
lags behind that of Japan.
A major objectives of materials handling is increased productivity, which can be
accomplished in many way. The use of flow racks can reduce waling by employees
in picking warehouse orders. Replacement of defective and/or older-model
equipment will reduce downtime for employees and equipment, as well improve

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operational efficiency. Increasing materials flow by installing new materials
handling systems will eliminate bottlenecks and yield a greater output. Reducing
damage to materials, be better handling methods and procedures, will decrease
materials shortages and improve customer service. There are countless other ways
to improve productivity through materials handling innovations.
Benefits of proper materials handling and major considerations
Carefully planned and operated materials-handling policies can result in the
following benefits:
1. Reduced handling costs
2. Greater economy in use of space (through higher storage density)
3. Reduced risk of damage to stocks
4. Reduced labor requirement
5. Less fatigue
6. Increased safety
Basic considerations
The variety of factors affecting the handling of materials makes it very difficult to
enumerate all the basic principles. Each problem must be examined on its own
merits according to the physical and financial circumstances prevailing in the
organization concerned. Subject to this proviso, the following points should be
considered when examining any stores-handling problem:
1. The position of the storehouse
2. Handle ability of the materials
3. The case for manual handling
4. The method of packaging incoming materials
5. Economy of movement
6. the selection of suitable machines
7. the storehouse layout
8. Training of operators.

4.2.3 Materials Handling Principles

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The college-Industry council on materials handling education (CICMHE) is an
independent organization that prepares and provides information, materials, and
activities to support materials handling institute, Inc., developed 20 principles of
materials handling. Webster’s New World Dictionary defines a principles as “a
fundamental truth, law, doctrine, or motivating force, upon which others are
based. “These 20 principles represent they are simply application of common
sense.

The CIC-MHE principles can be applied as building blocks for the analysis and
design of any new facility. These fundamentals are an invaluable resource for
materials management personnel seeking materials handling design improvements.
It has been said that anyone indoctrinated with the 20 principles can walk through
almost any existing building and develop beneficial short-term and long-term
improvements:

1. Orientation principle: Study the system relationships through prior to

preliminary planning in order to identify existing methods and problems, and
physical and economic constraints, and to establish future requirements and goals.
Typical applications of the orientation principle are:
A. Review the entire facility from the point of incoming materials through
various operations and outgoing shipments to be familiar with all existing
materials handling equipment and practices.
B. Use basic analytical techniques, such as from-to charts, flow process charts,
and product quantity charts to determine potential improvement areas.
C. Determine management’s long-term plans regarding new products, changes
to existing products, forecasted customer demand, and financial constraints.

2. Planning principle: Establish a plan to include basic requirements,

desirable options, and the considerations of contingencies of all materials handling
and storage activities. Typical applications of the planning principle are:

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A. Provide appropriate staging areas for temporary storage of materials at
strategic locations
B. Design materials handling systems that provide for accumulation, where
operational volumes can vary
C. Consider providing manual overrides for automate operations in case of
equipment failure

3. Systems principle: Integrate those handling and storage activities that are
economically viable into a coordinate system of operation including receiving,
inspection, storage, production, assembly, packaging, warehousing,
shipping, and transportation. Typically applications of the systems principle
are:
A. Avoid re handling by using the materials handling system to transport
materials through as many operations as possible.
B. Coordinate handling activities with suppliers, customers, and transportation
carriers.
C. Provide alternative handling methods for emergency situations.

4. Unit load principle: Handle product in as large a unit as practical. Typical

applications of the unit load principle are:
A. Consider development of optimum-size loads to increase productivity of
equipment, storage space, and personnel
B. Design unit loads for safe storage and handling
C. Provide suppliers with specifications for unit’s loads that are desirable for
internal receiving, storage, and dispersal

5. Space utilization principle: Make effective utilization of all cubic space.

Typical applications of the space utilization principle are:
A. Use pallet racks, stacking frames and other materials handling equipment to
provide higher storage

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B. Design corrugated cartons to allow use of floor storage space at maximum
heights, without damage to materials
C. Reinforce floors to allow heavier floor loading and provide for higher stacking
of materials.

6. Standardization principle: Standardize handling methods and equipment

wherever possible. Typical applications of the standardization principles are:
A. Establish and adhere to standard container sizes
B. Determine and specify standard equipment specifications in order to reduce
spare parts inventories and decrease training time for maintenance
personnel and operators.
C. Develop written procedures that provide standard methods for all handling
activities
7. Ergonomic principle: Recognize human capabilities and limitations by
designing materials handling equipment and procedures for effective
interaction with the people using the system. Typical applications of the
ergonomic principle are:
A. Reduce load sizes or use mechanized equipment whenever loads are too
heavy for manual handling.
B. Select materials handling equipment that provides readily accessible controls
and that can be easily seen
C. Design materials handling systems that employee body movements to reduce
fatigue and injury.

8. Energy principle: Include energy consumption of the materials handling and

materials handling procedures when making comparisons or preparing
economic justifications. Typical applications of the energy principle are:
A. Reduce the amount of energy required for heating building areas by
employing automated storage retrieval system (AS/RS)

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B. Establish a preventive maintenance program to assure equipment operating
at peak efficiency and to reduce energy costs.
C. Eliminate heat loss by sealing gaps around overhead dock doors and
insulating the doors.

9. Ecology principle: Minimize adverse effects on the environment when

selecting materials handling equipment and procedures. Typical applications
of the ecology principles are:
A. Select materials handling equipment for enclosed operations that does not
generated dangerous fumes
B. Design materials handling systems that conform to OSHA (Occupational
Safety and Health Act) sound level regulations
C. Establish housekeeping procedures and regulations to provide a good
employee environment.

10. Mechanization principle: Mechanize the handling process where feasible to

increase efficiency and economy in the handling of materials. Typical
applications of the mechanization principle are:
A. Use wire guidance systems for narrow-aisle trucks to reduce operator driving
activities.
B. Reduce employee fatigue and increase productivity by using mechanized
materials handling equipment instead of manual handling
C. Avoid excessive mechanization or automation

11. Flexibility principle: Use methods and equipment that can perform a
variety of tasks under a Varity of operating conditions. Typical applications of
the flexibility principle are:
A. Employ random-path flow conveyors where a variety of products can be
assembled on the same line, at the same time

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B. Use wire containers, which can contain a variety of materials, can be stacked
to high levels, and can be stored in racks.
C. Recognize the flexibility afforded by lift trucks that use a variety of
attachments.

12. Simplification principle: Simplify handling by eliminating, reducing or

combining unnecessary movements and/or equipment. Typical applications
of the simplification principle are:
A. Utilize basic industrial engineering methods for motion economy.
B. Develop materials handling procedures and flows that eliminate re handling.
C. Minimize employee walking by strategic location of materials, equipment
controls etc...
13. Gravity Principle: Utilize gravity to move materials wherever possible, while
respecting limitations concerning safety. Product damage and loss. Typical
applications of the gravity principle are:
A. Employ gravity flow conveyors to provide non powered movement and FIFO
materials rotation.
B. Use roller conveyors, wheel conveyors, chutes, etc.., between operations.
C. Use spiral chutes to move materials between floors.

14. Safety principle: Provide safe materials handling equipment and methods
that follow existing safety codes and regulations in addition to accrued
experience. Typical applications of the safety principle are:
A. Develop, promulgate, and enforce safety rules, regulations, and work
methods.
B. Inspect equipment regularly to ensure that safety devices are operating at
desire.
C. Maintain aisles that are unobstructed, without debris and wet or oily
conditions.

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15. Computerization principle: Consider computerization in materials handling
and storage systems. When circumstances warrant, for improved materials
and information control. Typical application of the computerization principle
is:
A. Use computer-controlled automated guided vehicle systems (AGVS) for
automatic routing and positioning and to provide efficient materials flow.
B. Employ computers to generated directive information to mechanized order
picker operations, using video display and keyboard consoles on board the
truck.
C. Integrate various island of automation by means of conveyor transfer and
storage using programmable controllers.

16. Systems flow principle: Integrate data flow with the physical materials flow
in handling and storage. Typical applications of the systems flow principle
are:
A. Use move tickets to provide manual control systems, where applicable, to
maintain information regarding materials movement and storage.
B. Employ AS/RS systems for both automated materials movement and
inventory control.
C. Design automated routing of parts from one work station to another and
maintains accurate production and inventory records thought the use of
automatic identifications systems.
17. Layout principle: prepare an operations sequence and equipment layout for
all viable system solutions; then select the alternative system that best
integrates efficiency and storage. Typical applications of the layout principle
are:
A. Identify major objectives and factors for the materials handling system to
provide standards for comparison of alternative solutions.
B. Utilize the input of other in generating viable alternative layout designs.

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C. Apply quantitative techniques such as queuing theory and simulation to
evaluate, compare, and test the feasibility of alternative solutions.

