CHAPTER ONE

INTRODUCTION
1.1 DEFINITION AND SIGNIFICANCE OF MATERIALS MANAGEMENT
After you complete this chapter you will be able to:
 Define what does materials management mean?
 Know the basic significances of managing the material resource you have in an
organization.
 Understand materials management department position and its relationship to
other departments in an organization.

1.1.1 DEFINITION
We can define materials management as the function responsible for the coordination of
planning, sourcing, purchasing, moving, storing and controlling materials in an optimum
manner so as to provide a pre-decided service to the customer at a minimum cost.

Materials management is the integrated function of purchasing and allied activities

so as to achieve the maximum co-ordination and optimum expenditure in the area
of materials.
From the above definition it is clear that the scope of materials management is vast. We can
broadly identify the following functions:
Material planning and control
Based on the sales forecast and production plans, the materials planning and control is
done. This involves estimating the individual requirement of parts, preparing materials
budget, forecasting the levels of inventories, scheduling the orders and monitoring the
performance in relation to production and sales.
Purchasing
This includes selection of sources of supply, finalization of terms of purchase, placement of
purchase orders, follow-up, maintenance of smooth relations with suppliers, approval of
payments to suppliers, evaluating and rating suppliers.
Stores and inventory control
This involves physical control of materials, preservation of stores, minimization of
obsolescence and damage through timely disposal and efficient handling, maintenance of
stores records, proper location and stocking. Store is also responsible for the physical
verification of stocks and reconciling them with book figures. The inventory control covers
aspects such as setting inventory levels, ABC analysis, fixing economical ordering
quantities, setting safety stock levels, lead time analysis and reporting.

1.1.2 SIGNIFICANCE OF MATERIALS MANAGEMENT

There are several reasons for the importance of materials management. But the two major
ones are:

1. The smooth operation of the different units and departments with in organizations
as well as the overall organization depends on the effectiveness of the operations of
the materials management department. The materials management unit has to
supply the required qualities and quantities of materials at the right time and place
to the user departments or to the store. Its failure to do this will force the other
departments and units to stop or delay their operation. Materials management has a
function of such as planning for purchase, receiving, materials planning and
inventory control, stores, traffic, material handling and maintenance, and scrap,
surplus, and disposal.
2. The investment in materials constitutes one of the largest uses of cash of
organizations. i.e. materials consume the largest expenditure of organizations. In
many cases more than 60% of the expenditure of the organizations is spent on
materials.

Example
Construction & petroleum industries e.t.c …..… > 75%
Sugar, wool, furniture industries e.t.c………….. 65 - 75%
Cotton, textile, bread industries e.t.c…………… 55 - 65%
Chemicals, pharmaceuticals e.t.c………………. 45 - 55%
 Steel, fertilizer industries e.t.c………………… 35 - 45%
Therefore, materials management can be a fertile ground to reduce the total cost and
increase profitability of organizations. Because of its consumption of the largest
expenditure, a small effort in decreasing cost of materials pays much more than decreasing
the cost of other expenditures. Also cost reduction in other items is difficult.

Example
In come statements for XYZ Company for the year ended 2005 was as follows.
Sales…………………………………..40,000
Expenditure
Materials……………..28,000
Administration……….4, 000
Others………………..5,000
Total exp………………………………37,000
Profit ………………………………… 3, 000

Required
By what percent would the profit increase if 10% deduction were made from:
a) Materials expenditure
b) Administrative
c) Other expenditures

Solution
a) 10%(28,000) = 2800 c) 10%(5,000) = 500
Increase in profit is 2800 Increase in profit is 500
Percentage increase in profit = 93% Percentage increase in profit = 17%
b) 10 %( 4,000) = 400
Increase in profit is 400
Percentage increase in profit = 13%
The above example shows that a small percentage decrease in materials expense brings a
large percentage increase of profit than a decrease in other costs.
1.2 STRUCTURE OF MATERIALS MANAGEMENT
Dear students! Where do you think Materials Management department be located in
the organization structure?

Structuring materials management in an organization depends on several factors. Including

the type of the organization, the size of the organization, percentage of materials costs to
total costs and the attitude of top management towards materials management. Let’s see
some of this factors:
A. Type of organization
Different types of organizations require different structures for materials management.
Business organizations do not structure materials management as non-business ones.
B. The size of the organization
A separate and independent materials management unit may not be required in small
organizations. The activities of materials management may be placed under other
department like the production department because it has interest with materials
management. N.B putting materials management departments depends on the objective of
the organization. But big organizations should have an integrated materials management
department headed by its materials manager.
C. Percentage of Materials expense to total expense
A separate and independent materials management unit may not be required if the
percentage of materials expense to total expense is low. But a separate and independent
materials management unit is required if the percentage of materials expense to total
expense is high
Attitude of top management towards its materials management unit will affect its structure.
Therefore, if its attitude is positive then the materials management unit is likely to have an
independent unit

General Manager

H.R.M Mkg. Mgt. M. M Prod. Mgmt

Purchasing Inventory control Stores Cost reduction Planning

Fig 3: Materials Management Structure for Large and Modern Organizations.

General Manager

H.R.M Mkg. Mgt. Prod. Mgt. Finance

M. M

Fig 2: Materials Management Structure for Small and Traditional Organizations.

1.3.1 Materials Management & Other Departments

Dear student! can you write the relations of materials management department with other
departments? Some of them include the following:

1. Materials Management and production & operation departments

The relationship of the two is that production and operations is the use of materials and
materials management of the supplier and materials. The functioning of production and
operations depends on the quality of materials and the smooth and uninterrupted flow of
materials. It is for these reasons that production and operation would like materials
management to be under it.

2. Materials Management and Finance department

Finance is the supplier of money to the purchase of materials and materials management
uses money. Finance considers materials management as a basket of different costs i.e. as
a unit that doesn't add value. In order to control the finance (Money) Finance department
would like materials management to be structured under it.
3. Materials management and marketing department
Marketing is concerned about the satisfaction of customers by providing quality products.
The quality of products depends largely on the quality of materials. Marketing would like
materials management be under it to control the quality of the inputs.

CHAPTER TWO
2. FORECASTING DEMAND AND PLANNING OF MATERIALS
After you complete this chapter you will be able to:
 Understand what forecasting is
 What technique are used to make demand forecast.
 What materials plan is and how it relates with other functions

Forecasting is the art and science of predicting future events. Forecast and actual events are
usually varied. Thus, the quality of decision depends up on in large part on the quality of
the forecast. Forecasting year can be minimized by more reducing errors through better
forecasting i.e. by building more flexibility in to operations and by reducing the length of
time over which forecasts are required. Next we are going to discuss on the two major
types of forecasting techniques.

2.1 Qualitative Forecasting

This is subjective or judgmental and it is based on estimates and opinions of individuals.
It doesn't need the specific mathematical models. It is used when there is lack of data or
when fast data are not reliable predictors of the future. It is used for medium and long
term forecasts as well as for new products introduction where historical data are not
available. This method relies on the opinion, experience, judgment and intuition of
specific people like the sales person, and production managers. We can not totally rely on
this technique as the result differs from one individual to another. This technique should
be applied when no historical data is available.

This techniques consists the following methods.

 I. Grass root method: This method forecasts demand by collecting data from
individuals found at lower level of the organization structure hierarchy, which deals with
what is being forecasts. In other words, this technique focuses on individuals who have
direct contact with customers.
II. Market research: This technique forecasts demand for materials through
collecting data from the market. This can be done through interview, questionnaire and
other means of data collection. This technique specially used for existing product in
which data are available in the market.
III. Panel consensus - This technique is developed through open meeting with free
exchange of ideas from all levels of management and individuals with the belief that
people from different position can develop a more reliable forecast than a narrow group.
The difficulty with this open style is that higher levels of management intimidate lower
level employees.
IV. Delphi method: In this technique the identities are not known because of the
problem of intimidation can be avoided. It can be done through e-mail or questionnaires.
It has the following steps:
Steps
1. Experts from variety of knowledge are invited to participate.
2. All participants will provide a written response for questionnaires presented through e-
mail or questionnaire.
3. Results of the participants will summarized and distributed to the participants along with
new questions.
4. Results of the reconsideration are summarized again distributed to the participants along
with new questions.
5. Repeat the procedure until an appropriate forecast is achieved.
V. Historical Analogy Method : This method will determine by what is being
forecasted with a similar item. It is important in planning new products where a forecast
may be arrived by using the history of a similar product.

2.2 Quantitative Forecasting Method

This technique utilizes mathematical and statistical models to predict and estimate the
future requirement on demand based on past data. The basic assumption for this method is
that past data and data pattern are reliable predictors of the future. It uses the following
methods.
I. Arithmetic Mean (Average) technique method: This technique forecast demand
(DD) by calculating the average of all past consumption (actual demand) of materials.
i.e. forecast demand for next period = average demand for previous period.

Ft = Ai Where: Ft -forecast demand for next period

n
Ai - previous period actual demand
n - Number of time period.

Example
Period Actual DD Forecasted DD
1 6 -
2 4 6
3 8 5
4 7 6
5 4 6.25

II. Last period demand: This technique tries to overcome the weakness of various
methods by eliminating the influence of old data and base the forecast only on the demand
of previous period.

Ft= At - 1
Where: Ft - is forecast DD for next period
At - actual DD for previous period

Example
Period Actual DD Forecasted DD
1 6 -
2 4 6
 3 8 4
4 7 8
5 4 7
6 7 4

III. Moving Average Method - This method represent the two previous method in that
neither is the forecast influenced by the whole data nor does it solely reflect the figure for
the previous period.

Ft= A1+A2+A3....+An
n
Where: Ft- is demand forecast for next period
A1, A2, A3 -is actual demand for the previous
period which include in the moving average.
Example: Forecast the demand for materials based on a four period moving average.

Period Actual DD Forecasted DD

1 50 -
2 60 -
3 50 -
4 40 -
5 50 50
6 55 50
7 40 48.75
8 30 46.25
IV. Weighted Moving Average - This technique gives more emphasis or weight for more
recent data with the believes that more recent data are more reliable to forecast the future
than the older data.
Ft= W1A1+W2A2+W3A3+...+WnAn
Example. A department store may find that in a few month periods the best forecast is
derived by using a 40% weight for actual demand (dd) of the most recent month 30% for 2
months ago, 20% for 3 months ago and 10% for 4 months ago. If the actual dd was as
follows what will be the forecasted dd for period 5?

Period Actual dd forecasted dd

1 100 -
2 90 -
3 105 -
4 95 -
5 - 97.5
Ft = 40% (95) + 30%(105)+20%(90)+10%(100)
=97.5 unit the forecasted demand for period 5
V. Simple linear regression analysis: This regression line uses only one independent
variable (x) the equation for the simple linear regression is
Y = a+bx
b = nxy - (x) (y)
n(x2) - (x)2
a = y - bx
n
Example:
A manufacture wants to develop a facility plan to build a production capacity for its
factory. The amount of capacity required in the future depends on the number of products
demanded by its customers. The data below shows past actual sales of its product.
Year (x) Actual sales (y) X2 XY
1 1000 1 1000
2 1300 4 2600
3 1800 9 5400
5 2000 16 8000
- 2000 25 10000
x =15 y=8100 x2=55 xy = 27000
Required - Using simple regression analysis, forecast demand for products for each of the
next 3 years (6, 7, 8)
Solution
b = nxy - (x) (y)
n(x2) - (x)2
= 5(2700) - (15) (8100)
5(55) - (15)2
= 270

a = y - b x
n
= 8100 - 270 (15)
5
a = 810
The regression equation is y=810+270x
Y6 = 810 + 270 (6)
= 2430
Y7 = 810 + 270(7)
= 2700
Y8 = 810 + 270 (8)
= 2970
VI. Exponential Smoothing: This method uses only three pieces of data to forecast the
future. These are;
 The most recent forecast
 The actual demand occurred for that forecast period
 A smoothing constant alpha (), which determines the level of smoothing
and the speed of reaction to the difference between forecasts and actual
occurrences. It ranges b/n 1 and 0
Ft = Ft-1 +  (At-1 - Ft-1)

Where, Ft = the exponentially smoothed forecast for the future

 Ft-1 = the exponentially smoothed forecast for the prior period
At-1 = the actual demand (DD) in the prior period
 = the smoothing constant
Example:
Assume in XYZ Company demand for its product is relatively stable and a smoothing
constant  (0.05) is considered appropriate; assume that last month the forecast of the
company was 1050 units while actually 1000 units were demanded.
What will be the forecast for this month?
Ft = Ft-1 +  (At-1 - Ft-1)
= 1050 + 0.05 (1000 - 1050)
= 1050 + 0.05 (-50)
= 1050 - 2.5
Ft = 1047.5
VII. Time Serious analysis: is method of forecasting the behavior of a variable in relation
to time. It assumes factors affecting the variable continue in time.To use time serious
analysis, we have to find the equation of the line that fits the data. The equation of the line
is given by ; y  a  b (x )

xy  n x y
Where a  y  b x b
x 2  n(x ) 2
Example
Consider the following three companies A, B and C and their demand for Aluminum.
Companies /Aluminum in tones
Year A B C
1995 20 15 13
1996 20 16 17
1997 20 17 16
1998 20 18 16
1999 20 19 21
2000 20 20 20
2001 20 21 20
 2002 20 22 23
2003 20 23 25
2004 20 24 24
2005 20 25 25
Required
-Forecast the demand for Aluminum for 2006 for each company
Solution
For companies A and B, we can make use of simple observation to make the forecast,
which will be 20 and 26 tones respectively.
But for company C we can not forecast using simple observation. Therefore first select one
of the years as abase year and assign zero, negative integers above it and positive integers
below it. Any year can be chosen as abase year. Then complete the table as follows.
Year x y xy x2
1995 -5 13 -65 25
1996 -4 17 -68 16
1997 -3 16 -48 9
1998 -2 16 -32 4
1999 -1 25 -21 1
2000 0 20 0 0
2001 1 20 20 1
2002 2 23 46 4
2003 3 25 75 9
2004 4 24 96 16
2005 5 25 125 25
 0 220 128 110

Then find the equation of the line that fits the data. The equation of the line is given by
y  a  b (x )
 xy  n x y
Where a  y  b x b
x 2  n(x ) 2

y xy
a y b
n x 2

220
a= y   20  a
11
xy 128
b  = 1.163
x 2 110
Thus, y  20  1.163 x

Where x is the number of year counted from the base year, forecast for
y  20  1.163(6)  26.978 Tones
Therefore the forecast for 2006 will be approximately 27 tones.
VIII. Regression Analysis:
It is a method of forecasting similar to time serious analysis. Where as time serious tries to
see the relationship between variables and time but regression analysis looks the relation
sheep between one variable and another variable having dependence relationship, example
what will happen to community expenditure if tax increases?
Regression analysis uses the same formula as time serious analysis.
Where y = a + bx

 y b x xy  n x y
a   y  bx b
n n x 2  n(x) 2
x = independent variable
y = dependent variable

Example
Suppose you are a manager of a building materials production company. And you feel
demand for the plastic board your company is producing and selling is related to the no of
construction permits issued by the municipalities in your locality in the previous years.
You have collected the following data. If construction permit for the next year is 30 what
would you think the demand for the board shall be?

(x) Construction permit Demand for board

(100)
xy  n x y
b  .395
15 6 
x 2  n x
2

9 4
a  y  b x  0.91
40 16
y  0.915  .395 x
20 6
 0.915  .395(30)
25 13
 12.96  1300 Units
25 9
15 10
35 16
30 ?

IX. Correlation: Means the strength and direction of the relationship between
the dependent and the independent variables. It can large from -1 to 1. Correlation
becomes -1 if they are strongly unrelated i.e. The dependent and the independent variables
move in different directions and correlation is +1 if both moves to the same direction and
have strong relation.
nxy  xy
r
nx 2

 (x ) 2 ny 2  (y ) 2 
Determine the correlation between demand for the plastic board and the number of
construction permits issued. And interpret your result.
8(2146)  (184  80)
r
[(8  5006)]  [(184) 2 ] [(8  950)  (80) 2 ]
 0.90
Interpretation: The number of construction permits issued and demand for board are
strongly related.
2.3 Planning of Materials
Materials planning is the scientific way of determining the requirements of raw materials,
components, spares and other items that go into meeting production needs with in the
economic investment policies. Thus, by definition, it follows that the materials planning
function is a subsystem in the overall planning activity. This is evidenced by the following
figure, which shows the relationship between materials planning and other major functions.

Figure: relationship between materials planning and other major functions

Sales Production Materials

Forecast programme Plan
d

Feedback information
and review

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

CHAPTER THREE
3. PURCHASING
This chapter leads you to understand the purchasing issues, which you will be able to
understand:
 What purchasing is
 What the purchasing cycle looks like
 What Methods of buying are available
 What procedures to follow in purchasing
 How to take Buy or Make Decision
 How to select out of available suppliers and so on.
3.1 Definition (meaning) of Purchasing
Purchasing is a function of procuring goods and services from sources external to the
organization. Different books may define the term purchasing differently. But the main
essence is included in the following compiled definitions:
“Purchasing is the procuring of materials, supplies, machine tools and services
required for the equipment, maintenance and operation of a manufacturing plant.”
Another definition
“purchasing is the procuring of materials, tools, stores (or supplies) and services
required for the manufacture of a product, maintenance of the machines, and
uninterrupted running of the manufacturing plant in a manner that guarantees the
marketing of the company’s products in the quantities desired, at the time promised
and at the competitive price consistent with quality desired.”
Purchasing in essence is the task of buying goods of right quality, in the right quantities, at
the right time and at the right price. These essentials of scientific purchasing are though
complimentary yet achievement of one does not guarantee the other. The buyer may have a
source that is capable of giving quality product but he may not have enough capacity to
meet quantity requirements in time, or the source may have the capability to supply goods
of right quality and in the right quantities but he may not supply at the right price or at the
right time. But if the buyer has right kind of sources, then he can get the goods of right
quality, in the right quantities at the right time and at the right price. To conclude, for
scientific purchasing, greater emphasis has to be placed on locating, selecting developing
and retaining right king of suppliers.

3.1.1 Growing Importance of Purchase

Traditionally, purchasing was regarded as one of the activities of the production
management. Now it is being considered too specialized activity to be treated as line
function. Many management doctrines has already realized that in lieu of changing
business conditions, growing competition, continual escalation in the cost of inputs,
purchasing must be given status equal to that of other major functions (i.e. production,
sales, and finance). Few important reasons for the change in emphasis are:
A. Higher cost of goods and service:
Raw materials, components and services account for a significant proportion (as much
as 50 to 60%) of the company’s total expenditure. In the paint industry, materials
account for over 60% of the cost of the product. Effective purchasing, therefore, can
result in a substantial saving to the company. Mere one percent saving in material cost
can give benefit equivalent to eight to nine percent rise in sales volume.

