CHAPTER- FOUR

Materials Management

Instructor: Muluken Mesfin (MSc)

 Learning Objectives
• Introduction to material management
• Define inventory
• Discuss types and functions of inventory
• Discuss inventory classification and counting
• Clarify inventory costs
• Discuss inventory models
 Material Management
❑Material management is a scientific technique, concerned
with Planning, Organizing & Control of flow of
materials, from their initial purchase to destination.
❑The term material refers to all commodities which are
consumed in the production process. The materials which
are
✓ Direct Materials
✓ Indirect Materials
Material is generally called raw material.
 Objectives of Material Management
To get
1. The Right quality
2. Right quantity of supplies
3. At the Right time
4. From the right source
5. For the Right cost
So as to co-ordinate & schedule the production activity in an
integrative way for an industrial undertaking.
The followings are the activities of materials management.
✓ Material requirements planning,
✓ Purchasing,
✓ Inventory planning,
✓ Storage,
✓ Inventory control,
✓ Material supply,
✓ Transportation & material handling
This chapter mainly focus on inventory management
 What is inventory?
❑ Inventory: An inventory is an idle stock of material in store used
to facilitate production or to satisfy customer needs. ranging from
small things such as pencils, paper clips, screws, nuts, and bolts to
large items such as machines, trucks, construction equipment, and
airplanes.

❑ Inventory Management: Scientific method of finding out how

much stock should be maintained in order to meet the production
demands and be able to provide right type of material at right time,
in right quantities and at competitive prices.
 Cont..

❑ Inventory control is concerned with achieving an optimum

balance between two competing objectives.

❖Minimizing the investment in inventory (Inventory cost).

❖Maximizing the service levels to customer’s and its operating

departments.
 Types of Inventory
❑ Raw material - Purchased but not processed.
❑ Work-in-process - Undergone some change but not completed.
❑ Finished goods- Completed product awaiting shipment.
- Goods-in-transit to warehouses or customers.
❑ Distribution inventories; Finished goods that are located in the
distribution system.
❑ Maintenance/repair/operating (MRO)- Replacement parts, tools,
& supplies
- Necessary to keep machinery and processes productive.
Type of organization Type of inventories held
Manufacturer Raw materials, semi-finished goods,
finished goods, spare parts, etc.
Hospital Number of beds, stock of drugs,
specialized personnel, etc.

Bank Cash reserves, tellers, etc

Air line company Seating capacity, spare parts,
specialized maintenance crew etc.
 Functions of Inventory
❑ To meet anticipated demand.
❑ To meet variation in product demand.
❑ To smooth production requirements.
❑ To allow flexibility in production scheduling.
❑ To provide a safeguard for variation in raw material delivery time.
❑ To protect against stock-outs.
❑ To take advantage of order cycles.

❑ To help hedge against price increases or to take advantage of quantity

discounts.
 Classification of Inventory
▪ Inventory classification: is defined as a process of classifying
items into different categories, thereby directing appropriate
attention to the materials in the context of company’s viability.
▪ ABC classification system: Classifying inventory according to
some measure of importance and allocating control efforts
accordingly.
▪ Importance measure = price * annual sales
A - Very important
B – Moderate important
C - Least important
 ABC Classification Example

• A Items – typically 10 - 20% of the items accounting for 60 - 70%

of the inventory (Vital few) .

• B Items – typically an additional 30% of the items accounting for

15% of the inventory (moderate).