18. Cost principle: Compare the economic justification of alternative solutions

in equipment and methods on the basis of economic effectiveness as
measured by expense per unit handled. Typical applications of the cost
principle are:
A. Select a common, convenient, standard unit to ensure equitable
comparisons.
B. Use the economic justification for the selected alternative solutions as a basis
for future audit.
C. Recognize that maximum economy in expense per unit handled is not always
the overriding goal, as in the case of need for higher production and safer
working conditions.

19. Maintenance principle: prepare a plan for preventive maintenance and

scheduled repairs on all materials handling equipment. Typical applications
of the maintenance principle are:
A. Require daily inspection of equipment by operators using easily completed
check sheets.
B. Provide adequate maintenance facilities and qualified personnel.
C. Maintain maintenance records for individual pieces of materials handling
equipment.

20. Obsolescence principle: prepare a long-range and economically sound

policy for replacement of obsolete equipment and methods with special
consideration to after tax life–cycle costs. Typical applications of the
obsolescence principles are:
A. Establish a company policy regarding replacement of materials handling
equipment

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B. Develop a yearly budget for replacement of materials handling equipment
C. Do not allow supervisors to fall into the habit of “string saving,” continuing to
keep older, less productive equipment.

4.2.4 Typical Equipment and Applications of Materials Handling

Devices
Materials handling problem analysis normally involves some type of equipment.
Materials management personnel responsible for developing solutions must become
acquainted with the large and constantly increasing types of available materials
handling equipment and their application. Frequently, an individual piece of
equipment cannot accomplish the desired results. A beneficial solution often
requires various pieces of equipment that together comprise an integrated system.
Therefore, the designer must have knowledge of individual pieces of equipment,
optimum use of the equipment, and how to integrate one piece of equipment.
Equipment may be required to move materials over many different paths,
accommodate significant changes in sales volume, and handle a variety of
products. Flexibility has its trade-offs. For example, special-purpose equipment can
lower unit costs, but it may not be able to handle a variety of products or apply to
different applications. Current trends in equipment provide low-cost handling as
well as flexibility. For instance, automatic guided vehicle systems have increasing
application in conventional plants and warehouse operations and also serve as an
integral part of flexible manufacturing systems. Generally there are two categories
of materials handling devices: hand-operated and power –driven.
4.2.4.1 Hand –Operated Equipment
Hand trucks and sack barrows
The common wheelbarrow is ideal for carrying small quantities of sand, gravel and
other loose materials, particularly in stockyards.

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Sack barrows are naturally intended for bagged goods, and they are still widely
employed in spite of the increasing trend towards mechanical handling of this type
of store.

Selector trucks
Selector trucks are extensively used where incoming and/or outgoing
consignments consist of numbers of varied items of reasonable size and weight
held in fixed locations in different parts of the building; for example, machinery or
transport spares. The operator can conveniently deal with a list of items by
wheeling the truck round the various bins or racks, picking out the articles as
he/she goes along and placing them on the truck until he/she has complete a
compete consignment, when he/she takes the load to the issue counter. Mixed
incoming consignments are put away in their appropriate locations by the reverse
process. Select trucks may be two-wheeled and there are several variations in size
and shape. Supermarket trolleys are useful for this purpose.

Silage trucks
These consists of wheeled platforms managed by a drawbar. As a rule they are
fitted with a small hydraulic unit, actuated by ‘pumping’ the drawbar to raise or
lower the platform a few inches. In operation, the truck platform, in the lowered
position, is run in between the legs of silage; the platform is elevated, thus lifting
the silage clear of the floor, and the truck, complete with load, is wheeled away.

Pallet trucks
These are very similar to silage trucks, except that they are fitted with forks instead
of a rectangular platform and are, of course, designed to handle pallets and not
silages.

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Hand Stacker
A hand stacker consists of a vertical framework of angle iron carrying a platform
which can be raised or lowered for stacking or un stacking. It is based on the
windlass principle, or alternatively the lift is hydraulically actuated.

Pulley blocks
This is geared pulley system fixed to an overhead beam and fitted with a lifting
hook at the end of a chain. A separate endless chain is used to operated the
mechanism. Blocks are not fast in operation, but are suitable where the need for a
heavy lift is only occasional.

Monorails
A monorail is a single ‘I’ section rail fixed overhead and bearing small wheeled
trolleys which run on the rail. From the trolleys, loads can be suspended and then
moved by hand along the rail to their appropriate destination. Monorails are often
used in conjunction with pulley blocks for handling heavy loads out of or into
vehicles in receipt or dispatch bays.

Chutes
A chute is a wooden or metal trough inclined at such an angle that articles will
slide down when placed upon it. Chutes are used for transporting stores from
upper to lower floors, but they are convenient only for loose materials, robust
packages or other goods not liable to damage.

Roller Conveyers
These are made of a metal framework bearing horizontal rollers spaced at intervals,
and the goods to be conveyed are pusher along the top of the rollers. Conveyers will
transport materials between floors in the same way as chutes, and can also be
used for horizontal movement at or above floor level. They can be built up in

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portable sections and rearranged as required. Roller conveyers are generally used
for fairly heavy packaged goods.
In many storehouses, a large proportion of the item in stock are binned or racked
by hand or with manually operated trucks or trolleys. Shelves and racks should be
arranged back to back as far as possible to save space and traveling time, and
gangways need to wide enough only for pedestrians with small trucks. The
minimum width can be 75 cm, but in most cases one meter will be found more
comfortable for walkways between rows of bins, the main gangways down the
middle of the building, and perhaps also at the sides, should be wide enough to
allow two people with trucks to pass each other and to accommodate a motorized
vehicle if one is required from time to time.

4.2.4.2 Power-Driven Equipment

No attempt can be made here to classify and describe exhaustively all the available
types of power-operated materials-handling equipment, or to examine the many
variations of each type. For present purposes, materials handling is being
considered in relation to storehouse and stockyard work only, and the following
paragraphs seek merely to given an indication of some of the equipment most
frequently encountered in stores work.

Fork-lift trucks
The most important type of mechanical handling equipment encountered where
lifting and stacking operations are to be performed is the fork-lift truck; there is
today an enormous range of types and sizes of such vehicles available, ranging
from pedestrian operated stacker trucks to giant machines capable of handling
containers weighting 40 tones. The important types are described in the following
paragraphs.

Reach trucks. In this type of vehicle the forks can be accommodated within the
wheelbase of the truck while goods are in transit, and projected by moving the

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mast and forks forward when a pallet or other load is to be lifted. The advantages of
this type of truck are that there is no need for heavy counter balancing, so the
mass and length of the truck can be reduced, and because the truck travels with
the forks dawn back within the wheelbase, it can turn more easily in a confined
space. The gangway requirement for a 2 tone machine would be approximately 2.3
meters as opposed to about 4 meters for a counter balance truck. (See fig. 14.3)
Side-loading trucks. These trucks are a variation on the reach truck theme, but
the mast and forks can be projected from the side of the vehicle rather than on a
fore and aft basis. These trucks are particularly useful where lengths of materials
such as piping or timer are stored alongside aisles, and can operate in a gangway
only 750mm wider than the truck itself. If is possible to acquire side-loading reach
trucks equipped so that all wheels can be turned through 90 0, enabling four-way
travel and further increasing the versatility.

Order Pickers
In organizations where mixed loads have to be taken and collated from bulk store,
order picking machines are commonly employed. A variety of types are available,
such as those with from or side lifting forks, machines with which use a special
latch on silage, or those with a cage arrangement around the pallet so that the
operator can walk out on to the pallet to pick bulky items. An order picker differs
from a fork-lift truck in that the operator rises so he/she can hand-pick goods from
storage.

Platform trucks
These are of two types: fixed-platform and platform-lift trucks. The lifting-platform
variety is based on the same principle as a ‘low lift’ fork-lift machine, but instead of
forks it has a platform which can run under a suitable container or silage and lift

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the load clear of the floor. Both types of platform trucks are best used where stores
have to be carried fairly long distances.

Tractors
Tractors of various sizes we found in storehouses and stores to be moved. The use
of two or more trailers per tractor in suitable circumstances is economical, because
the tractor can be transporting one or more trailers while other are being loaded or
unloaded, thus getting the maximum loading facilities and the maximum work
from one powered unit. This kind of vehicle is, like platform trucks, most suitable
for long hauls. Some tractors can be fitted with various attachments for particular
jobs, such as forks for handling pallets or buckets for sand and gravel. Tractors
can also be useful for shunting railway wagons, or pulling narrow-gauge rail
trolleys.

Cranes
Overhead electric cranes
Weights of stores to be handled seldom exceed 10 tones at a time and this is well
within the capacity of overhead cranes. There are special cases where bigger
machines are used, but 5-tones and 10-tones overhead-electric traveling cranes
are the sizes most commonly to be found engaged on stores work. There are two
main types: floor controlled and cab-controlled. In the first case there is a control
panel attached to a cable leading from the crane ‘bridge’ overhead; the operator
holds this panel in his hand to control the machine walks up and does underneath
it as it travels to and from along its rails, which are supported on the columns of
the building. In the second case, the crane is managed form above by an operator
sitting in a cab mounted in the crane bridge. Floor control is best where use of the
crane is spasmodic, as the operator concerned can easily move off to do other jobs
when he is not required for the crane. Cab control is quicker to operate and more
satisfactory when the machine is in continuous use, but it is more expensive.