B. Escalating cost of stock outs:

Lack of continuity in the availability of materials seriously affects all major companies.
It can damage profitability of the company and lower employee morale. Financial loss
due to stock outs o materials in mass/flow production units, process industries and
capital intensive units can be enormous.

C. Higher present day cost of capital:

The capital distribution between fixed and working capital in firm is normally around
60:40. further, around 80% of the working capital is locked up in inventory of raw
material work-in-progress, finished goods, spares, etc. no organization can afford to
invest such a big part of its capital in the stock especially these days when the cost of
borrowing money is as high at 20%. Bulk of these stocks can be reduced and
unnecessary capital lock-up can be avoided if purchasing is made efficient.

D. Purchase is not mere act of buying

Purchase is not mere act of buying. It is in fact a much broader concept. Purchasing in
today’s context includes a wide range of materials related activities such as market
research, vendor rating, standardization and variety reduction, codification, indent
control, pre-purchase value analysis, price negotiation, inventory control, surplus
disposal, purchase budget, import substitution, purchase system design etc.

E. Changing nature of purchases:

 Purchasing today is no longer just a commercial activity, but is techno-commercial-
activity. More and more technical persons are being inducted into the purchase
department and naturally these people, like their counterparts in production, design and
other departments, expect a better treatment.

F. Professional isolation of materials function:

Like other branches of industry, purchase too has experienced development of many
management concepts such as: ABC analysis, economic lot size, learning curve, critical
path analysis, line of balance, variety reduction, codification, value analysis, vendor
rating, etc. the knowledge of these techniques is being considered essential for the
middle and senior management personnel in the purchase department. This additional
knowledge has given rise to a group of professionals or specialists in the purchase field
who expect status at least equal to their counterparts in the other functional areas.

G. Changing concepts of buyer-seller-relations:

Buying scene also has undergone a major change. Old concept that “a supplier is
dependent upon buyer and he can made to perform his part of the contract the way
buyer desires” no longer exists now. Efficient buying- continuity in availability of
materials with the lowest inventory investment-demands a buyer to be good at business
relations. He must buy goods of right quality, at the right time, and at the right price for
which he must have right source. Retention of good suppliers, with increasing
competition, is becoming difficult and hence the buying function is becoming
challenging day by day.

3.1.2 Objectives of Purchasing

Objectives of purchasing include the following:
i. To procure at a competitive price the needed materials, supplies, tools and services
of the right quality, in the right quantity and at the right time.
ii. To maintain continuity of supply to ensure production schedule at minimum
inventory investment.
 iii. To ensure the production of goods of better quality at the competitive price by
procuring materials which best suit the product and the purposes for which they are
intended.
iv. To suggest better substitutes to materials which are currently being used with a
view to lower cost and maintain quality of the products?
v. To render assistance in standardization, variety reduction, value analysis and cost
reduction programmers.
vi. To advise on probable price, deliveries and performance of items under
consideration by the design, development and estimating departments.
vii. To create goodwill and enhance the company’s reputation for fairness and integrity
through dealings with the suppliers.
viii. To enable company to maintain competitive position and earn a fair return on its
investment.
3. 1.3 Functions of Purchase Department
Major functions of purchase department include the following:
 Locating, selecting and developing qualified sources of supply.
 Scrutinizing purchase indents and deciding suitable method of buying.
 Floating enquiries, processing quotations, conducting negotiations, and releasing
purchase orders.
 Pre-delivery follow-up and shortage cashing.
 Co-ordination with inward inspection including timely return of defective materials
back to suppliers.
 Endorsing suppliers’ invoices for payment.
 Processing supplier’ requests for price increases including price renegotiations.
 Attending to suppliers’ representatives and traveling salesmen.
 Arranging discussion meetings between suppliers’ representatives and company’s
officials.
 Disposal of surplus, obsolete and scrap materials.
 Advising management as regards to new materials, new products, forward buying etc.
 Acting as a link between company’s finance department and suppliers for timely
payments/settlement of suppliers’ bills.
 Attending to periodical activities like applying for import license, quota etc.
 Maintaining company’s image among suppliers.

Classification of Functions: The functions or the duties to the performed by the

purchasing department may be classified as under:
Primary Duties Secondary Duties Optional Duties
(1) (2) (3)
a) Receipt, scrutiny of a) Make-or-buy decisions a) Traffic
purchasing indents and
determination of method b) Capital equipment & b) Stores
of buying construction purchases
b) Search for suppliers c) Inventory control
c) Acquisition and d) Purchase research
analysis of suppliers’
proposals
d) Selection of suppliers
e) Follow-up with
suppliers for timely
receipts of materials
f) Performance
evaluation and feed back.
g) Disposal of surplus,
obsolete and scrap
materials

3.1.4 Purchase as a Profit Center

Purchasing department in almost all companies is the biggest spending department and
literally the “custodian” of the company’s purse. Almost 50 to 60 percent of a company’s
income is spent on materials. The very fact that purchase department is responsible for such
a high percentage of company. The purchase department is though a cost centre, but
 considering its scope to save company’s money it should be looked upon as a profit centre.
Moreover, unlike in sales function, a Birr saved is not a Birr earned. To earn a Birr, sales
volume equal to ten Birr or more is required which implies that a Birr saved is equal to a
ten Birr sale. Also, a sale is one time sale. A saving on the other hand is a repetitive saving.
Every Birr saved goes straight to profit. Therefore, effective purchasing can make a
tremendous effect on the profitability of the firm. Purchase department contributes to profit
as under:

i) Purchasing and competitive price:

Buyer looks for a supplier who can and is willing to supply goods of right quality, in the
right quantities and at the right time. The buyer discuses with supplier and agrees on a
mutually acceptable price. Numerous historical incidents prove that skillful negotiation can
easily cut down procurement cost up to 5 percent from the total cost of goods purchased.
ii) Purchasing and capital release:

Profit making, however, is not a function of purchasing at lower price. There is yet another
well known parameter, called capital turn-over rate, relevant in this context.
Profit OR Profit X Sales (B/C you can cancel sales by sales)
Rate of Return = Capital Sales Capital
(R.O.R)
OR = (Profit Margin) X (Capital Turn-over)
Where as, Profit Margin = Profit & Capital Turnover = Sales
Sales Capital
Rate of return, alternatively, can be improved by peeling off unnecessary fat from the total
capital.
Capital is of two types: (a) fixed capital and (b) working capital. The study in the area of
inventory management reveals that around 52% of the company’s total capital is deployed
in fixed assets and remaining 48% in working capital. Fixed capital is fixed anyway; hence
a little can be done about it thus leaving us with working capital. The study of this portion
of the capital reveals that a little over 80% of the working capital is locked up in
 inventories. Scientific purchasing can help to reduce inventory investment thereby increase
stock turnover rate and therefore rate of return on investment.
iii) Purchasing and procurement cost reduction:

In a conventional approach, purchases department spends bulk of its time one low value
items which increases paper work costs and follow-up costs. Drastic reductions in these
costs are possible through “blanket orders” “group purchasing” and “system contracting”.

iv) Purchasing and life-cycle costs:

Conventional purchasing of capital equipment aims at low initial price of the equipment.
Scientific purchasing on the other hand advocates life-cycle approach wherein the costs
covering the entire life of the equipment are considered. Such an approach besides price
considers maintenance logistics, maintainability, reliability etc. and this reduces the sum of
procurement and operational cost of the equipment.

v) Purchasing and transportation cost:

Handling and transportation costs constitute an important constituent of materials cost
which in turn is basins to the total cost. Transportation cost in some industries such as
mining, fertilizers, heavy machinery etc. ranges between 20 to 40 percent of the production
cost.
Besides direct transportation costs, transportation service is also equally important. Serious
production delays causing big financial losses can occur if shipments do not arrive on
schedule. Selection of the appropriate mode of transportation such as rail, roads, or air, etc,
should not the based merely on transpiration cost considerations. But their effects on the
inventory levels should receive proper attention. Small transit lead time employing faster
mode of transport especially in case of high-value-low-weight items often proves
economical.
Transportation costs and transportation service, therefore, significantly affect a firm’s cost
of materials. Its efficient management very effectively helps in improving profitability.
Hence there is a need to grasp essentials of scientific purchasing.
 Scientific purchasing ensures that:
 The most efficient and effective mode of transportation minimizing the overall cost
covering the transpiration costs and transit inventory cost is introduced.
 Source selection and source development activity employs transpiration cost as one of
the criterion for selecting the source. (i.e. nearest available sources are used when it is
profitable to do so and vice-versa).
 Materials are purchased as well as are released by suppliers in the quantities that reduce
overall total cost, transformation cost being one of the important cost elements.
 Carriers-truck, rail, air and water carriers – are selected based on engineering economic
principles.
 Principles of competitive bidding are used while selecting a carrier and thereby taking
full advantage of its competitive nature.

vi) Purchasing and wastage control:

Though waste control can be extended to all kinds of resources, its usage in the materials
field can be most regarding. Various causes of material waste are:
 Wrong buying  Improper handling leading to
 Over buying breakages.
 Impulsive (rash) buying  Improper handling leading to
 Over specifications of requirements breakages
 Procurement of uneconomical size  Wrong selection of materials.
(e.g. oversize)  Lack of standardization.
 Spillage of materials  Poor handling of materials resulting
 Evaporation losses (e.g. petrol) in unnecessary rework rejection.
Many wastes of materials can be eliminated by improving effectiveness of purchasing
function and implementing different tools and techniques of materials management.

vii) Purchasing and economical disposal of surplus of materials:

The disposal of surplus and obsolete stocks can be effected in various ways, the return
being different from different channels. For example, surplus materials, if sold as scrap to
a scrap dealer, are hardly expected to fetch 20 to 30% of original cost while if the surplus
material is returned to the original supplier, it may bring in 90 to 95% (sometimes even
100%) of original cost. The selection of the appropriate channel, therefore, is important.
Thus, effectiveness of purchasing function even in areas such as disposal of obsolescent
and surplus material can be really rewarding for the company.
From the above discussion, we can conclude that the purchase is really a profit centre and
this profit concept is not restricted to manufacturing firms. Even in non-profit service
organizations-hospitals, defense and government departments-scientific purchasing can
lead to considerable reduction in expenditure.

3.1. 5 Purchasing Principles (5 R’s Of Buying)

Purchasing is the most important function of materials management. Scientific
purchasing, however, is not mere procurement of needed materials at the lowest price but
their procurement in a way that minimizes the overall cost of the product. To ensure this,
scientific purchasing is governed by five well-known parameters called basic elements of
scientific purchasing or also called “5 R’s of buying”. These 5 R’s are:
i. Right Quality iv. Right Time
ii. Right Quantity v. Right Source
iii. Right Price
Some of these basic elements can be further amplified into their sub-elements. For
example, the element of “right price” can be further split up into sub-elements, namely:
Right method of buying, right packaging and packing, right place of delivery, and right
transportation. Al these have been exhibited in
RIGHT QUALITY
-Quality specification
RIGHT SOURCE - Source selection and
-Source selection and development development
-Vender Rating -Vender quality Rating
-Purchase Research -Vender up gradation/ self
certification
-Value analysis
-Standardizing
 5 R’s of RIGHT QUANTITY
Purchasing -EOQ
-Replenishment Methods

RIGHT PRICE
-Basic element of price
-Competitive bidding
-Negotiation
RIGHT TIME -Learning curve
-Replenishment methods -Right place of delivery
-Lead time analysis -Right Transportation
-Legal aspects
-Price renegotiation
-Payment Methods

Figure: Constituents of each Element purchase principles

(1) Right Quality
Quality of a product is measured in terms of its design, materials, chemical composition,
heat treatment, surface treatment, manufacturing processes, mechanical and electrical
properties, workmanship, etc. Two distinct but closely inter-related aspects of quality are:
“quality of design” and “Quality of conformance”.

Quality of deign for purchased items refer to the quality specified by the company’s
design department in the form of specifications while quality of conformance refers to the
extent to which the goods and services purchased complies with the laid down
specifications. To determine the quality of conformance of purchased items, sampling
plans may be used.
Different methods of providing quality specifications are: brand or trade names,
commercial standards, performance standards, blue prints, sample etc.

(2) Right Quantity:

Right quantity is yet another important parameter in buying. Quantity decisions are
influenced by “replenishment methods” and “buying methods”
Replenishment methods such as “re-order level”, “two-bin-system” “review system:
optional replenishment” and or “review system compulsory replenishment” help to
provide broad guidelines. For example order quantity under first three replenishment
systems is fixed and generally the economic order quantity though the same might have
been modified in the light of constraints. However, the re-order quality under the forth
system (i.e. review period: compulsory replenishment) varies and equals the difference
between the maximum level less the sum of “stock on hand” and “stock on pipeline”
Buying methods following by the buyer too has an influence on order quantity. For
example, re-order quantity under:
 Hand to mouth buying is to small
 Scheduled buying can be either economic order quantity, smaller or larger than EOQ.
 Forward buying is generally very large covering a long period consumption.
 Contract buying is received in staggered lots, each lot at times may equal EOQ.
Besides the above mentioned factors, consumption, market condition lead time, source of
supply (indigenous or foreign) etc., too influence the decisions of right quantity.

(3) Right price

Right price does not mean the lowest price but the price which minimizes the overall
cost. Right price is not that easy to determine. The technique of:
 Negotiation is used when there are limited vendors, and/or time available to make
purchase is short, and/or items belong to fixed price category.
 Tender system is followed in public sector organizations to identify the lowest
potential bidder.
 Learning curve is employed to determine the price of the item with high labor
content.
A most common equation used in this connection is” Value = Quality
Price
(4) Right time
Right time and lead time are closely related. Right time implies that time at which the
goods requested should be received while lead time refers the time that elapses between
the communication of the need for the item by indentor to purchase till the item is
actually received and is made available for consumption. The buying department has the
sole responsibility of developing lead time information for all items and make it available
to those concerned – mainly planning and stores – so that they indent requirements well
in advance and avoid the need for rush purchases.
Basic elements of lead time are:
 Time required by the indentor to communicate requirement to purchase.
 Time required by purchase to locate, select, develop qualified source of supply
including agreement on contractual terms.
 Transit time for the purchase order to reach supplier.
 Time required by he supplier to route buyer’s order through his administrative
channels.
 Time required by supplier to fill buyer’s order (i.e. time required by the supplier to
manufacture goods).
 Transportation time for the goods to reach buyer’s destination.
 Time required by buyer’s receiving department to collect materials from transporter’s
god owns, verify receipted quantities and prepare necessary documents.
 Time required by the buyer’s inward inspection to verify the quality of goods.
 Time required by the main stores to take possession of the goods, deposit them into
appropriate bins and update stock cares.
Since the inventory investment of an item to a large extent is influenced by its lead time,
the buyer must analyze each of the above mentioned elements and try to reduce them to
the extent possible. This is especially important for items of A and B categories.
Occurrence of one or two contingencies, namely, strike or lockout, flood, etc, at
supplier’s plant may require purchase to make rush purchase from local supplier at higher
price. (The being possible for items produced to commercial standards) or approach new
suppliers and crash develop the item (for items produced to buyer’s design). To ensure
continuity in production, buyer must maintain sufficient inventory in case of single
source items.
(5) Right source:
Only the right source can give goods of the right quality, in the right quantities, at the
right price and at the right time. Right source aspect requires decisions as to what items
should be purchased directly from the manufactures, which items from dealers and which
items from open market. Right source also requires the analysis of transportation costs
along with the basic price to make selection between a distant supplier and a local
supplier.

Besides the factors mentioned earlier, reliability and timely delivery have to be seriously
reckoned with. Actually there are four stages of source selection:
1. Survey stage 3. Negotiation stage
2. Enquiry stage 4. Experience stage
3.2 Purchasing Cycle
3.2.1 Meaning of purchase cycle
Purchasing activity plays a vital role in all the firms in general and in the manufacturing
firms in particular. Purchasing is not merely “buying to satisfy the indentor’s
requirements” but “buying goods of right quality, in the right quantities, at the right time
and at the right price”.
Purchase cycle consists of following eight major activities
1. Establishing and communicating the need for procurement.
2. Scrutiny of the purchase indents.
3. Market study and selection of sources of supply.
4. Order preparation.
5. Follow up
6. Receiving and Inspection.
7. Storage and Record keeping.
8. Invoicing and payment

Establishing and the Scrutiny of the

need for procurement purchase indents

Order preparation Purchase Market

Research
3.2.2 Elements of procurement cycle

1. Establishing and communicating need for procurement

The need for purchase originates in one of the firm’s operating departments or its
inventory control section. The demand may be for raw materials, such as steel; or it may
be for semi-finished goods such as castings, forgings, semi-machined parts; or it may be
for bought out parts; or for cutting tools such as drills, reamers, cutters, etc.; or it may be
for supplies or for spars. The need is communicated to the purchase department through a
formal document called “purchase indent” or a “Bill or Material”
ESTABLISHING THE NEED FOR PROCUREMENT
1. Recognizing the need for procurement
2. Determining the requirements
3. spelling out the specifications
4. communicating requirements to purchase
a. Purchase indents/bill of material(production items)
b. Purchase Indents (other items)

2. SCRUTINY OF PURCHASE INDENT

1. Completeness of description
2. Appropriateness of request
3. Routing of indent through stores
4. Logging of indents into indent register

3. MARKET RESEARCH
1. Telephone quotations
2. Written quotations
3. Scheduled buying
4. Source selection and source development

4. ORDER PREPARATION
1. Scrutiny of quotations
2. Negotiation
3. Placing orders on suppliers
4. Obtaining suppliers’ acceptance of purchase orders

5. FOLLW UP
1. Pre-delivery follow up
2. Shortage chasing
 a. Reminder
b. Personal visit
c. Telephone/telegrams
d. Faxes/ Telexes
e. Posting of personnel at suppliers’ works.