• C Items – Typically the remaining 50% - 60% of the items

accounting for only 5% - 15% of the inventory value (Trivial
many).
Cont..
 Steps in ABC Analysis
a. Compute Annual Usage in Dollars for each item and
Compute Total Annual Usage.
b. Compute the percentage of Annual Usage for each item.
c. Sort the list of items by the percentage of Annual Usage
in Dollars, from largest to smallest.
d. Calculate the Cumulative Percentage of Annual Usage in
Dollars for the first item, first 2 items, first 3 items, etc.
For the last item, the cumulative % should be 100%.
Using Cumulative % as a guide, assign the items to A, B,
and C categories.
ABC Analysis Example
Solution
 What inventory classification and counting?
A physical count of items in inventory
▪ Periodic/Cycle Counting System: Physical count of
items made at periodic intervals.
▪ How much accuracy is needed?
▪ When should cycle counting be performed?
▪ Who should do it?
▪ Continuous Counting System: System that keeps track of removals
from inventory continuously, thus monitoring current levels of each
item.
▪ Two-Bin System - Two containers of inventory;
reorder when the first is empty
▪ Universal Bar Code - Bar code printed on a label
that has information about the item to which it is attached.
 Inventory Costs
❑ Holding costs: the costs of holding or “carrying” inventory over time.
❖ Housing costs (including rent or depreciation, operating costs, taxes,
insurance), Material handling costs (equipment lease or depreciation,
power, operating cost), space, and obsolescence, Labor cost
❑ Ordering costs: the costs of placing an order and receiving goods, Fixed,
constant dollar amount incurred for each order placed.
❖ Developing and sending purchase orders, Processing and inspecting
incoming inventory, Inventory inquiries, Utilities, phone bills, and so
on for the purchasing department, Salaries and wages for purchasing
department employees, Supplies such as forms and paper for the
purchasing department.
❑ Shortage costs: Loss of customer goodwill, back-order handling, and
lost sales.
❑ Investment costs: borrowing costs, taxes, and insurance on inventory.
Demand rate usually expressed per year.
 Inventory Models
❑ Inventory models deals with determining optimum inventory level that should be kept
to keep the inventory cost to the minimum and customer satisfaction or service level to
maximum.
❖ When to order?
❖ How much to order?
❖ How much and when to produce?
❖ Level of inventory
❑ Important terms in inventory modes:
❖ Lead time: time interval between ordering and receiving the order (L).
❖ Reorder point (R)
❖ Service level (SL)
❖ Safety Stock (SS)
❑ Inventory Models
❖ Economic Order Quantity (EOQ)
❖ Economic Production Quantity (EPQ)
❖ Price Discount Models/Price Break Models
 Economic Order Quantity (EOQ)
❑ An optimizing method used for
determining order quantity and reorder
points. Part of continuous review
system which tracks on-hand inventory
each time a withdrawal is made.
❑ Assumptions:
➢ Only one product is involved
➢ Annual demand (λ) requirement is
known and fixed.
➢ Lead time does not vary.
➢ Each order is received in a single
delivery.
➢ Variable stock holding cost per
unit per year.
➢ Shortages are not allowed
 EOQ Model
1. You receive an order quantity Q. 4. The cycle then repeats.

Q Q Q

R
L L
2. You start using
them up over time. Time
3. When you reach down to a
R = Reorder point level of inventory of R, you
Q = Economic OQ place your next Q sized order.
L = Lead time
EOQ Model Costs
 EOQ Costs
 D  Q  Total Annual Costs = Annual Ordering Costs
TC EOQ =  S  +  H 
Q   2  + Annual Holding Costs
Where
TC = total annual cost
D = annual demand
Q = quantity to be ordered
H = annual holding cost
S = ordering or setup cost

❑ The optimal or minimum cost

occurs at the intersection
point of holding cost and
ordering cost. So using
calculus the Q value at this Reorder level (R) can be computed
point can be computed. as demand during lead time times
lead time.