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Overhead cranes are very satisfactory for heavy lifts, particularly when loading or
unloading road vehicles or railway wagons with ‘box’ bodies. They can serve the
whole area enclosed between the rails supporting the crane bridge as far as the
rails extend and only a few gangways, wide enough to allow the slingers access, are
required. There is a ‘dead area’ all along both sides of the building under the crane
rail which cannot be served by the crane, but this can usually be occupied by
stacked or palletized goods. The method of storage under the overhead crane itself
depends on the nature of the materials and the maximum height of the crane hook.
Circumstances vary greatly but, as far as is possible, items should be stacked one
on top of another, either with or without the assistance of boss pallets, cradles or
other devices. Overhead cranes can be employed for outside work, but a special
supporting structure has to be set up to carry the rails and the carne itself and the
capital cost is heavy. Therefore they are best employed in stockyards only where
substantial tonnage’s are involved and the throughput is high.

Goliath cranes
A Goliath crane is a special version of the overhead traveling crane. Instead of
erecting an overhead gantry track all along the traveling distance, the crane is
mounted on legs fitted with wheels, and the whole structure moves along railway
lines set in the ground.

Stacker cranes
In large store houses economic consideration may lead to the adaptation of stacker
cranes, which perform similar lifting and transport actions as a fork-lift truck. They
operate from an overhead fixed track set above the aisles. Suspended from this
track runs a carriage with a driver’s cab below which is a post reaching practically
to ground level. Forks travel up and down this post and also rotate about it. Pallets
can thus be raise or lowered and inserted and withdrawn from the racks. The aisle

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width can be reduced to thus space required for the maneuver of the post and
forks. Disadvantages are high installation costs and inflexibility (it being restricted
to the fixed track.

Mobile job cranes (road)

Machines of this nature are not particularly suitable for inside work because they
are mounted on wide-wheeled chassis which require wide gangways and the long
jibs need high doorways for clearance, but they are very useful in a stockyard. They
can be designed for much heavier lits, but the commonest types in use for stores
work are from 2 to 6 tones, with jobs up to about 12 meters or so, which can be
lifted or lowered to increase or decrease the reach of the crane. When the
superstructure chassis, the equipment is described as a ‘slewing’ crane. Practically
all Mobil road cranes are of the slewing type.

Locomotive cranes
These are rail-mounted, self-propelled job cranes somewhat similar to the Mobil
road crane. They are, of course, suitable only for use in stockyards served by
railway lines.

Powered Conveyers.
There are four main types of powered conveyer employed in storehouses: roller,
belt, overhead towline and sub-floor towline.

Roller conveyers
These consist of a metal structure carrying horizontal rollers spaced at suitable
intervals. The rollers are revolved by means of a chain or belt driven from an
electric motor, and the goods to be transported slide along the surface of the
rollers.

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Belt conveyers
These are made of endless lengths of rubber, canvas, PVD or other appropriate
material. At one end, known as the ‘head’, the belt passes round the outside of the
drum driven by an electric motor, suitably geared. At the other end, known as the
‘tail’, the belt passes round another drum, which is free to revolve and not power
driven. Between the head and the tail, the belt is stretched tightly and supported
by idler rollers spaced at intervals along its length. Material handled is carried on
top of the belt. Slat, plate, bar and chain conveyers are variations of this based on
the same principle.

Automated guided vehicles

Truckes with no driver, but guided automatically, are now fairly frequently
encountered in the storehouse environment. The first systems used for pallet
transportation were developed in Sweeden in the early 1970s, though widespread
adoption of AGVs (as these trucks are usually called) did not take place until the
late 1970s. It is the developments in computer technology which have made it
possible for these vehicles to compete with and replace normally driven trucks.

Robots
Many handling operations associated with storage and distribution are fairly
repetitive, yet need to be undertaken with some precision. They are not very
different in fact from the assembly tasks and machine loading and unloading
operations in which robots are already fairly widely employed. It has been
suggested that there will be rapid growth in the use of robots in storage, packing
and handling activities. The advantages are obvious, in that the work can be done
more consistently, at a faster rate, with no labor costs. Frequently an analysis of
the cost of acquiring and operating a robot as compared with labor cost is the sole
criterion for making the investment decision, but ‘incidental’ benefits arising from
their adaptation are discovered later, such as improved quality, less damage to
materials handling and smoother flows leading to lower inventories. Robots are

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proving valuable in reducing the effects of skill or labor shortage, and bring
benefits in avoiding the need for difficult manual handling tasks and the associated
risk of accident or injury.

Palletizing is an activity which has been found to be very appropriate for the
employment of robots. Robots differ from earlier crude palletizing machines in that
they can be programmed to palletize different package sizes, insert slip sheets and
position of the completed unit loads. Robot palletizes have been combined in some
case with pallet wrappers.

The organizations which are marketing robots for handling purposes stress that
potential users should give thought to designing their systems and procedures for
automation. It is seldom the case that robots can be used to displace manpower
without some radical changes to the organization and flows of work.

4.3 Decision in Materials Handling

A large variety and size of material handling equipment may be available, and
choosing the proper equipment is always a difficult process. Primarily it may be
based on the cost factor that includes the following.

Investment
Labor
Maintenance cost
Replacement of spares
Operational cost etc...
The choice of equipment may also rest in various parameters in relation to the
principles of Materials handling discussed earlier. Generally the critical factors that
affect equipment selection are following:
Material characteristics
Nature of movement

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 Equipment characteristics such as speed noise, life fumes flexibility,
reliability etc
Cost considerations

4.4 Maintenance and Replacement

All equipments are subject to natural wear and tear and if not accompanied by
proper maintenance, their rated capacity, desired level of performance and
reliability will be lowered down. Rated capacity, accepted quality, and available
working hours can be determined by maintenance.

Maintenance hours and machine down time are also inversely related with
production hours of equipment. Moreover, it involves timely and planned supply of
spare parts. There are two types of maintenance: preventive and repair (breakdown)
maintenance.
Preventive maintenance is also called planned maintenance. It is always preferred
to repair maintenance for the following reasons.
a) it can be scheduled in light of facility and availability of manpower
b) Preventive maintenance prevents unnecessary work stoppage
In some cases standards of cleanliness and neatness, and operational procedures
are considered as part of preventive maintenance.
Preventive maintenance card be conducted in three ways.
i) Preventive Maintenance based on calendar time-maintenance at regular
intervals.
ii) Preventive Maintenance based on usage time – after seems prudent as
revealed by planned inspection.
Derating, in some cases, is also considered to be the fourth method of preventive
maintenance.
Deratins is running an equipment at speeds (or loads) lower than their rated
capacity such as preventing the equipment from:
- Overheating

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 - Excessive friction
- Defective performance
Maintenance is thus an important factor in the decision of purchasing or leasing
equipment because more machine breakdowns lead to idle time of workers.
Depending on the complexity and number of machines to be used, maintenance
can be done by one or more of the following methods.
i) Service construct with the manufacturer or independent service
organization
ii) Interned service department within the organization
iii) On per call basis with no contract.

Replacement
The reasons for replacement are obsolesce and depreciation
Obsolesce – when technologically superseded by a new.
Depreciation – when it works for at longer time.
Thus management should predict the cost of its equipment needs annually. There
is a need for closely controlling the replacement schedule of the machines to
minimize extensive reconditioning, replacement of parts and special cleanings.

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 CHAPTER FIVE
INVENTORY MANAGEMTN
Learning Objectives

The main purpose of this chapter is to introduce students with the major concepts
of inventory management. Therefore, after completion of this chapter students
acquire the basic skills and knowledge to effectively and efficiently manage
inventories of organizations. Specific techniques of inventory management are
presented to support the discussion. Thus at the end of this chapter students will
be able to:

1. Define the concept of inventory control

2. Describe the importance of inventory control
3. Identify types of inventory
4. Find out the consequences of excess inventory
1. Mention types of inventory costs
2. Discuss inventory control techniques

5.1 Introduction
Inventory constitute one of the most important elements of materials management
in any organization dealing with supply, manufacture and distribution of goods

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and services. It is a major type of control system applied in most organizations. The
meaning of inventory can be defined in the following two ways (Ahuja; 1992):

1) Inventory is defined as “ any idle resource of an enterprise”. The concept

of idle resource in this definition means that it is not kept for immediate
use and shows the importance of having some inventories for the smooth
functioning of an organization
2) Inventory is made of all those items ready for sale of items that keep the
process running well. Inventory is a stock of materials that are used to
facilitate production or to satisfy customers’ demand. The concept of
inventory control is as old as the concept of business itself. But the
practical application of inventory management got emphasis after the
second World War. The development of operations research and computer
technology paved the way for the practical application of inventory
management
Inventory can be classified into three major types. These are raw materials, work-
in-process, and finished goods inventories.