6. RECEIVING AND INSPECTION

1. Receiving dispatch details(RR/LR/CAN) and logging them into the consignment
register
2. Collection of materials from the transporter godown
3. Inspection for physical damages to the packages and number of packages
4. Entering consignment details into GRR register
5. Uncrating of goods
6. Quantity certification
7. Raising of GRR
8. Intimating receipt of materials to the indentor
9. Inspection of goods

7. STORAGE AND RECORD KEEPING

1. Movement of materials to concerned store/ rejection store
2. Quantity certification
3. Application of protective coating/ marking
4. Storage of materials in appropriate racks
5. Posting of receipts into stock card

8. INVOIVING & PAYMENT

1. Receiving GRRs in Accounting department
2. Receiving suppliers’ bills
3. Linking of GRR and suppliers’ bills
4. Posting of purchase register
5. passing of bills
6. Effecting payments

Fig. 2 Constituent activities of purchase cycle

A) Purchase indent
Purchase indent, also called purchase requisition, is a formal request made to the
purchase department to purchase materials or services specified therein. The document
serves as an authority to purchase department to go ahead with the purchase activity and
it also provides written information regarding quantity specification, time when required
etc. A purchase indent originates either from the firm’s inventory control section,
production control department, or from one of the operating departments the indent
alternatively be raised either by plant engineer, or by maintenance engineer, or by office
manager, or by other responsible persons authorized to request these items. The authority
to raise purchase indents is limited and standing instructions as to who in the organization
is permitted to sign the purchase indents for different kinds of items are issued by the top
management. The purchase indents from inventory section or section or stores are
generally for items of regular use (stock items). Operating level – minimum level re-order
level, order quantity – are generally established for each of the standard items. When the
stock level drops to or nears the re-order level, an indent is sent from stores to the
purchasing department to replenish the supply. The buying department may also receive
indents for capital goods, the purchase of which has already been approved by the
management.

The indents for non-standard items which are which are not carried in stock are filled in
by the operating department. The requests for items to be sub-contracted may come from
planning department of the company. Normally, indents are raised in triplicate by all
indenting departments except stores who prepare it in duplicate. Original is sent to the
purchase second goes to the store, and third copy remains with the originating
department. The different copies, for convenience, may by print in different colors.
Purchase indents from inventory section or the store is sent directly to the purchase
department. Purchased indents from all other persons must be approved by the authorized
signatory and should be routed through inventory section or stores to see whether
required items are carried in the stores.

ABC PVT. LTD. PURCHASE INDENT No.:

Date:

Please purchase the following materials for___________________________________

Sr. Description Code Quantity When Stock Average Previous

required required on consumption rate and
hand order No.
Route
Indented Stores Purchase
by
Figure: Sample of purchase requisition form (N.B: This form is not identical in all types
of organizations as well as to all types of materials)
B) Bill-of-material
Bill-of-material, also called parts list or building list, is yet another document which
forms the basis for the purchase department to take purchase action.

Bill of material is prepared by the engineering department. The final assembly is broken
into major assemblies; major assemblies are divided into sub-assemblies; and sub-
assemblies are divided into parts. The individual parts comprising each assembly are
arranged, as far as practical, in the manner in which each part is assembled. Bill-of-
material indicates whether the part is to be made or purchased and it also gives the
quantity of each part. The bill-or-material along with the production schedule can be
routed through stores to purchasing as notification of the need for materials. The stores
checks and forwards the bill-of-material serves as the purchase indent. The main
advantages of bill-of-material are:
i. It eliminates the necessity of listing, wiring or typing the part name/part
no.s etc, of the items which are to be purchased. This saves time and energy.
ii.The possibility of writing incorrect or wrong part is avoided.
iii.Since only materials indicated on the document are purchased and issued,
there is thus check on the wastage.
ABC PVT. LTD. Desc
BILL OF MATERIAL Main assembly
No.
Sheet No.
Sr. Drawing Description Quantity Source Material Requir Quantity Stock Stock
No. /set code ed for Regd./sets on shortage
Hand

Checked By Date Approved By Date

Figure: Sample of Bill of Materials (BOM) (N.B: This form is not identical in all types of
organizations as well as to all types of materials)

2. Scrutinizing purchased indents

A purchased indent may describe the items either by its brand name or by its
commercial standard, or by its performance standards. Sometimes the indents may be
forwarded together with the blue print of the item.
Regardless of the form of quality description, all indents received in the purchases
departments must be scrutinized for accuracy and completeness of quality
description.
The scrutiny of the indents is a routing activity of the purchase department. The
indent is scrutinized to see whether
i. It is signed by the authorized signatories in order to avoid irresponsible purchases;
 ii. It is routed through stores department to certify non-availability of the item in
stores;
iii. The description of the required item is correctly and clearly given.
iv. Whether or not qualified and developed sources and available;
v. Last supply of the stated item is completed or pending;
vi. Quantity shown against the item is correctly and clearly written.
Each purchase indent after scrutiny is logged in the purchase indent register and then
given to the concerned buyer. The second copy is initialed, dated and returned back to
its indenter.
3. Market research and selection of sources of supply
The next to following after the scrutiny of the indents is the stage of market study and
selection of the sources of supply. This stage involves segregation of items into item
groups, review of available information, (source register, catalogues, general
information, quotations received previously from potential sources/ traders/
manufactures) and selecting potential source (s) of supply who can-
i. Supply goods of the right quality;
ii. Supply goods at the right price;
iii. Meet buyer’s quantity requirements, and make reliable delivery promises.
The buyer’s previous experience with the suppliers’ catalogues and price lists,
quotations submitted by the traders and manufacturers in the past usually give him
basis for selection of suppliers.

In general, the work involved in market search and source selection is as under:
i. For the items purchased to commercial standards, telephonic quotations are obtained
from vendors and verbal order is given to a supplier whose terms are found to be better
than others. To regularize the transacting, a formal purchase order is sent later. An
alternative to this is the concept of blanket order system which has been discussed
elsewhere in the text.
ii. For the items of regular use and required to buyer’s design, delivery schedules are
released to the suppliers as falloffs against the contract order raised earlier.
 iii. For commodities and items whose prices fluctuate widely from time to time, an inquiry
is sent to probable sources and quotations are received. A comparative statement is
prepared from the quotations received from the supplier which is followed by
provisional selection of one or two sources. Vendors are called for negotiations and
precise terms of contract are finalized with one/two such vendors.
iv. For non-stock items, the sources are selected as per (i), (ii), or (iii) depending upon the
nature of the item (i.e. whether the item is required to commercial standards or the
buyer’s design).
v. For replacement and insurance spares (other than standard ones), enquiry is sent to the
manufacturer or its dealer. On the receipt of quotation from the dealer/manufacturer, a
purchase order is raised to authorize him to supply (i.e. price negotiations in such
situations are usually not possible)
vi. For procurement of capital equipment, enquiries are either mailed to the machine toll
manufactures or the enquiries are advertised (such tenders are called open tenders if
requirements are advertised in the papers of this country or they are called global
tenders if requirements are advertised also in the papers and periodicals of the other
countries in the world). Based on the quotations received in response to the lender,
potential sources are selected. Detailed negotiations are held and finally and qualified
source is selected.
vii. When the amount involved is less and the item is easily available, the buyer may opt for
petty cash purchase.
viii. For new items (i.e. those which have not been purchased before), the buying
department may have to dig out information on likely sources and undertake the
activity of selection and development suppliers.

ABC PVT. LTD.

Address:
P.O.Box……….
Tel……………..
Ref. No…………
Date: …….……....

DELIVERY SCHEDULE
Vendor Code Vendor’s Name Mode of Note: Kindly register
& Address Delivery our schedule for the
following items and
supply the material in
the lots indicated in
column No._
No. Delivery Schedule
Sr. Item Purchase of J F M A M J J A S O N D
No. /Code order lots

For ABC PVT. LTD

Signature…………………

IMPORTANT (Back of the page)

 Make separate delivery Receipt for each item
 Make deliveries only for confirmed qualities.
 Advised immediately for inability/delay expected to meet confirmed
delivery schedule
 Quote the correct code and description of items given here in your
delivery receipt as well as the correct purchase order reference and
vender code.
Figure: Sample of Delivery Schedule format (N.B: This form is not identical in all
types of organizations as well as to all types of materials)
4. Order preparation
Having selected the source of supply, the next step is to authorize the selected suppler to
supply material, which is done by placing the purchase order. A purchased order is a
formal document (a written commitment) prepared by the buying department on behalf of
the company to authorize (request) the supply of the goods and services in the quantities,
at the time and at the price specified there in the document. A purchase order, in fact, is a
legal document and serves as an evidence of the contract between the buyer and the
seller.

ABC PVT. LTD.

Address:
P.O.Box……….
Tel……………..
PURCHASE ENQUIRY
TO Enquiry No.:
Date:
Due on:
Please submit your lowest quotation indicating the earliest delivery time for the following
items:
Sr. Code No. Particulars Unit Quantity Remarks
No.

1. Quotation should be the sent in SEALED ENVELOPES For ABC PVT. LTD
2. Rate quotes should be for free delivery at our works Signature
3. Excise duty, if applicable, should be quoted as Birr per unit. _______________
4. Sales tax rate should be specifically mentioned
5. Please return the drawings along with your quotation
 TERMS AND CONDITIONS (Most of the time are to be on the back of the page)
1. Goods must be strictly in conformity to our specifications.
2. Please mention specifically:
a. Packing and forwarding charges
b. Mode of dispatch
c. Discounts if any
3. Please return all drawings and specification along with your reply (in case there are any)
4. We reserve the right to accept or reject any quotation without assigning reasons.
5. Test certificates or test bars, sample pieces, etc will have to be produced in case required.

Figure: A Sample of purchase Enquiry (Order). (N.B: This form is not identical in all
types of organizations as well as to all types of materials)
Raising a purchase order takes time. The buyer thus has to get his comparative statement
approved by his immediate superior and obtain his signature on the same, assist the typist
by giving all possible details such as name and address of the supplier, prices,
description, delivery schedules/instruction, mode of transport, delivery, insurance,
payment terms, etc. the buyer should not leave things to be understood by the typist as
routine matter who is likely to commit mistakes. After getting the orders typed, the buyer
has to check for its correctness and sign it. Once the purchase order has been signed, it
requires to be entered in the purchase register. The individual copies of the purchase
order, materials required urgently are purchased on verbal or telephonic orders (i.e.
purchase order numbers given on phone) which are covered immediately by written
purchase orders.
 ABC PVT. LTD.
Address:
P.O.Box……….
Tel……………..
PURCHASE ORDER
XYZ PVT.LTD. Our order No.
Date
Your Ref. No.
Date
Please supply the under-mentioned goods to our works subject to conditions overleaf:

Sr. No. Description Quantity Per Rate Value

Excise: MST/CST
Octroi: Freight
Delivery:
Payment terms:
Remarks

Instructions:
1. Indicate P.O. No. on all documents and containers.
2. Invoice to be made in duplicate. Separate invoice for each P.O. No.
3. Materials shall be received between 9:00 AM to 4:00PM on working days
C.S.T. Regn. No. ___________
B.S.T. Regn. No. ___________

For ABC PVT. LTD

Signature…………………

Back page of Purchase order

Terms and conditions

1. Delivery
1.1. The supplier must ensure and guarantee that all supplies made by him against this
purchase order correspond with the description/ ordinal
specifications/drawings/approved samples.
1.2. Delivery is essence of this order. All items must be delivered in the stipulated time.
We reserve the right to cancel, amend and/or alter this order and delivery schedule
without assigning any reason and without in any manner incurring any liability on
us.
1.3. This purchase order shall be automatically treated as closed on 31st march and all
quantities undelivered till then shall be treated as cancelled.
2. Terms of payment:
2.1. Prices and terms and conditions mentioned in this order will be taken as firm and
cannot be changed till the order is fully executed.
2.2. Packing, forwarding, cartage and freight charges will be borne by the supplier unless
otherwise stipulated in the purchase order.
2.3. The supplier must give the description of the item and coder. Number and the
operations performed as specified on this purchase order. Failure to do so may
result in delay in acceptance of material and payment thereof.
3. Inspection:
3.1. All supplies are deemed to be accepted only after the final and detailed inspection at
our works. Payment for materials against this order prior to final and detailed
inspection shall not constitute an acceptance thereof
3.2. If the company finds that the material supplied is not of the required quality or not
according to the specifications as required by the company or are received in
damaged or broken condition or otherwise not satisfactory owing to any reasons,
the company will be entitled to reject the material, cancel the contract and buy its
requirement in the open market against the supplier.
3.3. The rejected material will have to be collected by the party from the works at its own
costs within fifteen days of the receipt of our G.R.R. tailing which the material will
be sent to the supplier on ‘freight-to-pay’ basis.
4. Others:
4.1. The blue prints furnished to the supplier are the sole property of the company and the
supplier on no account shall part with such drawings to any third party without the
written consent of this company.
4.2. This contract shall be deemed to have been entered into at Addis Ababa and only
Addis Ababa courts will have jurisdiction in all matters arising out of this order.

A written purchase order serves the following objectives:

i. It gives full and complete details of the materials to be supplied thereby avoiding
ambiguities.
ii. It helps buyer’s receiving department to verify that the materials received are in
accordance with those ordered
iii. It helps buyer’s accounts department in linking Goods-Receipt-Reports with
supplier’s invoices and preventing duplicate payments.
iv. It serves as a future reference for placement of orders
 The copies of the purchase order go to the supplier, the accounts department, the
receiving department, the indenting department, the reference file, and the follow-
up section. The acknowledgement of the purchase ordered complete until the
acknowledgement of the purchase order is received from the vendor.

5. Follow-up with suppliers

Follow up is the function of seeing that the suppliers effect deliveries on time. The follow
up function now-a-days has become the foremost function of the buyers. Vendors, be it a
small manufacture, a trader, or a supplier at a distance takes little initiative in delivering
the goods on time.
Basic rules of follow-up are:
i. Follow-up should be done on selective basics based on market condition and
buyer’s experience with the vendor’s delivery performance.
ii. Buyer should keep a constant track of outstanding orders and keep himself up-to-
date with latest progress on each order.
iii. Post-dated folder or tickler file should be used to remind the buyer of the action to
be taken.
iv. Mode of follow-up should be based on judgment of the buyer, importance of the
item, reliability or otherwise of the supplier, number of suppliers, location and so
on.
Purchase follow-up is required in two stages: pre-delivery follow-up and shortage
chasing.
Pre-delivery follow-up is intended to remind the supplier of the due date and obtain
advance information of expected delays. Pre-delivery-follow-up enables buyer-
 To make alternate arrangements (i.e. request other source for early delivery) if the
supplier is expected to fail in his delivery commitment;
 To decide expedited routing of goods from suppliers.
Typical methods used are:
i. Phone call to local suppliers at a set period prior to due date;
ii. Letters to outside supplier typed and signed by the buyer;
 iii. Delivery confirmation cards to be returned by the supplier intimating that
the delivery shall be made or not made on promised date;
iv. Regular visits particularly to new suppliers to review progress.

Shortage chasing is he universally accepted most vital part of purchase follow-up.

Methods vary but the purpose is always the same: first to obtain the shortage materials as
soon as possible and second to create a feeling at the suppliers’ works that it is less
troublesome to affect deliveries on time to this company then to have purchase people do
the shortage chasing.
The first of these purposes to obtain shortage materials as soon as possible is served as
under:

Shortage chasing is initiated as soon as due date is over. The nature of follow-up and the
level at which follow-up is done depends on criticality of items, availability of alternative
sources, quantity on hand, and coverage for future period etc.
The second purpose of shortage chasing is equally important i.e. to prevent future
recurrences. The approach to be followed depends upon the type of supplier.
I. A little or nothing much may be possible to be done in case of suppliers of
proprietary items except request them to take care in future supplies.
II. Cost expended should be presented during the informal discussions to impress
upon the supplier.
III. Supplier’s delivery ratings should be communicated on periodical basis. Suppliers
with A and B ratings should be encouraged. Those with C and D rating should be
coaxed to improve on their delivery performance. Such suppliers should be made
to promise that they will take steps to prevent recurrences. Performance of such
suppliers should be watched and those which fail to improve even after repeated
assurances should be warned, black listed and removed. (However, this being
possible wherever the buyer has alternatives).
IV. New sources should be developed and schedule on existing suppliers should be
gradually curtailed to bring pressure on them to improve.
 V. Meeting between the senior representatives should be arranged to discuss the
problems.

For example: At Addis Ababa based engineering company, the follow-up system in
operation is as under: Once the date is marked on the follow-up copy, the clerk segregates
all order copies and puts them into date compartments, made in the cardboard box.

Item group Days reserved for follow-up

i. Raw materials 1,8,15,22
ii. Tools 2,9,16,23
iii. Casting 3,10,17,24
iv. Packing 4,11,18,25
v. Consumables 5,12,19,26
vi. Lubricants 7,14,21
vii. Stationery 7
viii. Electrical 6,13,20,27

The buyers are asked to adopt the following method for follow-up
i. Telephone the party and remind;
ii. Telephone and also write a reminder on a cyclostyled form indicating the
delivery required, the quantity pending and so on;
iii. Long distance parties to be written separate letters, duly typed and signed by the
higher authorities;
iv. Telegrams: when urgency exists (shortages of materials due to delay or high
consumption or both ;)
v. Trunk calls: book a trunk call and discuss with party about the requirements;
vi. Personal visits (local suppliers), : pay a personal visit in case of extreme
urgency and in case of failure to get the supplier on phone:
vii. Distant suppliers: hand over the purchase order to the materials manager for his
decision for critical item (s)

6. Receiving and inspection

The supplier on receipt of purchase order fills up the buyer’s requirements and arranges
for delivery of the materials in accordance with the instructions relating to the quantities,
time, route, mode of transport, etc. contained in the purchase order. The section or
department which is entrusted there possibility of receiving materials and getting them
inspected is known as “Receipt” or “Receiving” department/section. In a small company,
the function of receiving materials is generally looked after by the stores department. The
activities involved are as under:

a) Receipt or collection of materials:

Materials in the receiving department are received against a specific document
department are received against a specific document depending upon mode of dispatch
and geographical location of the supplier.

Materials from local supplier may be received at the buyer’s place either as a result of
door delivery by the supplier or as a result of collection of materials from the supplier’s
go downs or works by the buyer. The supplier’s responsibility of delivery of materials to
the destination depends on the terms of contract. Materials to be delivered by the
suppliers are received accompanied by the supplier’s, “Delivery Note” or “Delivery
Advice” in duplicate or triplicate. The original copy of the delivery note is retained by the
receipt department. The duplicate copy is stamped “subject to physical count and
inspection” and is signed by the receipt clerk and is handed over to the supplier’s
representative.