R= d*L
R= d*L + ss (safety stock)
Example: A computer company has annual demand of
10,000. They want to determine EOQ for circuit board
which have an annual holding cost(H) of $6 per unit,
and an ordering cost of $75. Then determine EOQ,
reorder point( R) & total cost (TC) if the lead time is 5
days and assuming the company has 250 working days
per year.
2𝑆𝐷 2∗75∗10000
Solution: 𝑄 ∗= 𝐻
= 6
= 500 𝑢𝑛𝑖𝑡𝑠
𝑎𝑛𝑢𝑎𝑙 𝑑𝑒𝑚𝑎𝑛𝑑
𝑅 = 𝑑𝐿 but 𝑑 = =
𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑑𝑎𝑦𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
10000 𝑢𝑛𝑖𝑡𝑠/𝑦𝑒𝑎𝑟
= 40 𝑢𝑛𝑖𝑡𝑠/𝑑𝑎𝑦
250 𝑑𝑎𝑦𝑠/𝑦𝑒𝑎𝑟
𝑢𝑛𝑖𝑡𝑠
𝑅 = 𝑑𝐿 = 40 ∗ 5 𝑑𝑎𝑦𝑠 = 200 𝑢𝑛𝑖𝑡𝑠 (we
𝑑𝑎𝑦
should have enough amount for five days of lead time)
Cont…
 EOQ Example

❑ Annual Demand = 1,000 units; ❑ Holding cost per unit per

❑ Days per year considered in year = $2.50;
average 365; ❑ Lead time = 7 days;
❑ Daily demand = 1000/365; ❑ Cost per unit = $15;
❑ Cost to place an order = $10;
Given the information above, what are the EOQ, reorder point (R),
Cycle inventory, Order frequency (N) and Cycle interval (T)?

2D S 2(1,000 )(10)
Q OPT = = = 89.443 un its or 90 u n its
H 2.50

1,000 units/year
d= = 2.74 units/day Cycle Inventory = Q/2 = 45 Units
365 days/year
_
R = d L = 2.74units/day (7days) = 19.18 or 20 units
N = D/Q = 11.1 Orders T= Q/d = 32.85 days
Economic Production Quantity (EPQ)
❑ An optimizing method used for determining production quantity
and reorder points.
❑ Production done in batches or lots.
❑ Capacity to produce a part exceeds the part’s usage or demand
rate.
❑ Assumptions of EPQ are similar to EOQ except orders are
received incrementally during production.
❖ Only one item is involved
❖ Annual demand (D)is known
❖ Usage rate d or daily demand/usage rate is constant
❖ Usage occurs continually
❖ Production rate p is constant
❖ Lead time does not vary
 Economic Production Quantity (EPQ)
❑ The Maximum Inventory (Imax) is total production during
production phase (Q) minus depletion (Q(d/p)).

t1= production and

Production and Depletion, no
usage period
usage production only usage
t2= usage period

ROP

t1 t2

T L
Economic Production Quantity (EPQ)
❑ The total cost at economic
production is the sum of
holding and setup costs. At
the optimal point holding
cost and set up costs are
equal. Hence we can derive
EPQ formula as follows:
D  I 
TC EPQ =  S  +  MAX H 
Q   2  The cycle interval (T) is the sum
of t1 and t2.
 d
I MAX = Q1 −  t1 = Q/p
 p t2 = Imax/d
By substitution
2 DS
EPQ = T= Q/d
 d
H
1 − 

 p  R = dL (Usage rate*Set up time)
R = dL + ss (Safety stock)
 EPQ Example
❑ Annual demand = 18,000 units
❑Annual holding cost = $18 per
❑ monthly demand=1500 units
unit
❑ Production rate = 2500 =p
units/month ❑Setup time= 5 days
❑ Setup cost = $800 ❑No. of operating days per
❑ Daily demand =1500/20 month = 20

Given the information above, what are the EPQ, Imax, Cycle
inventory, reorder point (R), Order frequency (N) and Cycle
interval (T), t1, t2?
2 DS
EPQ = R = d*L= (1500/20)*5 = 375 Units
 d = 2000 units
H
1 − p 

 
T = Q/d = 2000/1500= 1.33 months
Imax = 800 units
N = 12/1.333 = 9 production cycles
t1 = Q/p = 0.8 month
TC = holding cost + set up cost = $14,400
t2 = Imax/d = 0.53 month
 Quantity Discount Models
• The third deterministic model considered incorporates quantity discount
prices that depend on the amount ordered. In reality, The purpose of the
discount is to encourage the customer to buy the product in larger
batches.
• Reduced prices are often available when larger quantities are purchased.
• Trade-off is between reduced product cost and increased holding cost.
▪ Example: Let the annual demand of item X is 5000 units, Ordering cost is $49 per
order, Holding cost is 20% of unit price per item per year. Determine the optimal
order quantity that minimizes the total cost.