1. Raw materials inventory

Raw materials inventory refers to raw material parts, components, and other basic
inputs that go into the production or service process

2. Work-in-process inventory
Work-in-process inventory refers to the stock of items currently being transformed
into a final product or service. It includes semi-finished products at various stages
in the production operation.

3. Finished-goods inventory:
Finished-goods inventory refers to completed products ready for shipment, or
awaiting for sale or transit to a customer. Organizations that provide services like

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hospitals, management firms etc don’t have finished –goods inventory since their
service couldn’t be stockpiled

5.2 Significance of Inventory Control

There are several reasons why organizations should maintain inventories of goods.
The fundamental reason for doing so is that it is either physically impossible or
economically unsound to have goods acquired in a given system precisely only
when demands for them arise. Without inventories, customers would have to wait
until their orders are to be filled from another sources or unit they are to be
manufactured. However, customers will not or cannot allow waiting for long periods
of time. For this reason alone, the carrying of inventories is necessary for almost all
organization that supply physical goods to customers (Dewan and Sudarshan;
1996)

There are also other reasons for holding inventories. For instance, the price of some
raw materials used by manufactures may exhibit considerable seasonal
fluctuation. When the price is low, it is profitable for organizations to procure a
sufficient quantity of it to last through the high price seasons and to keep it in
inventory to be used as need arises in production. Another reason for maintaining
inventories especially for retail establishments is that sales and profits can be
increased if one has an inventory of goods to display to customer.

In general, inventory control has the following major advantages

i. Introduction of a proper inventory control system helps in keeping
the investment in the inventories as low as possible.
ii. Ensures availability of materials by providing adequate protection against
uncertainty of supplies and consumption of materials
iii. Allow full advantage of economies of bulk purchase and transportation
iv. Reduce changes of going out of stock
v. Leads to reduction in inventory levels

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 vi. Releases more capital for other operations
vii. Increase profitability of an organization
viii. Helps to render adequate customer services
ix. Renders advantage of price discounts from bulk purchasing
x. Provides flexibility to allow changes in production time due to changes in
demands or any other reasons, and
xi. Even-out workloads on the shop in the face of fluctuation demand

On the other hand, according to Ahuja (1992), the following issues need special
consideration to get the advantages from inventory management.

i) The need to minimize the existence of time lags between manufacturing,

and transport operations
ii) The need to schedule various stages of the system independently
iii) The need to meet the fluctuation in demand and production rates
iv) The need to maintain control over the quality of the finished product
v) The need to exercise influence over changes of materials.

All the above factors involve cost. The inventory control is mainly concerned with
making optimum decisions with respect to the variable, which are subject to
control. Inventory is an idle resource, which is useable and has value. The idle
resource may be human resource, money, materials, and plant acquisition. The
human resources, capital and plant acquisition problems are essentially inventory
control problems.

The scientific inventory management helps the purchase department to determine

when to buy and how much to buy. The important thing is measuring and
analyzing the cost to have inventory and the cost not to have inventory concerned
unit must look at these issues seriously. An example is given below to describe the
cost to have inventory and the cost not to have inventory.

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The inventory control exists in some form in every business. The system in a
particular company may be format or formal, cheap or expensive. In one case
control may depend upon the efforts of a large control staff while in another the
responsibility may rest with the company manager and the foreman.

Inventory control determines the level of compositions of inventories or parts,

materials and products that will most effectively protect the production, sale, and
financial requirements of the business. A system of production planning and
control is not an end in itself. It can only be justified because it:
 Provide the means for effective coordination of the production department
with other departments of the business and
 Promotes effective shop operations through its control of activities within the
production department itself.
In any given company a good system of planning will strike the best possible
balance between the required amount of control and the overhead cost entailed in
achieving it.

5.3 Problems Associated with Excess Inventory

Having the over required volume of inventory may create the following
disadvantages (Ahuja; 1992):
 Essential though they are, inventories also mean locked up capital that could
have been invested in another profitable venture.
 Excess inventory adds to the cost of carrying the inventory, more store space,
equipment, personnel, insurance taxes, pilferages etc..
 Excess inventory invites risk of deterioration and obsolescence
 Changes in the price of inventory materials may go up unfavorable
 Cost of money for maintenance will be high.

Because of the above reason, organizations need to control their inventory level
appropriately. An organization, which finds that different portion of its inventory

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present different problems, will have three general methods of control to choose
from. These are elimination of certain inventories, semi automatic routines, and
periodic review.

To sum up, every organization has materials to stock. The type and qualities of
stock may differ from organization to organization. Inventory includes different
types of raw materials, components and parts, work in progress, including sub-
assemblies, finished goods, spare parts, other operating supplies, utilities and
consumable items(Lenders et. al., 1989). Inventory tie-up capital that can be
invested in another business, require storage space and need proper handling.
Inventories may deteriorate and become obsolete, incur taxes or require insurance.
There are also cases in which materials or goods can be lost or stolen.

Therefore, appropriate inventory management must be in place to solve the above

problems. The objective of materials management has to be guaranteeing a proper
amount of stock at a lower cost. Meaning, inventory management strives to ensure
the maintenance of stock at each level of supply.

Employees working in the area of materials management and special inventory

management has to consider the cost impact of having high or low stock level,
because both conditions are not normal. If the stock level is too low, satisfying
materials demand could not be easily possible. If the stock level is very high, it
means too much capital will be tied up and the return on the capital employed will
be decreased which results in reduction in overall profitability of the organization.
Excessive inventory is regarded as the reasons for the death of many businesses.
As a result of this, some organizations prefer to place more emphasis on having
working capital in the form of cash and securities. Measuring, emphasis is given on
having the means of purchasing materials as per demand than carrying the
materials themselves in their stock.

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5.4 Inventory Costs
Inventories may block considerable amount of capital. Sometimes this cost reaches
to 25 to 30% (Saboo and Narula; 1981). For the purpose of decision-making, all
possible type of inventory costs has to be sort out. The various inventory costs are
discussed in the following paragraphs

i) Relevant, Opportunity and Sunk Cost

Relevant Costs: Relevant costs are costs that are incurred due to purposeful
decisions. Relevant costs include costs such as
 Ordering costs (Set up costs)
 Carrying (holding) costs
 Direct labor and material costs
Opportunity Costs: Opportunity costs are costs foregone; i.e., showing a
return what would have been obtained if capital were invested in an
alternative venture other than the inventory. For instance, if an organization
invests Birr, 1,000,000 in an inventory in 2003, which is kept idle, the
opportunity cost can be for example, birr 30,000 which would have been
gained if that amount of money were deposited in the bank at a deposit rate
of 3%. The foregone return in this example is therefore, birr 30,000, which is
called opportunity cost.
Sunk Cost: These are costs, which have already been spent and are not
affected by the amount of inventory the organization has. For example, rent
and lighting costs. Such costs will not increase or decrease in relation with or
depending on the amount of inventory.
ii) Fixed and Variable Costs
Fixed Costs: Fixed costs are costs that do not vary with the level of outputs
Variable costs: Variable costs are costs that vary with the volume of
production or output.
iii). Inventory Decision Costs:

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 There are cost incurred that are relevant to inventory management decisions.
These costs include preparation costs, carrying costs, stock out costs, and
capacity related costs. These cost concepts are again briefly discussed as
follows.

Preparation costs: Preparation costs include cost of all activities required in

issuing a purchase or production order. Included in this category are cost of
writing the order, preparing specification, recording the order, order follow-
up, processing of invoices or plant reports, and preparation of payment.
Sometimes preparation costs are referred as set-up ( for production) costs.

Carrying Costs: Carrying costs are costs that are incurred as a result of
goods being kept in stock. Include in this category are the cost of capital
incorporated, the cost of deterioration, obsolescence, pilferage, insurance and
taxes; cost of record keeping requirements.

Storage costs: Storage costs include costs of storage, space and handling
costs. Often, these costs include:
 Utilities,
 Material handling personnel,
 Equipment maintenance, and
 Security personnel
Stock out costs: These type of costs occur whenever insufficient stock exists
to fulfill a replenishment order it would be difficult to calculate these costs in
a straight forward and explicate manner.

5.5 Economic Order Quantity (EOQ)

We should understand behavior of inventory related cost factors in order to make
decisions about managing an inventory. A manager must determine which items
should or should not be carried in inventory, which inventory levels should be

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carried for specific items, and what order quantities are appropriate for a given
item.

How much of the item should be ordered is the short term operating questions that
must be answered. This is the concept of Economic Order Quantity (EOQ). EOQ
concept holds that the appropriate quantiy to order may be the one that tends to
minimize all the costs associated with the order (i.e carrying costs, acquisition
costs, and the cost of the material itself).