Alternatively, materials may be collected from he supplier’s works by the buyer’s

representative. Here, the supplier hands over two/three copies of the delivery note with
the materials to the buyer’s representative. The original copy is meant for the buyer’s
receipt department and mailed back to supplier as a proof of receipt of material. The
triplicate copy, which may or may not be raised, depending upon the size of the
supplier’s company, serves as gate pass for the removal of materials. The
acknowledgement of the buyer’s representative signature is obtained by the supplier on
their sales department’s copy of the delivery note.

Materials receipts from outstation suppliers may be received through one of the following
Methods:
 i. Post parcel: Post parcel is the convenient method of receipt of materials from
outstation suppliers. No information is received from postal authority regarding receipt
of materials but postman personally delivers the spares. Only light weight materials
such as samples, spares, and cutting tolls are sent by the post parcel.

ii. Road transport: When the materials are sent through road transport, the receipt of the
transporter, called “Lorry receipt” is sent by the seller to the buyer. The lorry receipt is
numbered and contains description of the items packed in the boxes, the number of
bags/boxes/bundles, freight paid or to be paid and the type of delivery.
If the delivery is mentioned as “Door delivery”, the transporter has to deliver the goods
at the buyer’s works. If it is not door delivery, the lorry receipt received from supplier
will have to be produced to the transporter at the time of collecting the material form
transporter’s go down. The transporters generally inform the buyers when
consignments reach their go downs.

iii. Rail transport: This is similar to road transport except the following differences:
 The railway receipt is received by the buyer in duplicate;
 The railway does not inform the consignee of the arrival of the material;
 The materials require to be collected by the consignee.

iv. Air Transport: Air consignment (AC) note must be sent as soon as material is booked.
The receipt department on the receipt of A.C. note visits airlines office to collect
materials.
An important requirement of the system when materials are to be received from outside
(i.e. either by rail, lorry or air etc.) is that relevant documents such as railway receipts, air
consignment notes, etc. are received in advance from the supplier and sent to the
receiving department. The works of collection of materials from railway go downs,
transportation go downs or airlines office, etc. may be done by the clearing section of the
company or may be entrusted to a clearing agent of the company. Since it takes a long
time for clearing, a register is maintained to keep a proper control on the documents.
The register mentioned above serves many purposes:
  It enables buyer to know at any time the materials that are yet to be received.
 It enables the people in the clearing department to do follow-up with the transport
agency.
 It ensures that action is not left to memory and unnecessary demurrage is not
incurred.
 It enables clearing department to plan their administrative work load as well as
achieve optimum utilization of the company’s vehicles employed for collection of
materials.
(b) Recording of receipt of materials:
When materials are received with supplier’s delivery note, person from receiving
department takes out the copy of the relevant purchase order verifies to ensure:
i. That goods actually ordered have been received;
ii. The supplies are according to the delivery schedule (i.e. excess supply is
not received);
iii. Purchase order number, part name, part number, broad purchase category
etc. are mentioned clearly and correctly.

After having satisfied, the receipt clerk makers the entry of the receipt materials into a
register called “Goods Receipt Register”

(c) Preparation of Goods-Receipt-Reports:

Goods receipt register which gives the record of the materials received in the company
cannot be made available to different departments, be it accounts, indenter, purchase or
others who are concerned with the information. They require to be informed for which
the information from the goods-receipt-register is transformed on a document called
“Goods Receipt Report” (CRR), also called “Goods Inward Note” (GIN), or Receipt-
Cum-Inspection Advice (RCIA), or Materials Inward Note (MIN) or Goods Receiving
Voucher (GRV) etc.
The need for preparing a separate document such as GRR arises because of the following
reasons:
 i. Only one copy of the delivery note is received whereas the number of
departments interested in the information are many
ii. Delivery note received from different suppliers has generally different size
of paper.
iii. Delivery notes do not provide space for the inspection results to be
reported. And hence even if delivery notes are received in sufficient
number, there is still the need for a separate document to communicate
inspection results. Preparation of GRR helps to combine information of
delivery note and results of inspection.

(d) Intimation of receipt of material:

The preparation of GRRs, physical verification of the quantities, inspection of materials
and distribution of the copies of the GRRs takes time especially when inspection involves
metallurgical and/or performance checks. Moreover, the receiving as well as inspection
personnel may not know whether a particular material is required urgently. It is,
therefore, a good practice to intimate the concerned departments as soon as materials are
received. Though communication can be made on intercom yet written communication is
preferred (This because concerned person may not be in his seat when contacted to
communicate materials receipt).

(e) Physical count of the receipted material:

The receipt department is not only responsible for taking possession of the incoming
materials but also for their correct quantities. This implies that materials received require
to be verified for quantities. The verification method of quantities may be one or more of
the following types:
i. Counting by number,
ii. Weighing,
iii. Measurement for length.
While verifying the quantity, the receipt clerk has to attach receipt tag containing all
details about the delivery note to the part or to the package. The receipt tag also contains
delivery note numbers, description of materials, code numbers of materials, name of the
suppliers, number of packages received, quantity received and date of receipt.
The properly tagged material is kept ready for quality verification by the inward
inspection department. Materials after verification of quantity are entered in the
document called goods receipt report. Situations do arise when goods received are found
to be short. Suppliers need to be notified regarding such discrepancies. This is done
through a formal document called discrepancy Note.
ABC PVT. LTD.
Address:
P.O.Box……….
Tel……………

GOODS RECEIVED CUM ISPECTION NOTE

Mr. G.R.R. No.& Date

D.N. No. & Date
P.O.No. & Date

The following material(s) have been received and inspected as per details below

Sr. Receipt Inspection Results

No. Part As per Actually Accepted Rework Received Under
Description receipt Received w/out deviation
& part No. Operation

Vendor Accounts Stores Planning/Sub Cont.

/Customer
Receipt Purchase
Figure: Sample of Goods Received cum Inspection Note (N.B: This form is not identical
in all types of organizations as well as to all types of materials)
 (f) Inspection of goods
All supplies are subjected to inspection and testing. Items purchased to brand or trade
name do not require detailed inspection. These are accepted and put to use after visual
inspection of their pickings and verification of labels or cases.
Critical items requiring use of specialized and sophisticated measuring instruments whose
cost is not justified in lieu of limited purchase are inspected at vendor’s plant prior to
affecting the deliveries by the vendor.
All remaining items (i.e. except those mentioned above) are inspected on receipt by the
inward inspection at the buyer’s works for one or more of the following checks:
 Conformance to dimensions:
 Conformance to materials specifications, and
 Conformance to performance.

Conformance to dimensions is checked against component drawings. The component is

subjected to both visual (to check for mutilation, burn, finish etc.) as well as dimensional
checks with gauges and measuring instruments.

ABC PVT. LTD. DMMR No.:

DAILY MATERIAL RECEIPT Date:
REPORT
Date GRR Supplier’s Item Quality Quality Inspection Remarks
No. Name Description/ as per actually Ok Rework Rejected
Item Code Receipt Received
Figure: Sample of Daily Material receipt report form (N.B: This form is not identical in
all types of organizations as well as to all types of materials)

Conformance to materials specifications is decided with the help of chemical and

metallurgical tests. Small sample pieces of components and cut pieces of materials are
forwarded to the laboratories for checking hardness, materials composition, micro-
structure and other properties.

Conformance to performance is decided on the basis of tests and trial runs, e.g. mach
inability tests for raw materials, life test for bearings, size test for broaches etc.
The responsibility of inspection varies depending upon the nature of goods as detailed
below:

Item group Department responsible

i. Raw material Inspection department
ii. Bought out components Inspection department
iii. Gauges and measuring instruments Quality control
iv. Standard cutting tools Inspection department
v. Special cutting tolls Planning department + Inspection
department
vi. Replacement spares Maintenance department
vii. Supplies
a. Empties Dispatch department
b. Welding and soldering materials Production
c. Stationery Stores
d. Consumable spares Maintenance
e. Capital equipment Plant engineer

Removal of the accepted and rejected materials: The GRR is handed over to the
inspection department or the concerned department. The inspector or authorized person
from the department checks receipted materials and affixes stamp (“Accepted” or
“Rejected”) on the receipt tag.
Duly signed and checked GRRs are returned by inward inspection to the receipt stores.
The GRRs are then sorted out and accepted GRRs are sent to the main stores. The
respective materials are sent to the rejection store where they lie until they are collected
by the supplier or sent back the supplier.

ABC PVT. LTD.

Address:
DISCREPANCY NOTE P.O.Box………….
Tel……………

Mr. Disc Note No. Disc. Note

P.O.No. Date:
D.C.No. P.O.Date
G.R.R. No. D.C.Date
Dear Sirs.
This is to inform you that the material(s) supplied by your are received in short as detailed
below:
S. No. Description Quality Remarks
As per D.C Actually Short
Received

The material(s) has been kept aside in our stores. You are requested to get in touch with us
to settle the matter on the spot within 7 Days failing which we will process the G.R.R for
the actual quality received.
Your Faithfully
For ABC Pvt.Ltd.
Signature
………………………….

Route Supplier Purchase Receipt

Figure: Sample of Discrepancy note format (N.B: This form is not identical in all types of
organizations as well as to all types of materials)

7. Storage and Record Keeping

The goods after inspection are segregated into accepted/rejected, or rework categories
and only fully accepted quantity is forwarded to the stress. The quantity is physically
verified and entered into the kardex/ledger or bin cards and only thereafter the issue is
allowed. In urgencies, however, stores personnel accommodate by issuing without storing
the materials in bins.

8. Invoicing and payment

Receipts of supplier’s invoice: Normally, when the supplier supplies goods, he
immediately prepares invoices. Sometimes, both buyer and supplier have discussion and
supplier agrees to raise invoices after the receipt of goods-receipt-reports. Such a system
has a number of benefits namely:
i.Invoices are raised on receipt of GRRs which indicates to the supplier the exact
quantity of materials accepted by the buyer. This makes it easy for the buyer to link
up necessary papers with invoices which avoids delay.
ii.The need to raise credit or debit notes for discrepancies in quantities or rejection, etc,
is avoided.
iii.Paper work is cleared faster and payment wise there is no dispute

Though the system mentioned above is ideal but often the idea is not sold correctly to the
supplier. The result is that the suppliers’ invoices keep pouring in. the work of handling
invoices may be either carried out in the accounts department or in the purchase
department. Basic principles and procedures involved in passing invoices for payment,
irrespective of the department, remain same.
Scrutiny of the invoices: Supplier’s invoices on receipt are sent to the accounts
department where they are sorted out according to the suppliers and temporarily filed
until the GRRs are received. Accounts department also maintains a control register
wherein all GRRs are serially entered as they are received from receiving stores.
Customer’s invoice file is reviewed everyday to link up incoming GRRs and suppliers’
invoices.
GRRs that are linked with supplier’s invoices are kept separately for the purpose of
checking. Missing GRRs and missing invoices are investigated at the end of each
accounting period and the receiving department (for GRRs) or the suppliers (for invoices)
are asked furnish the same.
Linked up invoices (invoices liked with GRRs) are taken up verification. The price, sales
tax transport/carriage charges, discount etc. are verified against purchase order while
quantity is checked against the GRR. Arithmetical calculations are also checked ensure
correctness of the invoiced amount. The invoice is the stamped for the verification,
countersigned by the authorized person and is passed for payment.
Journal entries: Verified invoices are entered in a purchase register, called “purchase
journal” a purchase journal is a register wherein invoices are entered supplier-wise (i.e.
few pages are reserved for each supplier). Each invoice prior to its entry in the purchase
journal is allotted a sent number called “JE No”.
Effecting payment: The purchase journal is reviewed periodically (say weekly) and the
cashier is informed of the invoices which are due for payment. Cheques are

3.3 Methods of Buying

3.3.1 Introductions
The purchasing department of the company is responsible to provide goods and services
required by the company at the least cost to the company. The request to procure may be
received either from stores department or from one of the functional departments
Such requests may be received:
i. Either for direct materials or for indirect materials;
ii. Either for production items or for non-production items;
iii. Either for low priced items or for expensive items;
iv. Either for the items which are controlled by forces of supply and demand or for the
items which are available off the self;
v. Either for items to be procured from manufacturers or for items to be bought from
middlemen;
vi. Either for the seasonal items or for the non-seasonal items;
vii. Either for items produced to buyer’s design or for items produced to commercial
standards;
viii. Either for items sold at premium or for items sold at discount;
ix. Either to meet immediate needs or it may be to satisfy needs at a later date;
x. Either at time when prices are at their peak or at a time when prices are stable;
The above discussion, therefore, implies that there can be wide variations in the practices
to be followed for the purchase of different types of items. This chapter deals with such
practices (i.e. different buying methods)

3.3.2 Factors Influencing Selection of Buying Methods

A number of factors influence selection of a buying method. They are:
i. Nature of the item;
ii. Regularity of its demand;
iii. Quantities required;
iv. Susceptibility (vulnerability) to price variations

3.3.3. Methods of Buying

There are different buying methods used by different organization. Some of them include
the following:
1. Hand to Mouth Buying
Hand to mouth buying also called “buying according to the requirements” refers to the
frequent purchases of an item in small quantities.
Important characteristics of hand to mouth buying are:
a) Purchases are made only when demand arises
b) Purchases are made to cover when demand arises
c) Quantity purchased is generally small though at times large quantity may be
purchased.
d) The terms of contract are negotiated. Competitive bids are generally not obtained
as there is no sufficient time.
Advantages of the method:
i. Lower inventory investment
 ii. Low carrying charges
iii. Reduced deterioration and obsolescence of materials
iv. Lesser losses from price declines
Disadvantages of the method:
i. Comparatively higher price due to urgencies and loss of quantity discounts.
ii. Possible losses occasioned by an upward movement in prices.
iii. Possible interruptions of production schedules because of market shortage of
materials at the time of need.
iv. Higher clerical costs due to frequent purchases.
v. Acceptance of sub-standard goods in emergency.
Responsibility of buying department: The effectiveness of the buying department
depends on their connections with vendors. The selected vendors must be known for
quality, reliability and integrity so that they fill buyer’s order without taking advantage of
the situation. A long list of vendors is generally necessary.
Suitability of the method: This method applies to:
a) Items required for prototypes and for products under development
b) Items which are used infrequently and would not be required to stocked so they are
purchased when they are needed for definite consumption. Machine tools, special
building materials, office furniture etc. are some of the examples of this group;
c) Cover immediate requirements of a stock item caused either due to delay in delivery
from regular suppliers or due to increase consumption;
d) Cover immediate requirements of items whose prices are expected to fall in the near
future;
e) Procurement of replacement spares;
f) Items which have a limited shelf life and are not stocked for fear or perish ability;
g) Items which are bulky (e.g. packing materials like wooden boxes and thermo Cole
sheets, cotton waste etc.) and need lot of space for storage.
2. Scheduled Buying
Scheduled buying is the process of procuring an item in staggered deliveries according to
the delivery schedule furnished to the supplier by the buyer. The salient characteristics of
scheduled buying are:
 i. A purchase order covering annual requirements (alternatively a purchase order
without specifying the order quantity called open order) is placed with the supplier.
ii. The supplier is given the estimate of the procurement needs covering a mutually
agreed period of time. It is a common practice to give 2-3 months confirmed
scheduled and 2-3 months tentative schedule.
iii. Fresh delivery schedules are given to the supplier prior to completion to the
previous schedule. Fresh schedule supersedes the previous schedule. Fresh schedule
usually retains the confirmed as schedule of the over-lapping period while it
specifies confirmed as well as tentative schedules of the next few periods
iv. Monthly deliveries are usually specified except for perishable materials, bulky
items and others required in large quantities or where supplier has set up production
facilities especially for the buyer. In such cases monthly schedules may be split up
further into weekly schedules.
Advantages of scheduled buying: Both buyer and seller enjoy the savings resulting
from regularity of production and smaller inventories.
i. Buyer is assured of supply of goods while supplier is assured of business.
ii. Supplier can effectively plan his factors of production while buyer can plan his
requirements of finance.
Suitability of the system: Scheduled buying is best suited for:
 Items of regular use such as cutting tools, castings, forgings, lubricants, etc.
 Items produced to buyer’s design and requiring long lead time to manufacture.
 Proprietary items from suppliers who insist on long term schedules.

3. Market Purchasing
Market purchasing also called forward buying, refers to the procurement of sufficient
quantity of an item in advance of its need, and at a time when prices are low and/or
expected to rise.
Important characteristics of forward buying are:
a) Purchases are made to cover production requirements for a considerable period;
b) Quantity purchased is generally large;
c) The atmosphere is usually favorable for negotiation;
 d) Purchases are made when the prices are low. The buyer also gets discount on
large purchases.
Advantages of the method: Forward buying results in
 Lower purchase price,
 Greater margin of profit on finished goods,
 Saving in procurement expenses as purchases are usually consolidated,
 Security against shortage.
Disadvantages of the method: Such a buying may not serve entirely the needs of the
production department.
 Price expectations if not realized may result in major financial loss to the firm.
 Inventory holding charges are considerably higher.
 Large scale obsolescence may result if design changes occur.
Responsibility of the buying department: The buying department must keep abreast of
the market conditions. It must constantly study the statistics and factors that influence
availability of an item or its price balance, and be able to forecast the changing trends.
And high inventory carrying charges and deterioration should be constantly balanced
against price advantage.
Suitability of the method: Forward buying is best suited for
i. Non-perishable items,
ii. Items which have steady and regular consumption,
iii. Basic materials such as coal, steel, coke, etc., cutting tool, bought out parts which
are less susceptible to radical changes in specifications,
iv. Seasonal items,
v. Proprietary items to make purchases in advance of suppliers’ a agreement period,
vi. Pre-budget purchases,
Pros and cons of the method: Forward buying enables the buying department of effect
large savings in purchase prices, have lower purchasing expenses and ensure availability
of items. Forward buying when applied in extreme, however, can cause higher inventory
charges and problems of storage with large scale possibilities of obsolescence. Possible
error in judgment of market trend may at times lead to large scale losses. Forward buying
in case of expensive items thus should be left to the committee decisions rather than to
one person.

4. Speculative Buying
Speculative buying refers to the buying large requirements of an item when its price is
low with the intention to sell bulk of it at a higher price for speculative profits. Important
characteristics of speculative buying are:
a) Purchases are no way related to the company’s production programmer. An item
which is not even required for production may be purchased.
b) Speculative buying does not base decisions on quantity. Its single aim is to make
speculative profits. The quantity purchased is thus generally high and is as much as
the company finance can permit to buy.
Pros and cons of the method: The only advantage of the speculative buying is earning
of speculative profits. But its disadvantages are numerous such as tying up of large
amount of capital, storage problem, risk of obsolescence and ruination of the company if
predictions go wrong.