▪ Here the value of holding cost depends on the amount of units to be ordered, and it varies
for each discount.
▪ For the above example: H = i * P and Total product cost per year is = PD, where i is
percentage of holding cost.

Calculate EOQ*
for every
discount.
 Price break model procedure
▪ Calculate the EOQ for each price break.
▪ Determine whether the EOQ is feasible at that
price, check whether the EOQ is in the discount
range.
▪ Will the vendor sell that quantity at that price?
▪ If yes, stop – if no, continue.
▪ If EOQ is not feasible select the next higher
quantity, minimum on the discount range.
▪ Calculate the total costs (including total item cost)
for the feasible EOQ model of each price break.
▪ Compare the total cost of each option & choose the
lowest TC alternative.
 Cont..

2DS
Q* =
iP
2(5,000)(49)
Q1* = (.2)(5.00) = 700 cars order feasible

2(5,000)(49)
Q 2* = (.2)(4.80) = 714 items order, not feasible
adjusted to 1000 items.

2(5,000)(49)
Q3* = (.2)(4.75) = 718 items order,
adjusted to 2000 items.
 What inventory models?
▪ The total cost of each price break is computed as follows
including the annual product cost and holding cost for each range
which depends on product price.

TC = QH/2 + DS/Q + PD

▪ Choose the price and quantity that gives the lowest total cost
▪ Buy 1,000 units at $4.80 per unit, Discount number 2.
 Reorder Point and Safety Stock
❑ Reorder Point - When the quantity on hand of an item drops to
this amount, the item is reordered. We call it R. Determinants of
R:
➢ The rate of demand
➢ The lead time
➢ Demand and/or lead time variability
➢ Stock out risk (safety stock)
❑ Safety Stock - Stock that is held in excess of expected demand
due to variable demand rate and/or lead time. We call it SS.
❑ (lead time) Service Level - Probability that demand will not exceed
supply during lead time. We call this cycle service level, CSL.
❑ Risk of a stockout = 1 – (service level)
❑ More safety stock means greater service level and smaller risk of
stockout.
 Reorder Point and Safety Stock
❑ Without safety stock:
R = dL
where R = reorder point in units
d = daily demand in units
L = lead time in days

❑ With safety stocks:

R = dL + SS
where SS = safety stock in units

SS = z dL
i.e.,
R = dL + z dL
z = number of standard
deviations associated with
desired service level
 = standarddeviation of
demand during lead time
What inventory models?
 ROP and Safety Stock Example 1
❑ Daily demand = 20 units ❑ Service level (Z) = 90%
❑ Lead time = 10 days ❑ Determine:
❑ S.D. of lead time demand ✓ Safety stock
= 50 units
✓ Reorder point
R= dL + SS
R = dL + σ(1- SL) The value of area under normal
distribution (Z) can be found from
R = 20*10 + 50(norm of 10%) Z table and for 10% stockout the
= 200 + 50(1.28) = 264 units value of Z is 1.28.

SS =50(norm of 10%) Refer Z Table

= 50(1.28) = 64 units
 ROP and Safety Stock Example 2
❑ DDLT follows a normal ❑ Find R and ss Refer Z Table
distribution.
❑ μ = 350, σ = 10
❑ They want a 95% service
level (i.e. 5% probability of
a stockout).
❑ Here μ is expected demand
during lead time with
standard deviation of σ.
R= dL + SS
R = dL + σ(1- SL)

R = 350 + 10(norm of 5%)

From Z table area under 5% is 1.65
= 350 + 10(1.650) = 366.5 units

SS =10(norm of 5%)
= 10(1.650) = 16.5 units
End of Chapter
Four