The Economic order quantity (EOQ) model can be determined based on the
following assumptions:
1. Annual demand is assumed to be constant
2. Carrying costs per unit per year is fixed
3. Stock is replaced instantaneously (lead time constant and known)
4. Order size is uniform
Based on the definition and classification of inventory costs discussed above we
can have the following relationships.
TC = OC+CC=PC
Where,
TC = total inventory cost
OC = total ordering cost
CC = total carrying cost
PC = purchase cost
Purchase cost is assumed to be fixed and is not relevant for the computation of
Economic Order Quantity (EOQ).

Ordering cost is so high if the item is ordered frequently in small lots. Cost per unit
decreases as higher quantities are ordered per unit. The total ordering cost
increases because it includes cost of generating, processing and handling an order
along with its related paper work.

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Ordering costs are the functions of a number of orders placed or deliveries received
during a given period of time. They are not related to inventory size. The ordering
costs are made up of indirect labor and overhead costs generated in purchasing
and in the other units of an organization that are involved in handling some
activities associated with purchase. The cost of supplies and services consumed in
the placement and handling of an order varies directly with the number of orderly
placed. The following figure these relationships.

Cost OC/Unit

EOQ Order quantity

The ordering cost per year for the material in question can be calculated as follows:

OC = D x CO
Q
Where, OC = total ordering cost
D = Annual demand
Q = Quantity ordered
CO = Ordering cost per order or per delivery

Carrying costs, however, rises and falls proportionally with the rise and fall of the
inventory level. The inventory level is directly related to the quantity ordered. In
other words, when the quantity ordered per lot is small, the carrying cost balls.
When a complete order is delivered at one time, the larger the order quantity, the
higher will be the average inventory level during the period covered by the order.

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Hence, costs of carrying inventory vary nearly directly with the size of delivery
quantity.

Reasons for Holding Inventories

Inventory exists because organizations cannot function without it. It would be ideal
if demand and supply could be so coordinated that no inventories would be needed.
Because it is either impractical or impossible to know future demand with full
certainty, and because the availability of supplies cannot be guaranteed at a given
moment inventories are accumulated to ensure an availability of goods and to
minimize the overall costs of producing and distributing the goods.

Every organization stores materials of one kind or another for the following
purposes.

To Protect against uncertainties

In inventory system, there are uncertainties in supply, demand, price and lead time
of materials. Safety stocks are maintained in inventory to protect against those
uncertainties. Safety stocks of raw materials are maintained to absorb
uncertainties in demand, price and delivery be vendors. Safety stocks of in-process
inventories are maintained to allow for fast schedule changes. In a similar way a
firm also stocks finished goods inventories to absorb changes in demand without
immediately changing production. In most cases, the level of demand on a logistic
system and the time required for re supply cannot be known for sure. To assure
product availability at a reasonable price safety stocks are maintained to provide
this protection.

To achieve economies of scale in purchasing, transportation and production

Due to ordering costs and quantity discounts, it often economical to purchase in
large lots because more can be purchased at one time than is immediately needed.
Likewise many purchases on small quantities can mean that the highest

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transportation rates are paid; one purpose for establishing an inventory would be
to allow shipping to or from the inventory under the lower per unit rates of full
vehicle load quantities. In a similar way, the lowest per unit cost for producing
products generally occurs with long or continuous production runs at constant
quantities. Inventories act as buffer between demand and supply so that
production can be geared to more constant output than fluctuating demand might
otherwise allows. This makes it possible to spread the setup cost of the production
machines over a large number of items.

To Hedge Against Contingencies

Labour strikes, fires, floods, and earth quick are just a few of the contingencies
that can be fall an organization. Maintaining a backup inventories is one way in
which normal supplies can be maintained for a period of a time.

To cover anticipated changes in Demand and Supply

There are several types of situations where changes in demand and supply may be
anticipated. One case is where the price or availability of raw materials is expected
to change. Another source of anticipation is planned market promotion where a
large amount of finished goods may be stocked prior to sale. Finally, companies in
seasonal businesses often anticipated demand in order to smooth employment

To Improve Customer service

Inventories are an aid to the marketing of a firm’s products. Products can be
spotted near where customers purchase them and in the quantities that they wish
to buy. This is an advantage to the customers who desire or must have immediate
stock availability or short delivery times. To the supplying firm this can mean a
competitive edge and reduced lost sales, especially for those products that are
service sensitive.

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Classification of Inventories
Inventories may be classified on various ways:
1. Based on criticality, VED (vital, Essential, Desirable)
analysis,
2. Based on scarcity, SDE (Scare, Difficult, Easily Available)
analysis,
3. Based on movement or transaction, FNSD (Fast moving,
Normal, Slow moving, Dead items) analysis.
But the most common way to classify inventories is value analysis or ABC analysis

ABC Analysis of Inventories

A few products in a firm can result in most of the value or a few usually account for
most of the inventory value as measured by dollar usage( the product of annual
usage times unit purchase cost or production cost. ) Inventory control managers
should avoid the distruction of unimportant details and concentrate on significant
matters. Inventory control procedures should insolate those items that require
detailed and precise control from those that do not.

It is often uneconomical to apply detailed inventory control analysis to all items

carried in an inventory. If no adjustment is made, every item is treated the same in
terms of the level of stock availability. Also, every item in stock is checked
constantly or periodically for level. However, inventory investment and operation
costs can be kept down if we recognize that not every item in inventory deserves the
same attention or requires the same level of availability to satisfy customers. It is
usually economical to purchase large supply of low value items and maintain little
control over them. Conversely, small quantities of high value items are purchased
and tight control is exercised over them. Thus one can manage these few items
intensively and control most of the inventory value. This suggests that before a firm

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policy for inventory control can be established, each product should be classified
according to its requirement.

One of the chief methods to practice selective inventory control is through ABC
classification scheme. In inventory it is frequently advantageous to divide
inventories into three classes: A, B, and C. The ‘A’ class is high value items whose
dollar volume typically accounts for 75-80% of the value of the total inventory,
while representing only 15-20% of the inventory items. It therefore represents the
most significant few. At the other extreme class C contains 5-10 of the inventory
value but 60-65% of the inventory items. These items are low value items with very
little contribution to the dollar value of inventory. In the middle is class B that
contains 10-15% of the value of the inventory, and representing 20-25% of the
inventory items.

Summary of ABC inventory Management

Item Percentage of Percentage Degree of Type of Lot Frequenc Size of
total inventory of total No. control records sizes y of safety
value of item review stocks
A 80 20 Tight Accurate & Low Continuous Small
complete
B 15 25 Moderate Good Medium Occasional Moderate
C 5 55 Loose Simple Large Infrequent Large

5.6 Effects of Poor Inventory Management

All inventory systems are subject to problems in two major areas: maintaining
adequate control over each inventory item and maintaining accurate records of
stock on hand. If problems occur here, materials management will have difficulty in
maintaining efficient operations because of inaccurate information. Symptoms of
these problems are many, varying in degree from operation to operation.

Inaccurate inventory records

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Inaccurate records are a good indication of poor inventory management. When
inaccuracies occur, actual physical counts may differ from those recorded; and if
these differences are always beyond specified tolerances. The problem can be
attributed to poor inventory management. Another indication of poor record
keeping is that management seems to be more concerned about C items in the
typical ABC Classification than A items. A lack of regularly planned audits of
inventory record, including actual physical counting of the quantities of each item
in inventory to verify inventory records, is also a symptom of inaccurate, or careless
record keeping.

Poor Customer Service

The most obvious sign of poor service is late deliveries, resulting in unfilled order.
In such situations, customers must be willing to wait for receipt of items, or they
will cancel the orders. Other indications include the existence of few, if any,
customer service objectives, lack of concern about measuring performance; idle
time in a facility such as materials handling due to materials and/or component
shortages: and stock outs of inexpensive items.

High Inventory Levels

Large inventories are required when there are demand and supply time variations
due to poor service, high ordering costs, stock out avoidance, and excessive
production disruptions. These large inventories require excessive expenditure of
funds and increase the possibility of obsolescence. Good inventory management
has the objective of determining a rational approach for balancing these two-sided
risks. High inventory levels indicate inadequate attention to the application of
inventory management techniques; management has taken the easy way out by
having excessive inventory.

Excessive expediting

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Excessive expediting to satisfy customers indicates poor inventory management.
Increased inventory investment and decreased customer service may result if a
system is overburdened, physically or administratively. Such stress to the system
may produce some or all of the following problems: material lots are lost; materials
handling throughout of the company is inefficient, setups create scheduling
difficulties; the information system is unable to handle the volume; the storage
locations. All of these circumstance lead to excessive expediting

Manufacturing Problems
In manufacturing poor inventory management has the same consequences as poor
customer service. When a stock out occurs during production, the operations must
be either stopped or changed to another product line that does not require the
stock out material. As a result, scheduled shipping dates are not met, and back
orders occur.