Suitability of the method: Speculative buying is not really a function of the buying
department. It should ordinarily be discouraged.

5. Contract Buying: Though all purchases are by contract buy the term contract buying
is applied to those special contracts which call for deferred delivery over the period.
According to spriegel, “contract materials, the delivery of which is frequently spread over
a period of time.”
Important characteristics of contract buying are:
a) Contracts are given to suppliers for large amount of future requirements of for a
certain period (say a year)
b) Quantity received per occasion is generally small. The cycle time between two
consecutive receipts may be a week, fortnight, or a month or any period considering
the value of requirements, distance and the mode of transport;
c) The buying department usually finds sufficient time to secure competitive bids and
negotiate terms of contract.
Pros and cons of the method: Contract buying offers a number of advantages over other
methods such as forward buying or buying as per requirements:
i. It saves the company from the trouble of inviting quotations, preparing comparative
statements, placing of orders, etc. which otherwise will be necessary on every
occasion the items are required. This reduces the procurement expenses;
ii. The buyer’s company is assured of regularity in supply despite market fluctuations;
iii. The buyer needs to keep very little working stock and safety stock. This reduces
capital lock up and the cost of carrying inventory to the barest minimum;
iv. Prices and other terms of contract are generally favorable to the parties involved.
v. The buyer can plan his requirement of finance as he has an advance idea as to when
and what amount he has to pay to his vendor.
Types of contracts: Contract buying is of three types:
 Rate contract where the rate is fixed and not the quantity. Some indications of
the probable requirements, however, are given.
 Running contract where the rate and quantity both are fixed for the contract
period. As soon as the specified quantity is supplied by the vendor, the contract
automatically comes to an end.
 Service contract where the various services are obtained periodically.
Suitability of contract buying: Contract buying is suited to the procurement of materials
and production items of regular use. Service contract may be entered into to obtain
periodical services such as servicing of typewriters, punching clocks, air conditioners,
repairs or calibration of measuring instruments and gauges, filtering of oils, etc...

6. Blanket Orders
Blanket orders refer to the purchase of variety of items from single source, usually a
middleman. Important characteristics of blanket orders are:
 h) A blanket order specifies the categories of items covered by the order;
i) The items covered by the order generally have low unit value;
j) More than one middlemen may be selected to avoid hold-ups in case of non-
availability of an item with one;
k) “Market-price” is generally specified on the order which may include a specified
method of determining price variations;
l) The supplier is given requirements on phone who supplies and bills at the
“prevailing prices less agreed discount”. The records of the supplier are open to
inspection on demand. Alternatively, the buyer may contact vendors on phone,
enquire price from them, and buy from one who quotes the lowest, the other terms
of contract being common to all.
Responsibility of the buying department: The middleman selected should be large
stockiest who are known for their honesty and reliability. The stockiest in the vicinity of
the factory should be given preference over others;
 The buying department must continually watch the items in the groups and
periodically check up whether the demand for any item has risen considerably to
justify its removal from the group and purchase as an individual item.
Suitability of the method: The method is best suited to general hardware, electrical
supplies, stationery, small cutting tools, etc.

7. Tender Buying
Government departments and public sector undertakings in India follow this method of
buying. Private sector organizations too adopt tender buying if the value of the purchase
exceeds the prescribed limit say, Birr 25,000 or Birr 50,000 fixed by the management as
policy decision. Salient characteristics of the system are:
i. The buying department establishes a bidder’s list and invites them to submit bids
(a tender or quotation is written offer from a supplier to render a specified service
or supply materials of the specified quality, at the specified price and within the
specified time).
 ii. Bids on receipt are evaluated by comparison and the right supplier is selected.
Lowest price is the criterion used except when supplier quoting the lowest price
has questionable delivery time, quality, reliability or financial stability.
Advantage of the method: Tender buying is the purchaser’s most important single tool
to select qualified supplier on the basis of competitive prices.
i. It eliminates possibility of favoritism, patronage and personal preferences.

Disadvantages of the method: Tender buying is costly and time-consuming and

therefore used by private sector undertaking only when the value of purchases is high.
Responsibility of buying department: For each new product, material or service, a
buyer must. Obtain quotations from at least three potential suppliers.
i. Past performance in case of old supplier must be taken into account while seceding on
the contract of a new item. Buyers must guard against suppliers who submit extremely
low quotations initially and increase prices later.
ii. Quotations should be evaluated considering the capabilities of the competing firm. The
bid should be high enough to yield a reasonable margin of profit to the potential
vendor.
Types of tenders: Tenders are of four types:
i. Single tender refers to the system of tendering wherein the details of the
requirements are communicated only to one firm. Completion in this system is
altogether eliminated and price is fixed by mutual agreement. Single tender system is
used when there is only one supplier of the item. Quotations from the sole selling
agents of the manufactures belong to this group.
ii. Limited or closed tender refers to the system of tendering where in enquiry is sent
to a limited number of suppliers who are on the approved list of supplier and bids are
received in response. The decision concerning the number of suppliers to whom
enquiry to be sent is usually laid down in the ‘buying policies’ framed by the
management. The firms in the private sector usually send an enquiry to three to eight
suppliers, depending upon the rupee value of the order. However, firms in the public
sector are not able to restrict the number of tenderers to eight. All registered suppliers
require to be mailed buyer’s copy of the enquiry.
iii. Open tender system is the system of tendering where in the enquiry is advertised in
the newspapers or periodicals or trade journals of the home country and bids are
received in response. Since the system encourages unlimited competition by
publicizing an enquiry, hence the term ‘open tender’, or ‘unlimited tender’ is used.
Open tender system is used for items which are required in large value and /or are
difficult to procure.
iv. Global tender is the system of tendering wherein the enquiry is advertised in the
newspapers and trade journals of not only of the home country but also in the foreign
country and bids are received in response. The global tender system is used for
purchases involving huge investments such as procurement of plan and machinery i.e.
purchases that are both capital and technical.

8. Seasonal Buying
Seasonal buying refers to “buying of the annual requirements of an item during its
season”. This method is used for items available in particular season only. Such items
may be required for food processing and other similar industries. Important
characteristics of seasonal buying are:
a. The items involved are available in particular season only and therefore need to be
purchased and stocked in sufficient quantities till the next season (e.g. oranges,
sugarcane, apples, etc).
b. The items covered may be small in size but they are required in large quantity.
c. Market price is the lowest during the season. Therefore , the items can be purchased
at the cheapest rates;
d. Usually purchases are made directly from manufacturers / producers of the goods.
Responsibility of buying department: The responsibility of the buying department lies
in the locating the producers of items and negotiating price and other terms of
contract to achieve the maximum advantage.
Suitability: This method is suitable for items which are either of purely seasonal or items
which have shown marked price increase during off season

9. Group Purchasing
Group purchasing refers to ‘buying of items of trivial in a single purchase order.’
Important characteristics of group purchasing are:
a. Items required in small quantities are classified into few basic groups, basic group
being dependent on the source of purchase. For examples, drills and taps are placed in
one group, plug gauges in other group, hardware in other groups etc.
b. Inventory levels (i.e. minimum levels, re-order level, re-order quantity etc.) are fixed
for each item within each classified group.
c. One purchase within its group- covering a number of varied items within its group is
placed on the supplier.
d. Stocks- on-hand are reviewed periodically , say once a month on once in 2 months;
e. Replenishment action is taken (i.e. pre-fixed quantity of the item is communicated to
the supplier for supply) of all such items whose stock has fallen to or approached the
re-order level.
Benefits of group purchasing: Group purchasing results in significant saving in clerical
and delivery costs since one order is placed for a number of varied small items
instead of an individual order for each item.

10. Sub- Contracting

Sub-contracting is the work placed with outside supplier to design peculiar to the main
contractor for economic reasons or to augment the existing manufacturing facilities.
Sub-contracting is the hiring of another firm to perform some of the manufacturing
operations or to furnish certain parts and sub-assemblies to be incorporated into the
buyer’s end product.
Types of sub- contracting: Sub-contracting is of two types:
i. The company makes some quantity of the final product and buys balance from
outside. This happens when the company receives big orders but is unable to supply
the full quantity within the contract period;
ii. The company concentrates on certain items of the assembly and buys others from
outside. It is this type of sub-contracting with which the industrial buyer is concerned
more and more.
iii. The company gets certain operations like electroplating, heat-treatment, rough
blanking etc. done from others because either it does not have necessary
manufacturing facilities or its present facilities are overloaded.

Dear students! When do you think to undertake sub-contracting?

Sub- concreting is desirable when:–
i. The product involves number of components requiring different types of machines.
ii. Special expertise is required for certain components/ operations and the same is not
available with the buyer’s firm.
iii. There is shortage of capacity at the home plant which cannot be made good
immediately.
iv. The manufacture involves use of special manufacturing facilities whose procurement
is economically non-viable. Sub-contracting saves the buyer from incurring
investment costs in specialized machinery and tooling. Investment costs are be looked
upon as unwise decisions when the demand is of temporary nature or utilization is
likely to be poor due to irregular production requirements. Extra capacity irregularly
required can be generated by either borrowing facilities from vendors or sub-
contracting the items to them.
V) Comparative economics of the decision -cost to manufacture the part at the company’s
own plant versus cost of sub-contracting justifies procurement from sub-contractors.
Responsibilities of the buying department; The buying department must locate, select
and develop qualified sub-contractors who can supply parts of right quality, in the
quantities required, according to the required time schedule and at the reasonable
price.

i. Since sub-contracting is basically an extension of one own plant, the sub-contracting

should be within close proximity i.e. either in the neighborhood or within a
reasonable distance. Proximity to the sub-contractors have lot of advantage
 Transportation cost, both of men and materials is less.
  Follow up is easy and less costly.
 Buyer can have better control on supplier’s quality, made possible by
periodical visits, dialogues and feed-backs.
ii. More than one sub-contractor should be selected for each component provided the
requirement justifies.

Having more than one sub-contractor helps to:

 Bring an element of competition between them which helps buyer to have
competitive price and good quality product.
 Maintain supply of goods from alternate source in the event of any
production hold –up with one of the sub-contractors.
iii. The buyer should work out a detailed quality assurance system with the sub-
contractor, the complete manufacturing process and inspection criteria.
The elements of manufacturing process should include operations and their
sequence and the elements of inspection criteria should include raw materials
inspection, in-process inspection and finish product inspection.
Further, the inspection criteria should include gauges to be used during inspection at
each of the selected inspection points in the manufacturing process. Acceptance
standard for each of the elements should also be discussed and finalized between the
quality control personnel of the buyer and the sub-contractor.
iv. For the components sub-contracting to specialist units, the buyer should ensure that
his own quality control staff has fully understood the production specifications and
inspection standards.
v. Delivery scheduling is the most important aspect of sub-contracting decisions must be
based on outcome of cost benefit analysis. Many a time’s it is economical to machine
the item at the company’s own plant by procuring additional machinery or employing
additional manpower. However this will be possible only if the system is designed to
take care of all alternatives such as:
a) machine capacity and labour capacity is available in the plant;
b) only machine capacity is available and if the component is to be machined in the
plant, additional labour force will have to be employed;
 c) machine capacity and labour capacity both are not available which means
machines that will have to be purchased and personnel will have to be employed;
d) Building is available for keeping the machines or a new one is to be constructed
so on.

11. Central Purchase Organization

A large firm in the public or private sector may have section-wise stores at different
places. The requirements of these stores can be satisfied by either of the following
two methods:
a) Each store to make its own purchases.
b) A central store to make purchases and supply material in turn to section wise stores.
The advantages of central stores purchases are:
i. The central purchase organization (CPO) can obtain quantity discounts, lower
rate and better contract terms due to large purchases made possible due to
consolidating the requirements of individual stores.
ii. The CPO can exercise strict control on consumption thereby minimizing the risk
of malpractices.
iii. The CPO can contract directly with the manufacturers and obtain items as per
specifications. Individual section stores may not be able to do this.
iv. Malpractices by individual purchase officers by some kind of understanding
with the local dealers which can result in purchase at higher prices are avoided.

Typical examples of central purchase organization are: State Transport and

communication bureau, Addis Ababa road authority, Commercial Banks, Co-operative
Banks, etc.

12. Directorate General of Supplies & Disposal (Dgs & D)

The DGS & D is the central purchasing organization for the various government
departments. It enters into contract with various firms for the supply of certain materials
to the government departments during the year at the agreed rate. A formal document
raised for the purpose is called “rate contract”. Example: Ethiopia Purchase Agency

3.4 Purchase Procedure

Procedure means the manner in which a purchase proposal is carried in to effect.
Therefore it involves the functions to be performed by purchasing people from inception
to the conclusion of the deal. These functions are briefly enumerated now:
1. Ascertaining the need and recognition of it;
2. Accurate statement of specification, character, quality and quantity
requirements with full description;
3. transmission of the purchase requisition;
4. negotiation with the possible source of supply;
5. analysis of the proposal, determination of the price, availability and
delivery time;
6. selection of the vendor and placement of the supply order;
7. expediting and follow-up;
8. arranging for receipt, inspection, replacement of the rejected and defective
materials and goods, etc;
9. checking of invoices and bill payment; and
10. Completion of records and files.
It will be appreciated that essentials of scientific buying involve the determination of: (a)
what to purchase, (b) when to purchase, (c) from where to purchase, (d) how much to
purchase, and (e) at what price to purchase.

In order to complete the purchase deal and maintain proper records of the transaction, the
above procedural steps are necessary in almost all cases, which are called purchasing
inputs. They are mostly in the form of purchase requisition and product specifications and
generally emanate from outside the purchasing department.

3.5 Make or Buy Decisions

The objective of make or buy decision is utilize full productive capacity of the
undertaking. As already stated, any decision as to make- or- buy must be based on the
joint efforts of many departments. As such, a committee approach is essential. The main
purpose is to arrive at a decision on the manufacturer of some categories of parts and
components, for which the undertaking currently possesses necessary production
facilities, probably with minor investment in tools, jigs and fixtures. In the second
category will be parts and components which the undertaking can’t manufacture with out
substantial capital outlay. According to G.W. Aljian,* the following are the factors that
influence make- or- buy decisions.
1. consideration which favor making the part are:
a) cost,
b) desire to integrate plant operations,
c) utilization of excess plant capacity to help absorb fixed overheads,
d) need to have direct control over production and/or quality,
e) unreliable suppliers , and
f) Desire to maintain a stable workforce.
2. consideration which favor buying the part:
a) Suppliers’ research and specialized know-how,
b) Cost consideration,
c) Small volume requirement,
d) Limited production capacity,
e) Desire to maintain a stable workforce, and
f) Desire to maintain multiple sources of supply and indirect managerial control.
However, primarily it is the cost consideration which will, in most cases, outweigh other
considerations if they are not overwhelmingly important from the view point of the total
objective of the organizations.
The cost elements involved in making an item are:
1. raw material cost 4. purchase cost
2. labor cost 5. Inventory carrying cost
3. overhead cost
The cost elements associated with buying are:
 1. Purchase price
2. Receiving and inspection cost
3. Transportation and handling cost
4. Order processing and administrative cost
In any case, make -or- buy decisions should always be taken at a sufficiently high level
and the materials management department should always be consulted before making any
decision.
3.6 Evaluation and Selection of Suppliers
Evaluation and selection of suppliers is made on the criteria set for evaluation. It is also
called vendor analysis. There are many factors that can be used for evaluation. These
include quality factors, delivery factors, service, and price e.t.c. There are different
methods of evaluation and selection of suppliers. Two of these are: Weighted point
method and Cost-ratio method.

A. Weighted point method

It uses factors or criteria for selection and relative weights for evaluating and selecting of
suppliers. Accordingly. The supplier with the highest rate will be the right supplier.

Steps in the weighted point method

a. Identify factors that are going to be used in evaluation.
b. Assign weight for each factor out of 100 points.
c. Obtain data about the past performance of suppliers.
d. Multiply their performance by their respective weight.
e. Add the different ratings of each supplier to get the total rating.
f. Rank the suppliers.
g. Select the supplier with the highest rating or first ranking.

Example
Suppose you are a purchasing manager of a company and the company uses weighted
point method to evaluate and select among suppliers. The following criteria have been
developed by your organization with their respective weight.
 Criteria Weight
Quality…………………………………………….… 40

Delivery……………………………………………….…… 30
Cost reduction suggestion………………………………...20
Price ……………………………………………………...10
You have been provided the following past performance of suppliers A, B and C and
the price suppliers have quoted.

Suppliers Delivery rating (%) Quality rating (%) C.R.S(no.) Price

A 80 90 1 $40
B 90 80 1 50
C 100 70 3 60

Rank the suppliers?

B. Cost-Ratio method
It relates all identifiable purchasing and receiving costs to total value of purchase.
Since it is based on cost, the supplier with the highest cost is least preferable and the
supplier with the lower cost is the most preferable and ranked first. Quality cost,
delivery cost, service, and price are taken as factors of evaluation. While Quality cost,
delivery cost and price cost are costs service is not a cost. Supplier with a higher rate
of service is considered positively.

Steps for using Cost-Ratio method

1. To evaluate quality, compute the percentage of quality cost.
% Quality cost = quality cost
x 100
Total purchase
2. To evaluate delivery, compute the percentage of delivery cost.
% Delivery cost = Delivery cost
Total purchase x 100
3. To evaluate service which is not a cost for the supplier, two information are needed.

 Norm or performance standard

 Service package given in percentage
The steps involved are:
a. Compute the percentage gained against the norm (of service performance)
b. Subtract 100%to find out how much under or over each supplier has performed
above the norm or below the norm.
c. Multiply by the service percentage package.
4. Final rating adds 1, 2, 3 the percentage of prices to the price.

Example
Suppose you are the purchaser of the company and you want to select among suppliers A,
B, C, and D on the base of cost ratio method. And the factors used for evaluation are
quality, delivery, service and price. You have been provided the following data.