When poor inventory management prevails in manufacturing, many problems may

arise in order preparation. For example, there may be lack of, or deficiencies in, the
following. Specifications, recording orders, order flows-up, processing of invoices or
plant reports, orders for internal fabrication of items, required setup, and financial
arrangements. All of these problems produce delays and increase production costs.
Cost variances occur when actual costs are higher than standard costs.

5.7 Codification and standardization

Codification
The normal way of identifying an article is by simple description. But several
different names may be used for the same thing, eg. Again in order to identify some
articles accurately, a very long and complicate description may be required.
Everyone knows what is meant by a chair, but there are many kinds of chairs, to
identify only one of them properly, it is necessary to say that it is an armchair, with
frame made of beech, polished carved walnut legs, spring seat back and arms,

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staffed with house-char, finished in sage green moquette and fitted with two foam
rubber cushions; even this is not the whole story, for nothing has been said about
the quality of the materials or the dimensions of the various parts. It is necessary
to have some logical basis of identification which is more precise and less
cumbersome. This can be made by the process of codification.
Codification is the process of representing each item by a number or a letter or a
combination of both in the form of stores code. It would, therefore, be useful to
know the basic nature and characteristics of all materials used in an organization
and then classify them in broad categories and then to group and sub-group them
in logical progression of kinds, types and sizes, etc,. By adopting a well designed
codification system, the stores manager will have a unique precise, simple and
consistent method of identifying the items in his custody. The design of the system
should be such that the codes are compact and concise and are not unduly long.
They should be flexible enough to accommodate future additions.

The principal advantages of a rationalized codification system are outlined below:

1. Avoids repeated use of long descriptive titles and the confusion caused by
these long descriptions.
2. It helps to identify all items accurately.
3. Prevents duplication of items.
4. Assists in simplification, reduction of varieties and standardization.
5. Provides a foundation for an efficient purchasing organization because
suppliers can give different names for similar items.
6. Serves as a basis for sorting and recoding of documents.
7. Simplifies data processing or mechanical recording.
8. Can be employed as a basis for stock control accounts.

As mentioned earlier coding can be done with the help of figures, alphabets or a
combination of both. In coding materials, we first classify materials, group and
subgroup them. The most common methods to classify and code materials are by

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the nature and end use of the item. In fact codification can be made on the basis of
color making and technical spares.

Standardization
Standardization is the process of reducing the number of varieties stocked to a
controlled workable minimum. Mass production techniques of industrial
production are based on the principle of uniformity and interchangeability of many
parts, components and materials used in the production process. In its simplest
form, modern standardization has been recognized and used since the venture of
mass production of overall economy with due regard to functional and safety
requirements.,

Codification can be the starting point for standardization because we can

standardize materials required by an organization on the basis of the codes given to
each item. Material codification is usually made on the basis of their similarity and
interchangeability. In the field of materials management, standardization enables
an organization to proceed on scientific lines to locate factors influencing
preparation of inventory control programs, for achieving economy of materials and
parts, avoiding wastage, disposal of unwanted stores and reduction of stock covers
without much problem.

The grouping of like items together makes it easier to examine the complete range
of any given type of stores and consider whether the number of varieties held can
be reduced and standardization achieved on the minimum number of varieties held
can be reduced and standardization achieved on the minimum number of the most
suitable types, grades, sizes, shapes, models etc. For instance we can have the
same size or volume materials characteristics or end use of the materials, a store
manager has to select few appropriate grades by taking into account cost,
functional and safety requirements.

114
The conduct of a program of standardization involves a complete examination of
the list of materials stocked, to determine:
1. The use or uses for which each item is intended,
2. Which items have similar characteristics and can be used as substitutes
for each other,
3. What range of sizes is essential,
4. Which item can be eliminated and
5. What specifications are necessary for retained items.

CHAPTER SIX
INVENTORY MODELS AND CONTROL TECHNIQUES
6.1 Fixed Order Size System/Deterministic Models
The problem of balancing the costs associated with inventories is a complex one
due to the numerous and sometimes intangible costs that are relevant. Inadequate
inventories can result in costs due to production delays and inefficiencies, as well
as the shortage costs of lost orders or even lost customers. These costs are often
very difficult to measure directly. More than adequate inventories result in
excessive expenditure to hold the inventories.
Inventory policy involves an organizational dilemma. Marketing wants large
inventories to ensure the satisfaction of consumer demand. Production also wants
large idle stocks in order to reduce the ordering and setup costs, smooth operations

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and minimize idle time. However, finance is interested in minimizing capital costs
and thus prefers small inventories. Sound inventory management should consider
all view points and then develop a policy that minimizes the total inventory related
costs without affecting the smooth operations of the firm. The basic issues are how
much and when to order (or produce). Since inventory expenses are a substantial
cost of doing business for most companies, these issues warrant serious
considerations.
In a fixed order size system which is also referred to us perpetual inventory system,
the same number of units is always maintained and the demand rate is constant.
An order for a fixed number of units is placed whenever the inventory reaches a
reorder point. A typical fixed order size system is termed as Q-system, since the
size of order (Q) is fixed for each replenishment.

Stock available

Demand occurs
(withdrawn)

Determine stock position

(on hand + on order-back orders)

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 Is stock position  reorder point?

Issue replenishment Order

Economic order Quantity

An optimal inventory policy is one that would provide adequate inventory levels
when needed at the minimum total cost of ordering, carrying and purchasing. The
size of an order that minimizes the total inventory cost is known as the economic
order quantity (EOQ). It is the best known and most fundamental inventory
decision tool. To determine the optimum order quantity, information is needed
regarding the following parameters:
1. Appropriate costs
2. Forecasts of demand
3. Knowledge of lead times
The classical inventory model assumes the idealized situation shown in the
following figure. Where Q is the order size. Upon receipt of an order, the inventory
level is Q units. Units are withdrawn from inventory at a constant demand rate
Q

which is represented by the negative slope lines. When inventory reaches the
reorder point, a new order is placed for Q units. After a fixed lead time period, the
q/2

goods are received and placed in inventory. The vertical lines indicate the receipt,
so the average inventory if (Q+O)/2 or Q/2.
R

Maximum Inventory
O

Average inventory

Reorder point 117

a b c d e f
Q=LOT SIZE
q/2 = AVERAGE INVENTORY
R= Reorder point ROQ
ac = ce = interval between orders
ab=cd=ef=lead time
The derivation of the EOQ is based on the following assumptions:
1. The demand rate is constant, recurring and known. For example, demand
(or wage) is 100 units a day with no random variation and demand is
assumed to continue into the in definite future.
2. The lead time is constant and known. The lead time, from order
placement to order delivery, is therefore always a fixed number of days.
3. No stock outs are allowed. Since the demand and lead time are constant,
one can determine exactly when to order material to avoid stock outs.
4. Material is ordered or produced in a lot or batch and the lot is placed into
inventory all at one time.
5. A specific cost structure is used as follows. The unit item cost is constant
and no discounts are given for large purchases. The carrying cost depends
linear on the average inventory level. There is a fixed ordering or setup
cost for each lot which is independent of the number of items in the lot.
In choosing the lot size, there is a tradeoff between ordering frequency and
inventory level. Small lots will lead to frequent reorders but more inventories will
not be carried. This tradeoff between ordering frequency and inventory level can be
represented by mathematical equation using the following
Symbols: D=annual demand in units

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 C=purchase or production cost of an item
A = Ordering cost per order
H= holding cost
F=annual holding cost as a fraction of unit cost
Q=lot size
Annual ordering cost = (cost per order) (orders per year)
= A x D/Q
AD/Q

In the above equation D is the total demand for a year, and the product is ordered
Q units at a time; thus D/Q orders are placed in a year.
Holding cost per unit = (carrying interest rate) (purchase cost)
= F x C
= FC
Total holding cost = (holding cost) x (average inventory)
Total carrying cost per year=(annual carrying rate)(unit cost)(average inv.)
F x C X Q/2

Total annual cost = (purchase cost) + (order cost) + (holding cost)

Therefore

Example
Suppose you are given the following information concerning a certain note book
distributor company.
1. Customers demand 6750 units of notebook each month constantly.
2. Notebook can be purchased from a variety of suppliers for 50 cents a unit
regardless of the quantity purchased.

119
 3. Annual pilferage, deterioration, interest, and storage expenses are
estimated to be 18% of the value of average inventory.
4. The cost of preparing and processing an order is 45 minutes (3/4 hour) of
labor @ Birr 4/hour=3 plus paper, telephone and transportation =1,
setting up the display requires an additional expense of 15 minutes (1/4
hour) of labor @ Birr 4/hour=1.
The company’s problem is not to order quantity Q that minimizes the total
inventory cost, TC, stated in the above equation. The problem can be solved in
several ways. Using trail and error, the bookstore can select various possible
order quantities and then compute the resulting total cost as shown in the
following table.