Data related to quality cost

Supplier
Item of costs A B C D
Visit $300 500 400 200
Sample 400 700 800 600
Inspection 100 275 250 725
Rework 0 425 450 400
Rejects 200 1500 975 675
Others 0 200 325 700
Total 1000 3600 3200 2800

Data related to delivery cost

Supplier
Item of costs A B C D
Telephone $400 100 200 300
Fax 475 275 425 200
Expedite 875 300 975 750
Shipment 750 225 900 950
Miscellaneous 500 300 700 600
Total 3000 1200 3200 2800
 Data related to service performance

Supplier
A B C D
Maximum point Item of costs
Service facility 5 3 5 3
5………………..
20 Financial stability 18 18 15 8
………………
Labor relations 8 10 10 8
10………………
Geographic 10 15 6 0
15……………… Location
5………………. Flexibility 5 5 3 5
10……………… Expansion 10 8 7 9
20……………… Repair 15 18 10 9
10……………… Warranty 10 10 0 7
5……………….. Miscellaneous 3 4 0 0
100…………….. Total 84 91 56 49

- Maximum value of service package = 20%

- Acceptable service norm or standard = 60 points
- Quoted price per unit and total value of purchase:

Supplier
A B C D
Quoted price per unit ($) 85 86 82 83
Total value of purchase ($) 100,000 120,000 80,000 140,000
Required
Evaluate and rank the suppliers.

3.7 Discounts
Another aspect, which often leads to price- reduction (often through negotiation) are
discount offered and the buyer should be familiar with this. There are many types of
discounts, such as, trade, quantity, cash and seasonal, which are offered for many items.
A good buyer should take due advantage of such discounts, and securing the best
discount means a cost- reduction which may not be negligible sum when large quantity
purchases are made. Often, it is found that list- prices are much higher than the actual
selling price and discounts are allowed on the basis of cash payments, trade customs and
volumes.

CHAPTER FOUR
INVENTORY MANAGEMENT
After you complete this chapter you will be able to:
 Know the significance of inventories in a firm’s operation
 Determine the reasons for Holding Inventories
 Calculate relevant Inventory Costs
 Determine How much to order (EOQ)? And When to Order?
 Classify types of inventories
 Understand the most effects of poor inventory Management
 Have an understanding of MRP?
 Know the objectives of MRP
 Identify the basic elements of MRP
 Understand what does BOM mean in detail

4.1 The Definition & Significance of Inventories in a Firm’s Operation

The word inventory refers to any stock on hand at a given time ( a tangible asset which
can be seen, weighted, and counted). It is material held for future use in an idled or
unproductive state awaiting its intended purpose.
The control and maintenance of inventories is a problem common to all organizations,
non-profit institutions, and other social institutions. Inventory problem have proliferated
as technological progress has increased the organization’s ability to produce goods in
greater quantities, faster and in multiple design variations.
Inventory refers to any material held in storage for latter use or sale it may consist of
supplies, raw materials, in process goods, and finished goods, suppliers are inventory
items consumed in the normal functioning of an organization that are not a part of the
final product. Typical supplies are pencils, paper light bulbs, typewriter ribbons, and
facility maintenance items. Raw materials are inputs in to the production process that
will be modified or transformed in to finished goods. Typical raw materials for a
furniture manufacturer are lumber, stain, glue, screws, varnish, nails, paint, and so forth.
In-process goods are partially completed final products that are still in the production
process. They represent both the accumulation of partially completed work and the
queue of material awaiting further work. Finished goods are the final product, available
for sale, distribution or storage. The assignment of inventory to any of these categories is
dependent on the nature of the organization. This is because one entity’s finished product
may be another entity’s raw material. For example, varnish is a final product for a
chemical factory; a furniture manufacture considers it as a raw material. The customer
for finished goods inventory may be the ultimate consumer, a retail organization, a
whole sale distributor, or another manufacturer.

4.2 Reasons for Holding Inventories

Inventory exists because organizations cannot function 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 inventories are accumulated to
ensure an availability of goods and to minimize the overall costs of producing and
distributing the goods.

1. 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 by vendors. Safety stocks of in-process inventories are
maintained to allow for fast schedule changes. In similar way a firm also stocks finished
good 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 can not be known for sure. To assure product availability at a reasonable
price safety stocks are maintained to provide this production.

2. To achieve economies of scale in purchasing, transportation and production

Due to ordering costs and quantity discounts, it is 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 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 buffers between demand and
supply so that production can be geared to a more constant out put than fluctuating
demand might otherwise allow. This make it possible to spread the setup cost of tne
production machines over a large number of items.

3. To hedge against contingencies

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

4. 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 anticipate demand in order to smooth employment.

5. 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.

4.3 Types of Inventory controlling systems

Dear students! Inventory control as already stated is a technique by which the quantity
of materials is held between the predetermined levels. The following techniques of
inventory control are normally used to keep investment in inventories at the lowest
possible level and operational efficiency at the maximum.
1. Perpetual or Fixed Quantity System
2. Periodic Review system
3. Optional Replenishment system.
4. Two Bin system
1) Perpetual or Fixed Quantity system: Before discussing the perpetual inventory
system, it is pertinent to discuss some to the vital components of the system, such as
safety margin, reorder point, etc. Safety stock is the inventory held as a buffer or
protection against the possibility of stock out. In other words, it is the minimun level
of inventory which an organization would like to keep to avoid any exigency relating
to stoppage of work. The reorder point is defined as a point in time at which a
purchase order should be placed to replenish the inventory stock. Thus, three
variables, usage, lead time and buffer (safety) stock are an integral part of the reorder
point. Under the perpetual system, the reorder quantity is fixed but the frequency of
ordering varies depending upon the fluctuation in usage. Whenever the inventory
reaches a minimum level, known as the reorder point, a fixed quantity (EOQ) is
placed.
The perpetual inventory system is also known by the other names such as fixed order
quantity system or Q-system. Figure below illustrates the way in which the perpetual
inventory system op0erates. Small circles in the said figure are the reorder point i.e.,
whenever the inventory is depleted to such point, an order for fixed quantity is triggered
off.
 Order placed
Order placed

Figure: Perpetual Inventory System

2) Periodic Review
Another major inventory control tools is the periodic review technique, frequently
called the fixed-cycle technique. In this, inventory records are reviewed periodically
and replenishment order are placed for each item at each review. The review period
may be a week, month, quarter, etc., which is best for the situation. At each review
period, an order is paced for amount equal to the difference between a fixed
replenishment level and the actual inventory level. Thus, the order quantity is
variable in size, whereas period between placements of orders is fixed. For example,
the order quantity would be larger than usual when the demand has b been greater
than expectation, and it is smaller than usual when the demand has bee less than the
expectation. However, the review period is fixed in this inventory system.
The review period can be fixed by dividing EOQ by the annual consumption. The
replenishment level(s) may be calculated as under:
S= U (t + t1) + SS
Where, U= Average monthly or daily usage
t= Lead time in days or months
t1= Review period
SS= Safety Stock
Maximum stock level (M) is defined as:
M= B+D (t+t1)
With the uniform depletion inventory during the review period, the average level(S) of
inventory in this model is:
S= B+1/2Dt to
B= Maximum desired stock
D= Average demand
This technique may be contrasted with the conventional order point where the inventory
records are reviewed each time an entry is make and a replenishment order is placed
when the balance on hand reaches a predetermined order point. In the order point
technique, the order quantity is fixed and is usually the EOQ.

Under this system, enough stock is ordered to bring the total on hand or on order up to a
predetermined target level. This system is some sort of a replica of what is known as ‘imp
rest system of cash control’ is financial accounting. The periodic review technique is
useful under the following conditions:
i. When there are many small issues of items from inventory, so that posting
records for each issue is impracticable.
ii. Ordering costs are relatively small
iii. It is desirable to order many items at one time to make up a production
schedule.
iv. Determining levels for fast moving spare parts.
The above points have also been supported by George W. Ploss1. In general this system
is considered suitable for high value and fast depreciable items, because it allows for a
close control. Figure 5 illustrated the operation of periodic inventory system.

The periodic review system requires more inventory on hand, for a given frequency of
shortage, as compared to the perpetual inventory system. On the other hand, since the
perpetual inventory system requires perpetual auditing of the system, the cost of
operating the system is normally higher. However, because of the computer facilities, a
cost advantage of periodic review system is withering away and many companies are
resorting to perpetual inventory system.
 Order placed
Order placed

Fig 5.2. Periodical Inventory System

3) Optional Replenishment system
This system is combination of periodic and perpetual inventory systems. Optional
replenishments system is useful in situation where the cost of reviewing the inventory is
high or the cost of ordering is very significant. Under this system if perpetual records
cannot be maintained; due to high costs, then use of periodic review can be made. This
system is more advantageous in case or bulk items, where physical assessment of stock is
costly and could be inaccurate. Under this system an order should be placed for Q
(Quantity).
Where So + Qo < s Q= S- So – Qo
So= stock on hand
Qo= Outstanding quantity against previous orders
s= Reorder point
S= replenishment level
4) Two Bin Method
In this system an amount of stock equivalent to the order point is physically segregated
either in to a second bin or container. When all the open stock has been used up, the
second bin or reserve container is opened and material control is notified to order more
stock. This is a practical method for keeping control of low value items.

4.4 Relevant Inventory Costs

Inventory is any material or stock in an idle or unproductive state held for future use.
The control and maintenance of inventories is a problem to all organizations including
profit making non profit institutions and other social institutions. The need for greater
amount and a greater variety of materials has aggravated inventory problem.

The relative significance of inventory management to an organization can be gagged by

the overall investment in inventories and the magnitude of the material costs for all
products. Inventories tie up money, and poor control in inventories can limit the
expansion of an organization due to lack of capital and reduce the return on investment.
The pressure for capital and the effective utilization of resources has made decision
makers more aware of its significance.

The goals associated with materials management are neither monolithic nor easily
delineated.
The major goals of materials management includes:
1. To minimize investment in inventories.
2. To maximize customer ( beneficiary) service and
3. To assure efficient (low cost) operation.

It is plain to see that these goals can be inconsistent or even in direct conflict. The role of
the materials manager is thus to balance the objectives in relation to existing conditions
and environmental limitations. In preserving the continuity of supply, the basic objective
of inventory management is to maximize service through maintaining enough amount of
items when needed but no so much that an unnecessarily costly supplies incurred.
Reduction of inventory costs thus calls for the analysis of relevant cost structure of
inventories that primarily includes:
1. purchase (item) cost
2. ordering (setup) cost
3. carrying (holding) cost
4. stock out( depletion ) cost
1. Purchase cost
The purchase cost of an item is the unit purchase price of it is obtained from an external
source. Or the unit production costs if it is produced internally. For the purchased cost id
modified for different quantity level when a supplier offers quantity discounts. For
manufactured items, the unit cost includes direct labor, direct material and factory
overhead.
2. The order (set up) cost
The ordering cost is associated with ordering a bath or a lot of items. It originates from
the expense of issuing a purchase order to an outside supplier of from the internal
production setup. This cost is usually assumed to vary directly with the number of orders
or setups placed and not at all with the size of the order. The order to the
supplier,following up orders, receiving and inspecting materials. The setup cost
comprises the cost of changing over the production process to produce the order time. It
usually includes preparing the shop order, scheduling the work [re production setup,
expediting and quality acceptance.
3. The inventory carrying/holding cost
Carrying costs refer to all the costs associated with keeping items in inventory for a
period of time. The cost usually represents three components:

A. Cost of capital
When items are carried in inventory, the capital invested is not available for other
purposes. Inventories tie up capital that could be put to use other purposes inside or
outside the organization. This represents a cost of foregone opportunities for other
investment.
B. Storage cost
This cost includes space costs, taxes and insurance. Storage space costs are the
recurring costs for storage that relate to the amount of inventory stored. Insurance
premiums vary with the size of the inventory investment.
C. Inventory risk costs
These costs include the cost of obsolescence, shrinkage, deterioration, and damage.
Obsolescence is loss of value of inventories because of shift in style or consumer
 preference. Shrinkage is the decrease in inventory quantities over time from loss,
theft or pilferage. Deterioration is change in properties due to age or other factors
such as environmental degradation. The risk associated with these factors it directly
proportional with the level of inventories.
4. Stock out/depletion cost
Stocks out costs reflect the economic consequences of running out stocks. The costs are
based on the concept of foregone profits. They result from external and internal
shortages.

4.5 How much to order (EOQ)? and When to Order?

The problem of inventory control in industry is, there fore, of considerable importance.
Policies of inventory control in a firm may be complex, but the essential principles are
straightforward.

As we have already seen, there must be opposing costs. The problem is to determine the
policy which balances off these costs and which is, there fore, in some way the optimal
policy. For resolution of any particular problem, two questions must be answered:
(1) How much of particular items should be ordered?
(2) When and how often should it be ordered?
As we have already seen in answering these two basic questions, we must analyze and
considered opposing costs. If there were no cost associated with ordering too much, then
enormous quantity called be ordered. Similarly, had it been the case that there were no
costs associated with ordering too little, then no stock would be kept. In the same way, if
there were no costs associated with ordering too frequently, alternatively, no costs
associated with not ordering frequently enough, and then also there would have been no
problem.

Let us now put a little more insight on to the EOQ for all practical proposes. First and
fore most, we must also be able to predict our requirements sufficiently accurately in
advance. Suppose that we have found these cost data and the cost of replenishing an item
is Br 20 per order, and the inventory carrying cost is 15% of the annual usage value or
inventory investment during a year, which is Br 12000. From the following information
we can determine EOQ by using the formula below.

In a real life situation, demand is never deterministic. Even if demand remains known
over a range of probable values, the starting point for a design of an inventory system is
“EOQ” even though by it self it is not an inventory system. Another important feature of
“EOQ” is its justifying the conventional ABC and also elaborating it. This is shown
below:
EOQ = √ 2DOc
Cc

Then,
Annual ordering cost = DOc
EOQ
Annual inventory carrying cost = EOQ. Cc
2
Total inventory cost per annum = D . Oc + EOQ Cc
EOQ 2
Substituting for EOQ
Total annual inventory cost = √ 2DOc Cc
= √ 2OcCc √. Ds
= const. √ Ds
Since Oc Cc ones estimated are constants, the total annual inventory cost is proportional
to the square root of annual consumption.

4.6 Classifications of Inventories

Inventories may be classified on various ways; inventory can be analyzed by different
basis including the following:

 Based on value and quantity, ABC (Always Better Control) analysis

 Based on criticality, VED( Vital, Essential, Desirable) analysis
 Based on scarcity, SDE( Scarce, Difficult, Easily available) analysis
  Based on movement or transaction, FNSD (Fast moving, Normal, Slow moving,
Dead items) analysis

But the most common way to classify in most of then value or a few usually account for
most of a few products value as measured by dollar usage (the product of annual usage
times unit purchase cost or production cost). Inventory control managers should avoid the
distraction of unimportant details and concentrate on significant matters. Inventory
control procedures should isolate those items that require detailed and precise control
from those that do not.

It is often uneconomical to apply detailed inventory analysis to all items carried in an

inventory, If an adjustment is made, every item is treated the same in terms of the level of
stock avidity. 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 hog
value items are purchased and control most of the inventory value. This suggests that
before a firm policy for inventory control can be established, each product should be
classified according to its requirement.

One of the most applicable inventory control analysis is ABC Inventory control analysis.
ABC, Always Better Control, analysis is a way of classifying inventories in to A type, B
type, and C type inventories. Let’s see it in depth:

ABC Inventory Control: Control of inventory is exercised by controlling individual

items called stock-keeping units, SKUs. In controlling inventory, four questions must be
answered:
1. What is the importance of the inventory item?
2. How are they to be controlled?
3. How much should be ordered at one time?
 4. When should an order be placed?
The ABC inventory classification system answers the first two questions by determining
the importance of items and thus allowing different levels of control based on the relative
importance of items. Most companies carry a large number of items in stock. To have
better control at a reasonable cost, it is helpful to classify the items according to their
importance. Usually this is based on annual dollar usage, but other criteria may be used.
The ABC principle is based on the observation that a small number of items often
dominate the results achieved in any situation. This observation was first made by an
Italian economist, Vilifreedo Pareto, and is called pareto’s law. As applied to inventories,
it is usually found that the relationship between the percentages of annual dollar usage
follows a pattern in which:

A. About 20% of the items account for about 80%of dollar usage
B. About 30% of the items account for about 15% of the dollar usage
C. About 50% of the items account for about5% of the dollar usage
The percentages are approximate and should not be taken as absolute. This type of
distribution can be used to help.
 100

80
Percentage of value

60

40 A B C

20

0 20 50 100
Percentage of items

Steps in making ABC analysis

1. Establish the item characteristics that influence the results of inventory
management. This is usually annual dollar usage but may be other
criteria such as scarcity of material
2. classify items in to groups based on the established criteria
3. apply a degree of control proportion to the importance of the group

The factors affecting the importance of an item include annual dollar usage, unit cost, and
scarcity of material. For simplicity, only annual dollar usage is used this context. The
procedure for classifying by annual dollar usage is as follows:
 1. determine the annual usage for each item
2. multiply the annual usage of each item by its total annual dollar usage
3. list the items according to their annual dollar usage
4. calculate the cumulative annual dollar usage and the cumulative
percentage of items
5. Examine the annual usage distribution and group the items in to A, B, C
groups based on percentage of annual usage.

Example
A company manufactures a line of ten items. Their usage and unit cost are shown in the
following table along with the annual dollar usage. The latter is obtained by multiplying
the unit usage by the unit cost.
a. Calculate the annual dollar usage for each item.
b. List the items according to their annual dollar usage.
c. Calculate the cumulative annual dollar usage and the cumulative percent items.
d. Group items in to an A, B, C classification.

Answer
a. Calculate the annual dollar usage for each item.

Part number Unit usage Unit cost $ Annual $ usage

1 1100 2 2200
2 600 40 24000
3 100 4 400
4 1300 1 1300
5 100 60 6000
6 10 25 250
7 100 2 200
8 1500 2 3000
9 200 2 400
10 500 1 500
total 5510 $38,250

b, c, and d
Part Annual $ Cumulative $ Cumulative % of Cumulative% of class
number usage usage usage items
2 24000 24,000 62.75 10 A
5 6000 30,000 78.43 20 A
8 3000 33,000 86.27 30 B
1 2200 35,200 92.03 40 B
4 1300 36,500 95.42 50 B
10 500 37,000 96.73 60 C
9 400 37,400 97.78 70 C
3 400 37,800 98.82 80 C
6 250 38,050 99.48 90 C
7 200 38,250 100.00 100 C

The percentage of value and the percentage of items is often shown as a graph above.
Control based on ABC classification
Using the ABC approach, there are two general rules to follow:
1. Have plenty of low-value items. C items represent about 50% of the items but
account for only about 5% percent of the total inventory value. Carrying extra
stock of C items adds little to the total value of the inventory. C items are really
only important if there is a shortage of one item, when they become extremely
important so a supply should always be on hand. For example, order a year’s
supply at a time and carry plenty of safety stock. That way there is only once a
year when a stock out is even possible.
2. Use the money and control effort saved to reduce the inventory of high-value
items. A items represent about 20% of the items and account for about 80% of the
value. They are extremely important and deserve the highest control and most
frequent review.
Different controls used with different classification might be the following
  A items: high priority, tight control including complete and accurate records,
regular and frequent review by management, frequent review of demand forecast,
and close follow-up and expediting to reduce lead time.
 B items: medium priority. Normal controls wit good records, regular attention,
and normal processing.
 C items: lowest priority. Simplest possible controls-make sure there are plenty.
Simple or no records; perhaps use a two-bin system or periodic review system.
Order large quantities and carry safety stock.

There are benefits as well as costs to having inventory. The problem is to balance the
cost of carrying inventory with the following:
 Customer service: the lower the inventory level, the higher the likelihood of a
stock out and the optional cost of back orders, lost sales, and lost customers,. The
higher the inventory level, the higher the level of customer service.
 Operating efficiency: inventories decouple one operation from another and allow
manufacturing to operate more efficiently. They allow leveling production and
avoid the costs of changing production levels. Carrying inventory allows longer
production runs and reduces the number of setups. Finally, inventories late
manufacturing purchase in large quantities. The ABC inventory classification
system prioritizes individual items so that inventory and costs can be better
controlled.
Summary of ABC inventory management
item Percentage %age of Degree Types of Lot sizes Frequency Size of
Of total Total Of records of review safety
inventory no. of control stocks
value item
A 80 20 Tight Accurate and Low Continuous Small
complete
B 15 30 Moderate Good Medium Occasional Moderate
C 5 50 less Simple large Infrequent large
4.7 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. It
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.
1. Inaccurate inventory records:
Inaccurate records are a good indication of poor inventory management. When
inaccuracies occur, actual physical counts may differ from those records; and if these
differences are always beyond specified tolerances. The 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.

2. Poor customer service:

The most obvious sign of poor service is late deliveries, resulting in unfilled orders. In
such situations, customers must be willing to wait for receipt of items or they will cancel
the orders. Other indications include the existence or 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.

3. High inventory level:

Large inventories are required when there are demand and supply time variations dude 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 this two-side risk. High inventory levels
indicate inadequate attention to the application of inventory management techniques:
management has taken the easy way out by having excess inventory.
4. Excessive expediting:
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 the company is inefficient, setups create scheduling difficulties, the
information system is unable to handle the volume, the storage locations. All of these
circumstances lead to excessive expediting.

5. Manufacturing problems:
In manufacturing poor inventory management has the same consequences as poor
customer service. When a stock out occurs during production, the operation must be
either stopped or changed to another product line that does not require the stock out
material. As a result, schedule shipping dates are 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 standards costs.

4.8 Materials Requirement Planning / MRP

4.8.1 An Overview of MRP
Some manufacturing operations are managed in a more or less chaotic way. We might
find that inventories are swollen, parts are being expedited to get orders out on time, a
pressure-cooker atmosphere prevails. It is now possible to remedy this situation through
use of a new computerized planning and control system called Materials Requirement
Planning (MRP).
Materials requirement planning is a computer based production planning and inventory
control system. It is essentially a planning system providing a precise schedule of
priorities of production and a rescheduling mechanism for revising plans as changes
occur, keeping inventory at a low level while assuring the required materials are made
available only when needed. The major objectives of MRP are to:
1. Ensure the availability of materials, components and products for planned
production and for customer delivery.
2. Maintain the lowest possible level of inventory.
3. Plan manufacturing activities, delivery schedules and purchasing activities.

It is the attainment of these objectives concurrently that makes MRP worth while.
Basically it is most suited to a large manufacturing organization which produces some
components in its own workshops, buys some components from suppliers and ultimately
assembles them all in to a fairly complicated finished products. To mention a few,
examples are manufacture of motor cars, radio, television, electricity generators.

The concept of the system is that production control and inventory management are
integrated. This is done in such a way as to ensure that raw materials and components are
only made available when they are actually required, and not before. At the same time a
similar principle is applied to work-in-progress in the production shops. Each operation
in a component is managed so that when completed, the next part of the production line
will be ready to receive it and put it thought the next operation without delay and also
without accumulating large quantities of work-in-progress between operation.

A crucial distinction in inventory management is whether demand for an item is

independent or dependent. Independence means no relationship exists between the
demand for an item and any other item. Such as end products. Independent demand is
influenced by market conditions outside the control of operations. Thus it tends to be
continuous and fluctuates because of random influences. Finished goods inventories and
spare parts for replacement have independent demand for a higher level item, and is not
independently determined by the market. When products are building up from parts,
components or assemblies, the demand for these materials is dependent on the demand
for the final product. Dependent demand is not random but tends to occur in a lumpy
manner at specific points in time. Therefore, although the demand for the final product
may be continuous and independent, the demand for the lower level, subordinate items
composing thee product tends to be discrete, derived and dependent.

Demand should be forecasted only when it can not be calculated. Independent demand
items should be forecasted, while dependent demand items should be calculated via a bill
of materials explosion. Different demand patterns call for different approaches to
inventory management. For independent demand a replenishment approach is
appropriate. As the stock is use, it is replenished in order to have materials on hand for
customers. Thus an inventory begins to run out, an order to have materials on hand for
customers. Thus an inventory begins to run out, an order is triggered for more material
and the inventory is replenished.

For dependent demand items, a requirements approach is used. The amount of stock
ordered is based on requirements for higher level items. Dependent demand items need
ordered is based on requirements for higher level items. Dependent demand itrems ned
not be forecasted but are calculated by the MRP system from the master production
schedule. Dependent demand exhibits a lumpy, on-again, off-again pattern because
production is typically scheduled in lots. A quantity of parts is required and is made
available when needed, not before and not after. Although MRP system is applicable in
manufacturing, construction, merchandising, and service giving organizations most
inventory items in manufacturing enterprise should be controlled by an MRP system
because their demand is dependent.
4.8.2 Basic Elements of MRP (MRP Inputs)
The three major inputs of an MRP system are the master production schedule, the
inventory status record, and the product structure records. Without these basic elements,
the MRP system cannot function. The master production schedule outlines the production
plan for all end items. The product structure records contain information on all materials,
components and sub-assemblies required for each end item. The inventory status records
contain the on hand and on order status record of inventory item.

A. Master production schedule (MRP)

The purpose of master scheduling is to specify the output of the operations function.
Master scheduling devise the entire material planning process. The demand for end items
is scheduled over a number of time periods and recorded on a master production
schedule. The master production schedule expresses how much of each item is wanted
and when it is wanted. The planning horizon of the master production schedule should be
large enough to cover the cumulative procurement and production lead times for all
components and assemblies composing the end items. The MPS is developed from end
item forecasts and customer orders.

One of the functions of master production scheduling is to make sure that the final
master schedule is not inflated and reflects a realistic capacity constraint. As a result of
inflated master schedule, the order priorities (due dates) are no longer valid. The formal
MPS system then quickly breaks down and the informal planning and control system
takes over. The result is many past due orders, expediting and stock chasing to get the
product out at the door. Therefore, the master production schedule must project a realistic
plan of production that is leveled to accommodate the available capacity.

B. The product structure record

The product structure records, also known as bill of materials (BOM) is an inclusive
definition of a product that that includes a structured list of items, ingredients, and/or
materials needed to produce end items. The master production schedule shows how much
of each end item must be available on particular dates to satisfy the independent demand.
The quantities of components required to build the end item can be divided from the bill
of materials. Information on each item, such as part number, description, quantity per
assembly, unit of measurement, next higher assemble, and quantity per end item must be
available. The product structure records contain the bills of materials for the end items in
levels representing the way they are actually manufactured from raw materials to sub
assemblies to assemblies to end items.

C. The inventory status records

The inventory status record contains information on lead times, lot sizes or other item
peculiarities. MRP will determine from the master production schedule and the product
structure records the gross component requirements will be reduced by the available
inventory (on hand plus on order) as indicated in the inventory status records. Quantities
of items in inventory at the start of a planning horizon are available for use and are
referred to as “on hand”. “on order” quantities are those that are expected to become
available during a planning horizon from open work orders or open purchase orders.
MRP, takes into account both on-hand and on order quantities.

Forecast Customer orders

MASTER PRODUCTION SCHEDULE (MPS)

(Indicates products to be produced and When
they are needed)

Product structure
records
Inventory MATERIAL REQUIREMENTS PLANNING ( contains bills of
status record (explodes BOM per MPS requirements, net out
contains on inventory levels, offsets lead times and issues materials and
hand reports on how product is
balances, What to order and how many produced)
open orders, When to order
lot sizes, lead What orders to expedite, de expedite or
times, & Cancel.)
safety stocks
 Capacity requirement
planning
( what capacity is needed?)
1 manpower
2 equipment

The three sources (master production schedule, product structure, and inventory status
records) are the basic MRP elements. Remember that the master production schedule only
applies to upper level and items so MRP is left with the task of lower level scheduling.

As indicated in the above figure, however, capacity planning is added as a fourth element of
the materials requirement planning, the purpose of capacity planning is to check on the
validity of the master production schedule. The order launching system will determine
correct due dates or is not available inventories will rise, past due orders will build up and
expediting will be used to pull orders through the factory. To correct this situation, a
capacity planning system is required.

4.8.3 The Bill of Materials File (BOM)

The bill of Materials (BOM) is a file or set of files which basically contain the ‘recipe’ for
each finished products. The ‘recipe’ in a manufacturing goods environment consists of
information regarding which materials, components and sub- assemblies go together to make
up each finished product held on what is often known as a product structure file: and all the
standard information about each item, such a part number, description, unit of measure, lead
time for manufacturing or procurement etc., held on what is often known as a Part Master
file.

Product structure: MRP is well suited for fabrications and/or assembly type operations. A
fabricated part has had manufacturing operations performed on it such as bending, cutting,
grinding, milling, drilling, blanking, polishing or coating. An assembly is a collection of
parts and/or assemblies that are put together. A subassembly is an assembly that is used at a
higher level to make up another assembly. The term component in MRP refers to all
inventory items below the product level including subassemblies, parts and raw materials,
whether they are produced internally or obtained from suppliers.

A Bill of Materials (BOM) lists all of the subassemblies and components that go in to a
parent assembly showing the quantity of each required to make an assembly. It shows how
much of what materials are needed for every product. For MRP to be effective, it is
necessary to generate BOM that represents the way the product is manufactured. The
traditional bill of materials for a product defines its structure by listing all the components
that in to making it. A structured BOM specifies not only the composition of a product, but
also the process stages in its manufacture. It defines the product structure in terms of levels
of structure, each of which represents a completion stage in the build up the product. In a
schematic form a structured bill of materials is known as a product structure, product tree, or
Christmas tree. A schematic representation a typical product structure is shown in the
following figure.

A
Level 0
Level 1
B(1) C(3) D(1)

E (1) F (2) G (2) H (1) 1 (1) Level 2

J (1)
Level 3

K (1)

The letters represent assemblies/subassemblies

The numbers in parenthesis are the quantities required for assembly.
The structure of product defines the relationship among the various items that make up the
product in terms of levels as well as parent/component relationships. The product has four
levels of manufacture. The end product is designated, by convention, as being at level 0, and
its immediate components at level 1, and so forth. The parent/component relationship
indicates that A is the parent of B2/C, and D, B is the parent of component E and F.D is the
parent of component G, H, and F is the parent of components J and K. The only item that is
not a component; B, D, and F, are parents as well as components.

To show the presence of subassemblies or different levels of production, an indented bill of

materials can be used. All components of a given item are listed immediately below and
indented to indicate their lower level. The indented format is the most widely used method
of presenting multilevel bills of materials because of its ability to represent the product in the
manner in which it is manufactured. The dependent relationships among components to a
product are highlighted by their indentation. The quantities shown on the indented bill of
materials are the quantities needed to assemble one item at the next highest level.

Example 1
Bill of materials

Description Quantity/pereach Unit

Assembly
Leg assemble 1 Each
Rails 4 Each
Legs 4 Each
Back assembly 1 Each
Top 1 Each
Spindle 4 Each
Seat 1 Each

Suppose you are to produce 100 pieces of chairs in periods 11 with the product structure
shown below. If no stock on hand or on order, Determine when to release orders for each
component and the size of each order.
 Chair LT = 4

Leg Back Seat (1) LT

Assembly Assembly (1) =3

Retails (4) Legs (4) LT Top (1) LT = Spindle (4)

LT = 1 =4 2 LT = 2

MRP Plan for 100 pieces of chairs in period 11

Lead Description 1 2 3 4 5 6 7 8 9 10 11
Time
4 Chair Gross requirements 100
Planned order releases 100

Lead Description 1 2 3 4 5 6 7 8 9 10 11
Time
2 Leg Assbly Gross requirements 100
Planned order 100
releases

Lead Description 1 2 3 4 5 6 7 8 9 10 11
Time
1 Rails Gross requirements 400
Planned order 400
releases

Lead Description 1 2 3 4 5 6 7 8 9 10 11
Time
4 Legs Gross requirements 400
Planned order
400
releases
Lead Description 1 2 3 4 5 6 7 8 9 10 11
Time
1 Back Assblyy Gross requirements 100
Planned order 100
releases

Lead Description 1 2 3 4 5 6 7 8 9 10 11
Time
1 Back Assbly Gross requirements 100
Planned order 100
releases

Lead Description 1 2 3 4 5 6 7 8 9 10 11
Time
2 Top Gross requirements 100
Planned order 100
releases

Lead Description 1 2 3 4 5 6 7 8 9 10 11
Time
2 Spindle Gross requirements 400
Planned order 400
releases

Lead Description 1 2 3 4 5 6 7 8 9 10 11
Time
3 seat Gross requirements 100
Planned order 100
releases

MPR Computations: The computations and steps in the MRP process are not complicated.
They involve simple arithmetic as shown in the following.
Gross requirements: the total anticipated production. Use, withdrawals during each time
period. For end times, this quantity is obtained from the master production schedule
(independent demand items) for components (dependent demand items) it is derive from the
planned order releases of their parents.

Scheduled receipts: material that is already ordered (from manufacturing orders of purchase
orders) that is already ordered (form manufacturing orders or purchase orders) that is
expected to arrive (also known as on order, open orders, or scheduled orders) Projected on
hand: the expected quantity inventory at the end of the end of the period. Available for
demand in subsequent period from the “scheduled receipts” and planned order receipts” for
you know about BOM file?

CHAPTER FIVE
RECEIVING AND STORAGE
In this chapter we are going to see how to receive and store the purchased materials in
an organization. At the end of this chapter you are able to understand:
 What receiving is and its procedures
 What inspecting is
 What storage systems we have and what storage operational efficiency is
 How to locate and set the layout of stores
 How to classify inventories in a warehouse
 What stock taking is
 How to issue and dispatch
5.1 Receiving
Receiving is the process of identifying, visually inspecting, counting and recording the
receipt of all incoming materials receiving is usually a clerical activity.

Receipt system; this can be divided into receipts from outside suppliers and receipts from
internal divisions or source of supply. Systems for receipt start even before the time when
the material actually reaches the plant. When a purchase order is placed, a copy is sent to
the stores, indicating quantity and delivery date. This should be arranged in a
chronological sequence so that the stores manager can at any time estimate the volume of
receipt. This also helps in planning labour contracts when unloading activities exceed a
particular limit. This is the first step in the stores system.

Secondly, suppliers once they dispatch the goods normally send an advice note to the
stores. This provides information on the date of dispatch, carrier details, description of
the consignment and value. This is sent in advance so that quick and easy clearance may
be done.

The third stage is the document prepared by transport carrier; very often different
suppliers employ different transport organizations for transportation of their materials.
These transport organizations usually send consignment notes to the stores concerned.
These three documents normally, copy of the purchase order, suppliers advise document
and the consignment note, enable the stores manager to organize and plan for expeditious
clearance of materials and minimize handling costs. In some cases, suppliers send a
packing slip detailing the contents in the package.

5.1.1 Receiving Procedures

To make complete the receiving activity these are some sequential activities, it includes
the following;
1. unloading and checking the shipment: it is important all the packing quantity and
weight against the carriers manifest
2. unpacking and counting the material
3. recording overages, shortages or damages to the materials
4. paying or processing
5. filling and preparing the receiving report that consists
 date of receipt
 consigner
 consigner advise note number
 order
 method of transportation
 damage or shortage or overage
  store keeper identity
 inspector identity
6. notice users about arrival of material
5.1.2 Inspection of Incoming Material (Goods)
The materials manager is very much concerned with the quality of incoming materials, as
he is responsible for the supply of the right quality materials to the user departments, so
that the quality of the end products is ensured. For prudent materials planning, better
buyer-seller relations and vender rating, he should be aware of the inspection schemes
and rejections, whether the items are inspected by the user departments or by an
independent quality control section.

In all organizations, the stores department inspects a large number of standard items, as
well as detergents, and in a few organization’s, the materials department also inspects
raw materials and spare parts.

Some organizations have found it advantageous to integrate inspection department under

materials management. This reduces paper work, results in lesser materials movement
and swift clearance of documents leading to prompt payment of bills and timely claims.
However, there is a conflict of interests between quality and service to the user
department and this is the major drawback in this arrangement.

In a few organizations inspection is integrated under the respective user departments.

Here also, when production targets are ambitious, a tradeoff is likely to occur in quality
which ultimately affects the company image. Inspection in many organizations is an
independent activity where the manager in charge of quality control is responsible only to
the general manager. This arrangement ensures protection of quality standards.

Quality control inspection is undertaken in industry in order to ensure that quality control
inspection is carried out in the purchase of new materials, in the inter-departmental flow
of materials or components from one department to another and in the final acceptance of
finished products for distribution. Inspection of this kind helps to prevent sub-standard
items from reaching the next user department and the final inspection prevents defective
items from reaching the consumer. Through this process, it becomes possible to detect
the various sources of factors which cause defective production and then to take
appropriate remedial measures.