Given D=81000= (6750x12)

A=5(3+1+1)

H=0.09(0.50x0.18)
= 0.045Q

Quantitative decision making

Order Annual Costs
Quantity Q Purchasing Ordering Holding Total
(405,000/Q) (0.045Q)
500 40,500 810 22.50 41,332.50
1000 40,500 405 45.00 40,950.00
1500 40,500 270 67.50 40,837.50
2000 40,500 202.50 90.00 40,792.50
2500 40,500 162.00 112.50 40,774.50

120
3000 40,500 135.00 135.00 40,770.00
3500 40,500 115.71 157.50 40,773.21
4000 40,500 101.25 180.00 40,781.25
4500 40,500 90.00 202.20 40,792.50
5000 40,500 81.00 225.00 40,806.00

The data in the table show that the bookstore can minimize total annual inventory
cost at TC = 40,770 by ordering Q=3000 units each time if requires a shipment.
The value Qo is referred to as economic order quantity in the bookstores case,

D= 81,000
A=5
H=0.09

Therefore the EOQ

= 3000 units
This order size will balance ordering and holding expenses a

Each and minimize total inventory cost at

TC = 40,500 + AD/Q + HQ/2
= 40,500 + 135 +135
= 40,770

The EOQ results in items with high unit cost being ordered frequently in small
quantities (the saving in inventory investment pays for the extra orders; items with
low unit cost are ordered in large quantities the inventory investment is small and

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the repeated expense of orders can be avoided). If the order cost A is zero, orders
are placed to satisfy each demand as it occurs, which results in no holding cost. If
the holding cost H is zero, an order (only one) is placed for an amount that will
satisfy the life time demand for the item. The EOQ formula is based on the
assumption that the entire lot is added to stock at one time, and that the stock will
be withdrawn at a constant rate.
Order timing and frequency
The economic order quantity formula gives the order quantity that minimizes total
inventory costs. The equation, in effect, is a decision rule indicating how much to
order. However, management should also decide on the remaining basic issues that
are when and how frequently to place an order.
Once the economic order quantity is known, the expected number of orders placed
during the year, n, and the average time between orders, T, can be determined.
Since the store

Orders a fixed amount (the EOQ), the number of orders will equal the total annual
demand divided by the order quantity, Qo
Expected number of orders during a year

For example, if the bookstore ordered Qo=3000Units at a time,

n=D/Qo

= 27 orders per year

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If the working days of the supplier is assumed to be 250 days, management will
order approximately every 250/27=9.3 working days. This 9.3 days period between
orders is referred to as average order interval or the inventory cycle time
In general the average order interval of T days will equal the working days per year
N divided by the annual number of orders.

For instance the average order interval of the bookstore is =

= 9.3 days
Alternatively we can another formula to calculate the average interval or T days

where n inversely proportional

T =

The reorder point is obtained by determining the demand that will occur during the
lead time period. When the stock position ((on hand)+(on order)-(back orders))
reaches the

= reorder point in units

Reorder point, an order will be placed for Qo units, the economic order quantity.
The following formula gives the reorder point when the lead time L is expressed in
months:

If the lead time L is expressed in weeks, the reorder point is expressed as:

123
 = reorder point in units

If the lead time L is expressed in days, the reorder point is expressed as:

, where N = working days in a year

For example, in the case of the bookstore if we assume the lead time is equal to 5
days and the working days of the suppliers is expected to be 250 days, the reorder
point will be as follows:

= = 1620 units

The reorder point of 1620 units signifies that from the time of placement of an
order for Qo units up to the receipt of the order (i.e., in 5 days time., consumers
will demand for 324 units daily (or 1620 units in five days).
The goods are assumed to be received when the last item leaves the inventory, and
the inventory level is restored to a level equal to the amount ordered. If the lead
time is less than the average order interval (L<T), there will never be more than a
single order outstanding. If the lead time is greater than the average order interval
(L>T), there will always be least one order outstanding.

The minimum total cost per year is obtained by putting Qo for Q in the total annual
cost equation. The following formula for the minimum total cost per year results.

Example
ABC manufacturing company purchases 8000 units of a product each year at a
unit cost of Birr 10. The order and the holding cost per unit per year is Birr 3.00.
What are the economic order quantity, the total annual cost, the number of orders
to place in one year, and the reorder point when the lead time is 2 weeks?

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The classical EOQ model assumes a constant demand rate, constant lead time,
constant price per unit, fixed order cost per order, fixed holding cost per unit, and
the instantaneous receipt of an order. It is based on the situation where demand,
lead time, and all relevant costs are known and constant over time. Further no
stock outs will occur-which is reasonable, since the demand and lead time are
known and the entire order is received at one time.
6.2 Fixed order interval system.
The fixed order interval system is a time based inventory system which determines
the economic order interval that indicates when an order should be placed for an
item or item. Stock position is reviewed periodically rather than continuously and
orders for items are placed on a fixed cycle time. Suppose a supplier will only take
orders and make deliveries at particular intervals, for example two weeks. In this
case, the stock position is reviewed every two weeks an order is placed if material is
needed.
In the fixed order interval system, also called periodic inventory system, the
demand is assumed to be independent and continuous. There are only two
variables whose values must be chosen for a fixed order interval system. They are
the fixed review period and the maximum or target inventory level from which all
replenishment orders are calculated. A maximum inventory level for each item is
developed. After a fixed period of time (T) has passed the stock of each item in
inventory is determined, and an order is placed to replenish the stock. The size of
the order for each item is the difference between the maximum inventory level for
each item is developed. After a fixed period of time (T) has passed the stock of each
item in inventory is determined, and an order is placed to replenish the stock. The
size of the order for each item is the difference between the maximum inventory
level for each item and the inventory position. The fixed order interval system is
termed as a T-system, since the time between orders (T) is fixed. In this system,

125
orders are placed at equally spaced, predetermined, points in time. The order
quantity varies according to the fluctuations in usage between orders. The size of
an order is usually the difference between the stock on hand and a desired target
inventory level. A typical fixed order interval system is shown with the help of the
following figures.

Stock available

Demand occurs

Yes
Is stock demand?

no
Backorder/Loss sale

Has review period arrived

Determine stock position(on hand +

on order-backorders)

Compute order quantity (Max. stock-stock position

Issue replenishment order

Maximum inventory level

126
 Quantity

0 “L” T
Time Ti

Economic order interval/Deterministic Models

The basic problem in this system is determining the order interval T and the desire
maximum inventory level E. The economic order interval can be obtained by the
minimization of the total annual cost. If stock outs are not permitted and demand
is assumed to be constant, the total annual inventory cost is given by the following
formula:
Total annual cost – (purchase cost) + (order cost) + (holding cost)

Replace Q by D/n

Where = number of orders or reviews per year

Average inventory in units

T= order interval in years

Average inventory Q/2

Annual ordering cost

=AD/Q
= An
=A
Annual holding cost = handling cost per unit x average inventory
= H x DT/2

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 =

=
The total annual cost equation is depicted in the following graph

TC
Cost

DC
A/T

0 order interval (T)

To obtain the minimum cost order interval, the first derivative of the total annual
cost with respect to the order interval T is set equal to Zero;

Solving the equation for T, the following formula results:

Economic order interval (EOI) in years.

The minimum cost number of reviews per year (n) is simply the reciprocal of to, or

no=

The alternative means to calculate the economic order interval (EOQ) is with the
help of the average order interval in the economic order quantity as in the
following.

128
 T=

= , where =
= NQo

Then substituting the EOQ formula for Qo, we have

Example
Suppose we are managing a warehouse which distributes a certain type of
breakfast food to retailers. The breakfast food has the following characteristics:
Average demand = 200 cases per day
Lead time= 4 days for re supply from the vendor

A= Birr 20 per order

F= 20% per year
C=Birr 10 per case

Assume that a continuous review system will be used and also assume that the
ware house is open 5 days a week, 50 weeks a year, or 250 days a year. Then
annual demand= 250(200)=50,000 cases per year

Then the optimal review interval is:

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The maximum inventory level E must be large enough to satisfy demand during the
subsequent order interval T and also during the lead time L. The following formula
gives the maximum inventory level when the order interval and lead time are
expressed in years.
E=DT+DL=D (T+L)
= Qo+R = maximum level of inventory
The following formula gives the maximum inventory level when the order interval
and lead time are expressed in days and there are N operating days in the year:

or

To illustrate, we will use the bookstore business example from the last section.
Recall that:
EOQ= 3,000
D=81,000
C= 0.50
A= 5
H= 0.09
N= 250 days
L = 5 days
D= 324 (daily demand)

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6.3 Types of Control Systems
The most common types of inventory systems are the perpetual, two bin, periodic
optional replenishment, and material requirements planning systems. The
perpetual, two bin, periodic, and optional replenishment systems usually apply to
end items, while the materials requirement planning system applies to materials
and components used to produce an end item.

The perpetual and two-bin systems have a fixed order quantity and a variable
review period; the periodic and optional replenishment system have a fixed review
period and a variable order quantity; and the MRP system is geared to planned
production requirements (the order quantity is variable and the review period can
be fixed or variable. The two bin system is a special type of perpetual system, while
the optional replenishment system is a special type of periodic system.

The perpetual and two-bin systems are referred to as fixed order size systems
(quantity based). The periodic and optional replenishment system is referred to as
fixed order interval systems (time based). The material requirements planning
system is termed a derived order quantity system (production based). Quantity
based systems are checked continually with each demand to determine if an order
should be placed (thus the name “perpetual”). With time based systems, a count of
stock is made on designated review dates (thus the name “periodic”). Production
based systems order stock only to preplanned manufacturing schedules.

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There are two major variables in an inventory system. They are the order quantity
and the frequency of ordering. If one of the variables is held constant, the other
tends to fluctuate. The perpetual inventory system holds the order size constant
and tends the frequency of ordering fluctuate according to demand requirements.
The periodic inventory system holds the frequency of ordering constant by
establishing a fixed order period and lets the order size fluctuate according to
demand requirements. In the optional replenishment system, the review period is
held constant and the order size is variable but no orders are placed until the stock
level is less than or equal to a recorded point.

Perpetual Inventory System

A perpetual system keeps records of the amount in storage, and it replenishes
when the stock drops to a certain level. This system is based on the concepts of
economic order quantity and reorder point. Under this system the recorder point
and order quantity are fixed, the review period and demand rate are variable, and
the lead time can be fixed or for a single item. The average inventory is the safety
stock plus one half of the order quantity (average inventory)

Perpetual Inventory System

132
 C
Inventory Level

Safety Stock
O
D E F G H I

1. Variable demand (slop)

2. fixed recorder point
3. Fixed recorder quantity AC
4. Fixed lead time DE =FG+HI
5. Variable time between orders DF# FH

With the perpetual system, each time a unit (or units) is issued from stock, the
withdrawal is logical and the stock position is compared with the reorder point. The
perpetual system is completely defined by knowing the order size and the minimum
stock level which signals the placing of an order. The major disadvantage of the
perpetual system is that is requires perpetual auditing of the inventory in stock.
Since an order can occur at any time, this prevents the economies which result
from the amalgamation of several; items from one supplier into one order.

Fixed one supplier system requires a continuing review or observation of the

inventory levels. The objective is to know as quickly as possible when the reorder
point is reached. The review may consist of analyzing perpetual inventory records
(manual, or computerized) as they are posted or visually noticing the physical stock

133
when it reaches the reorder point (the two-bin system is based on the physical
identification without the additional records). The fixed order size system with
perpetual inventory records is excellent for high cost items needing close control.

The cost of operating a perpetual record system may far exceed the advantages to
be gained from it. The cost of record keeping as well as the clerical staff’s ability is
important considerations in the selection of the system. It is advantageous to use
systems which are not quite optimal when the cost of attaining the optimum is
prohibitive. Perpetual control means there is continuous control over the physical
units of inventory. Inventory records are kept up to date an entry being made each
time an item is issued or received from a supplier. Daily records are recorded
manually or on punch cards or are processed by a computer for disk or tape
storage.
Two-Bin Inventory System
The distinguishing feature of the two bin system is the absence of a perpetual
inventory record. The two-bin system is a fixed order size system, and it has several
advantages.
The most important advantage is the reduction in paper work. Records are not
maintained for each transaction. The reorder point is determined by visual
observation. When the stock in one bin or compartment is depleted, and order is
initiated, and demand is then filled from the second bin or compartment.
The system can even be used with only one bin. An order can be triggered when the
inventory level reaches a physical mark such as a painted line or a given volume
level (for gasoline or other liquids). The reorder point quantity can also be placed in
a bag or container, so that when the stock is drawn down to the sealed quantity an
order is placed. The two-bin system is best suited for item or low value, fairly
consistent usage, and short lead time, such as office supplies, nuts, bolts and so
forth.
Periodic Inventory system

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In a periodic inventory system the number of items in storage is reviewed at a fixed
time interval. A count must be taken of the goods on hand at the start of each
period. In the perpetual system an actual count is not required, since the inventory
records contain receipts, issues, and balances on hand. With the periodic system
the quantity to be ordered is not fixed, and the decision market changes the
quantity ordered to reflect changes in the demand rate. Under this system, the
review period is fixed; the order quantity, the demand rate, and the reorder point
are variable; and the lead time can be fixed or variable. Figure below describes the
behavior of the periodic inventory system for a single item. A maximum inventory
level E. is established for each item. The order quantity is the maximum inventory
level minus the inventory position of the review date. With the periodic system, the
number of units remaining  is not reviewed each time a unit (or units) is issued
from stock. The periodic system usually accounts for the number of units in stock
on the review date by an actual count. The size of the replenishment order is
variable and depends on the number of units in stock. The order quantity varies
from period to period and depends upon demand.
Periodic, Inventory system
1. Variable demand (Slope)
2. Fixed review period FH+HJ
3. Variable reorder points C D
4. Variable reorder quantities E-CCE-BE-D
5. Variable lead time FGHIJK
6. Safety stock + OB
(Reorder quantity = E-inventory level at level at review period)

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 Safety Stock
O F G H I J K
Time

The periodic system is completely defined by the order period and the maximum
inventory level. In the perpetual system the safety stock represented protection
against demand fluctuation during the lead time period.
With a fixed order period, the periodic system requires safety stock for
protection against demand fluctuations during both the review period and the
lead time. This means that the periodic system will require a larger safety stock
for a given item than the perpetual system. This additional safety stock results
in the optimal perpetual system being less expensive than the optimal periodic
system, though this may be offset by the economies of single supplier item
amalgamation. The periodic system is well suited for inventory control when the
supply sources are few or the source is a central warehouse.

Optional replenishment inventory system

The optional replenishment inventory system, which is also referred to as a min-
max system, is a hybrid of the perpetual and periodic systems. Stock levels are
reviewed at regular intervals, but orders are not placed until the inventory
position has fallen to a replenishment system for a single item. The maximum
inventory level is established for each item. If the inventory position is above the
reorder point on the review date, no order is placed. If the inventory position is
at or below the reorder point on the review date, and order is placed. The order

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 quantity is the maximum inventory level minus the inventory level at the review
period.
1. Variable demand (slope)
2. Fixed review period FH=HJ
3. Variable reorder points CBD
4. Variable reorder quantities E-CE-BE-D
5. Variable lead time FGHIJK
6. Safety stock + OB
(Reorder quantity = E-inventory level at review period)
Inventory Level

O F G H I J K L M N P Q
Time
The optional replenishment system is defined by three parameters:
1. The length of the review period
2. The maximum inventory level E
3. The reorder point B
Note that the perpetual and periodic systems are both defined by only two
parameters, while the optimal replenishment system requires three parameters.

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 The system permits orders to be placed in efficient quantities, and it reduced costs
resulting from the frequency placement of small orders. Fewer but larger orders are
placed than in the periodic system, so order costs are lower. When the review
period is so long that an order is triggered at almost every review, the optional
replenishment system is indistinguishable from the periodic inventory system.
The optional replenishment system can require substantial safety stocks. If the
inventory level at time or review is slightly above the reorder point, coverage is
required for two order intervals plus the lead time. The review period length is
established by procedures appropriate to periodic systems. The reorder point will
consist of safety stock and the expected demand over the lead time and the review
period. The safety stock is determined by analyzing the demand variation occurring
for the period covered by the lead time and the review period.

Materials Requirements Planning Inventory System

The material requirements planning (MRP) inventory system is used extensively

with planned production. For items that are material or components used by end
items, stock levels are derived from the requirements dictated by the end item. The
material requirements planning system is a derived order quantity system.

This system (also referred to in the literature as a requirements planning system)

functions by working backward from the scheduled completion dates of end
products or major assemblies to determine the dates and quantities of the various
components parts and materials that are to be ordered. The system works well
when (1) a specific demand for an end product is known in advance and (2) the
demand for an item is tied in a predictable fashion to the demand for other items.
Inventory System Features

Inventory Optional Material

a a b c
Factor System: Perpetual Two-Bin Periodic Replenishment Requirements

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 d
Planning
Order Fixed Fixed Fixed Variable Variable
Quantity Fixed Fixed Fixed Variable Variable
Reorder Variable Variable Variable Fixed Fixed/variable
Point Fixed Fixed Fixed/variable Fixed
Review Variable Variable Fixed/variable
Period Fixed Fixed Very large
Demand Variable Variable
Rate medium Medium
Lead time
Safety
stock

Fixed/
Variable Small/none
Large

a)
Perpetual and two-bin systems (Q.R): Review inventory status with each
transaction. If inventory I R, order Qo. If inventory I >R, do not order
b)
Periodic system (E, T): review inventory status at intervals of T. order E-I on each
occasion
c)
Optional replenishment system (E, T, and R): review inventory status at intervals
of T. If inventory IR, order E-I. If inventory I>R, do not order.
d)
Material requirements planning (MRP) system: order items to meet production
schedules.

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