Goods received should be inspected for quality. If defective materials are delivered the
buyer will suffer;
 cost of inconvenience
 cost of returning materials
 cost of production stoppage and
 Loss of customer good will and warranty claims etc.
5.1.4.1 Inspection methods
Before a lot, consignment, batch or shipment of items produced under homogeneous
manufacturing conditions, the following three alternatives are available to the buyer in
making the purchase;
1. to accept the lot without any inspection; this would depend up on the confidence
placed in the supplier or on the assumption that the items have been inspected and
passed at the suppliers end;
2. to inspect each and every one of the items in the lot; such cent per cent inspection is
not always practicable, because of the considerations of time, cost, destructibility and
fatigue;
3. to choose appropriate sample of the lot on the basis of sampling techniques and
under take planned inspection to identify items which conform to the standards and
segregate items which are found to be defective; and on this basis, to decide the
acceptance or rejection of the lot; in this event the entire rejected lots may be
returned to the supplier or it may be subjected to cent per cent inspection after which
only the defective items may be returned to the supplier for replacement.
The last alternative method is called acceptance sampling. It is to be emphasized hat the
purpose of acceptance sampling is to determine the acceptance or rejection of the lot as a
whole. The object is also to cumulate information about the manufacturing process,
which will be feedback to the supplier in order to achieve and maintain a satisfactory
standard.
Therefore to ensure the quality of materials delivered it is necessary to inspect the items,
however in all cases inspecting every incoming material will be impractical, therefore it
is better to inspect a sample of products/materials.

Sampling inspection is appropriate in the following conditions;

 inspecting involves destructive testing
 the cost of accepting defective item is not prohibitive
 Materials arrive in large batches
 It is possible to take a truly representative random sample
 It is economically feasible consistently to identify materials as acceptable or not

5.2 Storage System

Storage system can be viewed broadly from three classified systems; the receipt system,
physical up keeping and maintenance system and the issue system. In an organization
busting with materials needs, the systems design should not only permit matching of
present requirements with the existing supplies, but also take care of the future growth
potential and demands. The management of inputs and outputs flow will require a good
deal of consideration of physical factors for the proper storage of materials and
depending up on their characteristics and volume of transactions, the reporting,
accounting and verifying systems should also devised. Since the materials flow system
interfaces and interacts with other systems, it is better to consider how it affects and
influences the storage function, and see what the steps should be taken to regulate and
control this flow through storage.

5.2.1 Storage Operational Efficiency

Stores play a vital role in the operations of a company. It is in direct touch with the user
departments in its day to day activities. The most important purpose served by the stores
is to provide uninterrupted service to the manufacturing division. Further more the
following are functions of stores;
  To receive raw materials, components, tools, equipments and other items and
account for them.
 To provide adequate and proper storage and preservation to the various items.
 To meet the demands of the consuming departments by proper issues and account
for the composition
 To minimize obsolescence, surplus and scrap through proper codification,
preservation and handling
 To highlight stock accumulation, discrepancies and abnormal consumption and
affect control measures
 To ensure good house keeping so that material handling, material preservation,
stocking, receipt and issue can be done adequately
 To assist in verification and provide supporting information for effective purchase
action.
5.2.2. Location and Layout
More often than not, in the matter of location the stores, materials management is rarely
consulted. The normal practice is to locate the stores near the consuming departments.
This minimizes handling and ensures timely dispatch. In stores layout, the governing
criteria are easy movement of materials, good house keeping, sufficient space for men
and material handling equipments, optimum utilization of storage space, judicious use of
storage equipments, such as shelves, racks, pallets and proper preservation from rain,
light and other such elements. These problems are more important in the case of items
that have a limited shelf life. Other important factors governing the location are the
number of end users and their location, the volume and the variety of goods to be
handled, the location of the central receiving section and accessibility to modes of
transportation.

Since stores have to be nearest to the user, larger organizations usually have stores
attached to each consuming department, whereas receiving is done centrally. Items of
common usage are stocked in the central stores so that inventory is kept at an optimum
level. These factors are considered at the planning level of layout.
In the case of warehouse stocking finished goods, factors such as proximity to ports,
railway lines, quality of roads, availability of power, etc become quite important. It is
also important that the stores are constructed with a futuristic orientation, so that
sufficient flexibility for expansion needs is in built. The activities of recieving the goods,
stocking in appropriate locations, material handling and issues must be done swiftly and
economically. The stores building must have adequate facilities for preservation of stores.
Sometimes facilities, such as cold storage, heating equipments, air conditioning and
similar facilities may be required. These should be planned in advance, comfortable
working conditions must be provided to the stores personnel to get maximum efficiency
and morale.

5.3 Inventories Classification

There are many types of inventories, such as raw materials and production inventories,
components and service parts, as well as work-in-process and finished goods inventories.
All of them don’t necessarily require the same treatment and, there fore, policy with
regarded to each may also differ, according to their types and need in different types of
industries. They may also be functionally classified as: (1) movement inventories,(2) lot-
size inventories, (3) anticipation inventories, and (4) fluctuation inventories, etc.,
according to the functions they are required to perform. However, in general, their
treatment follows from their needs and cost-benefit analysis.

Thus broadly, inventories may be classified as under:

 Raw materials and production inventories: these are raw materials and other
supplies, parts, components which enter in to the products during the production
process and generally from part of the product.
 In-process inventories: these are semi-finished, work-in-progress and partly
finished products formatted at various stages of production.
 MRO inventories: Maintenance, repairs and operating supplies which are
consumed during the production process and generally do not form part of the
product it self. (e.g., oils and lubricants, machinery and plants spares, tools and
fixtures, etc.) are referred to as MRO inventories.
  Finished goods inventories: These are complete finished products ready for sale.
Inventories may also be classified on the basis of their functions as under:
 Movement or transit inventories: it arises because of the time necessary to
move stocks from one place to another. The average amount can be
determined mathematically thus:
I=SXT
Where, S represents the average rate of sales ( say, weekly average) and T, the
transit time required to move from one stage to another in a week, and I the
movement inventory needed.
 Lot-size inventories: in order to keep costs of buying, receiving, inspection,
transport and handling low, larger quantities are bought than are necessary for
immediate need. It is a common practice to buy some raw materials in large
quantities in order to avail of quantity discounts.
 Fluctuation inventories: in order to cushion against unpredictable
fluctuations in demand these are maintained. But they are not absolutely
essential in the sense that such stocks are always uneconomical. Rather than
taking what they can get, the general practice of serving the customer well is
the reason for holding such inventories.
 Anticipating inventories: such inventories are carried to meet predictable
changes in demand in case of seasonal variations in the availability of some
raw materials, it is convenient and also economical to build up stocks where
consumption pattern may be reasonably uniform and predictable.

5.4 Stock Taking or Verification

Stock verification is the complete process of verifying the kind, the quantity balance of
all items held in stock. To ensure proper control in inventory all items should be counted
physically and compared against book balance at least once a year. The books
subsequently are adjusted to match the actual count.
Purposes of stock verification
 To verify accuracy of stock records
 To support the value of stock shown in the balance sheet by physical verification
  To disclose the possibility of fraud, theft and loss.
 To reveal any weakness in the system for the custody and control of stock
Methods of stock verification
Periodic stock verification:
Under the periodic stock verification method the whole of the stock is counted at same
time at the end of the given period usually at the end of the financial year. It is also called
annual inventory method. This periodic stock tacking/verification is difficult to apply for
large organizations. It may cause unnecessary delay.
Continuous stock verification:
It is also called perpetual stock verification. It is a method where by stock is taken
continuously throughout the year in accordance with a predetermined program so that
each item is physically verified without interruption of production operation or upsetting
stock room activities unlike the periodical stock verification, in this case no store will be
closed, and no interruption/stoppage of job. This type of stock verification is important
for attractive and valuable items

5.5 Issuing and Dispatch

Receiving stockingissuing
We now come to the final stage, namely issue and dispatch. Issues can be further divided
in to issues to consuming departments and issues to out side suppliers, for processing or
conversion. In both cases there are certain common system requirements. The first aspect
is the control of issues. Issues are based on production programs. Based on this and the
bill of materials, work orders are printed, listing for each material, quantity to be issued
against each component requiring that material. This automatically controls consumption
because the work order gives details on quantity of components to be manufactured. So
only materials requirement over and above that indicated in the work order quantity
means excessive wastage and scrapping.

The task of issuing is to satisfy the needs of using department store keeper is evaluated in
his issuance, time of issue or issue service. Time of issuing is an important factor for
store keeper, the objective is avoiding delay. Therefore to avoid delay the issuing
department must arrange or provide a smooth flow of materials.

5.5.1 Procedure and Methods of issuing

A. issue on request:
 Immediate issue on verbal request
 Issue made after presentation of issue note in form of post
 Immediate issue upon presentation of issue but not at the user department.
B. Schedule issues to production: developing work schedule or delay need of material
C. Assembles and Kits: all components of the requested item must be supplied together
with materials
D. Imp rest issues: once where by a list of certain types of materials in a given quantity is
approved to held either in sub-store or on production line or elsewhere at the end of the
given period say a week or a month the user prepares a list of materials that has
consumed during that time and present an appropriate document at the main store house
for replacement, goods to bring his imp rest stock to the same level as it was in the
beginning of the period.
E. Replacement issues: tools, equipments etc already used and can’t used again to
replace the already used tools can be asked.
F. loan issue: temporary materials given for not to consume which after a time will be
returned or come back after rendering the service.

5.5.2 Dispatch of Materials

Dispatching is the release of the orders to the producing departments. It is also concerned
with directing movements of work and making reports in accordance with the routing,
scheduling and other planning already done.

Because of the complexity in job-lot shops, dispatching has to be organize with a more or
less flexible plan. Emergency jobs may appear at any time and if the control department
assumes rigid attitude, it will be only a matter of time.
In most shops it is necessary to have dispatcher in close contact with the foreman and the
shop conditions. The usual methods is to have the dispatcher located in the foreman’s
office, or preferably in separate small room in the center of the area to be served. Since
dispatching is a service function to the shop executives, the dispatcher must be the type of
individual who can give certain directions to the workers with out interfering with
prerogatives and prestige of the foreman.
Some responsibilities of the dispatcher include:
 The issuance of orders to move material from place to place as necessary to
complete the scheduled operations.
 The control of the movement of raw material to the first operation.
 The control of the delivery of finished goods to the finished goods store.
 To meet all required scheduled dates and to ask for extensions with reason delay
stated.
 And so on.
5.5.3 Classification, Codification and standardization
5.5.3.1 Classification and Codification
Quite often the reason for stocking a large number of unnecessary items in inventory can
be traced to different and misleading nomenclature, faulty numbering and use of trade or
brand names used to describe the same item. It would, there fore, be useful to classify
them as to their permanent basic characteristics, and the preceding from the general to the
particular, bring together, all closely similar materials and parts respective of their
functions and assembles for which they were originally designed. This would reduce
long, incomplete and ambiguous designations. Instead, standard numerical coding has to
be evolved for the purpose of use in purchase, stores and issues, and for other purposes in
order to symbolize such fundamental particular characteristics.

Dear students how can we classify and codify? One of the pre-requisites of classification
and codification is to know basic nature and characteristics of all materials used in an
enterprise and classify them in broad categories, and then to group and sub- group them
in logical progression of kinds, types, sizes. As for example, raw materials, semi-
processed materials, mechanical (products and equipment), electrical (products and
equipments), chemicals (allied products and chemical processing equipment), laboratory,
office (equipment and supplies), etc, can be classified, grouped and sub-grouped.

After the broad classifications as to their nature and use, a code or a symbol is allotted to
each of them. The code or symbol so allotted should be simple, flexibly and it should be
easily adoptable in order to exploit the full advantages to codification.

The following are the common systems of codification:

 Alphabetical system (e.g. ACT)
 Numerical system (e.g. 2006)
 Decimal system (e.g. 1.1.1)
 Combined alphabetical and numerical system (UOG 2006)

5.5.3.2 Standardization
Mass production techniques of industrial production are based on the principles of
uniformity and interchangeability of many parts, components and materials used in
production processes. Standard products can be manufactured on a mass scale and
their production cost can be kept to the minimum. Standardization leads to cheaper
and easier procurement and the cost of replacement can be reduced.

Standardization is the process of formulating and applying rules for orderly approach
to a specific activity for the benefit and cooperation of all concerned for the
promotion of overall economy taking in to account functional and safety
requirements. Anything useful and convenient for any human activity can be
standardized. Taking industries for example, there are many subjects which can be
standardized, like products, processes, materials, parts, components, so on and so
forth.
 CHAPTER SIX
MATERIALS HANDLING
After you complete this chapter you will be able to:
 Define material handling.
 What factors influence materials handling of an organization
 What guideline to follow in handling materials of an organization.
 What Materials Handling Devices/Equipments we use in an organization
 What advantages can we get if we give emphasis to materials handling of
an organization?
 What types of decisions are made regarding materials handling.
Introduction
Materials handling can be defined as the function dealing with the preparation, placing
and positioning of materials to facilitate their movement or storage. Thus the function
includes every consideration of the product except the actual processing operation. In
many cases, the handling is also included as an integral part of the process. Through
scientific material handling considerable reduction in the cost as well as in the production
cycle time can be achieved. It is obvious that no value is added to the end product
through material handling. However, poor material handling may result in delays leading
to idling of equipment.

Influencing factors and control

 Materials handling cannot be viewed in isolation. Many factors like plant layout,
processes, nature of raw materials and products influence the material handling
system. Therefore an integrated approach will have to be in the case of material
handling.
 It must be appreciated that material handling operations encompass suppliers,
stores, inspection, manufacturing, packaging, warehousing and transport to
 consumer. The objective therefore must be to obtain maximum overall
effectiveness in materials handling.

6.1. Materials Handling Principles

The following guidelines are invaluable in the design and cost reduction of the materials
handling system:
 As materials handling adds no value but increases the production cycle time,
eliminate handling wherever possible. Ideally this should not be any handling at
all.
 Sequence the operations in the logical manner so that handling is unidirectional
and smooth.
 Standardize the handling equipments to the possible as it means interchangeable
usage, better utilization of handling equipments, and lesser spares holding.
 Install a regular preventive maintenance program for material handling
equipments so that downtime is minimum.
 In selection of handling equipments, criteria of versatility and adaptability must
be the governing factor. This will ensure that investments in special purpose
handling equipments are kept at a minimum.
 Weight of unit load must be maximum so that each “handling trip” is productive.
 Work study aspects such as elimination of unnecessary movements and
combination of processes should be considered while installing a material
handling system.
 Non-productive operations in handling, such as slinging, loading etc. should be
kept at a minimum through appropriate design of handling equipment.
 Location of stores should be as close as possible to the plant which uses the
materials. This avoids handling and minimize investment in material handling
system.
 a very important aspect in the design of a material handling system is then safety
aspect. The system designed should be simple and safe to operate.
 Avoid any useful movements method study can be conducted for this purpose.
  Ensure proper coordination through judicious selection of equipments and
training of work men.

6.2 Materials Handling Devices/equipment

Broadly material handling equipments can be classified in to two categories namely:
fixed path equipments and variable path equipments.
1. Fixed path equipments are those equipments which move in a fixed path. Conveyors,
manorial devises, chutes, and pulley drive equipments belong to this category.
2. Variable path equipments have no restriction in the direction of movement although
their size is in a factor to be given due consideration. Trucks, forklifts, mobile cranes
and industrial tractors belong to this category.

There are different factors which that should be evaluated in the selection of material
handling equipments. The cost factors include investment cost, labour cost, anticipated
service hours per year, utilization, unit load carrying ability, loading and unloading
characteristics, operating costs and the size requirements. Other factors to b e considered
are source of power, conditions where the equipment has to operate and such other
technical aspects. Therefore, choice of equipment has to be made in the light of the
factors discussed above.
6.3 Benefits of Proper Material Handling
Proper material handling has the following advantages:
 Reduce handling costs  Less fatigue
 Grater economy in use or space  Increase safety
 Reduce risk of damage to stock  Improved working condition
 Reduce labor requirement  Improved productivity.

6.4 Decisions in Material Handling

Many decisions have a significant effect on the effectiveness of the material handing
system. Within this layout decision is the most one.
Layout decisions are normally taken on technological considerations. Very rarely
such decisions are taken in consultation with materials management and materials
handling departments. Such a consultative process could result in savings in terms of
reduction in the production cycle time. In such a consultative process, movement of
materials could be studied right at the out set from the receipt of raw materials stage to
that of dispatch of finished goods to warehouses.

Many organizations have used industrial engineering techniques such as flow process
charts and string diagrams to design effective integrated material handling systems. When
layout and handling are designed in an integrated manner, valuable insights can be
developed on the selection of handling equipments, number of equipments and maximum
utilization of floor space.

In the two basic layouts i.e. product layout and process layout, it has been found that
material handling is kept at a minimum in the case of product layout. This is because
product layout is designed as per the sequence of operations leading to the smooth flow
of materials. Also, machines are so located as to minimize the handling between
successive processes. However, process layout results in lower investment in capital
equipment and better utilization many compromise layouts can be worked out to suit
specific requirements. A good layout should be such that there is no congestion of
materials and in process inventory.

CHAPTER SEVEN
LOGISTICS

7.1 TRAFFIC AND TRANSPORTATION

7.1.1 Importance of Transport and Traffic
Transportation and traffic mean something to many people. Transportation is given a
broader interpretation in the sense that it means that management of the movement of goods
and materials through space and time from their original source to the ultimate destination,
where as traffic considers only the techniques and is, there fore, narrow in scope.

Historically speaking, transportation has been the foundation- stone on which economic
growth of nation rests. With the advent of large scale production/ distribution systems,
transportation has always exerted tremendous impact on supporting activities which are
associated with the production and marketing of goods, and general economic activities.

Transportation has an ever- increasing importance on the product- cost which ranges on an
average between 10 to 20 % of the cost of an item. It is not uncommon where it represents
20 to 40 % of the total cost. Thus, an important organizational goal is control transportation
costs. As the organization grows transportation service becomes crucial because mode and
methods of transportation are numerous and cost structures are complex. Sensitivity,
reliability and cost factors influence the choice and only careful planning and analysis can
yield economies in operation. Also, characteristics of materials or products as well as the
volume influence the transportation decisions. Its effectiveness, therefore, depends on the
knowledge of alternative sources, rates, schedules, etc. the most important aspects relate to
the choice of the mode, rout selection, rate verification, claims management for lost
materials/ damage and auditing. Dealing with the choice of mode of transport, the general
avenues open for choice are water, rail, road and air. But what ever be the choice, it is
transportation and traffic that must insure that they reach the destination in time with out
getting lost or damaged.

7.1.2 Modes of Transport

Water transport: shipping is generally considered in the case of imports. But, inland water
transport is also made use for the movement of material with in a country from one point to
another. Shipping orders originate either from a necessity to re-distribute materials among
plant sites or storages locations or from product sale. Like purchase orders, shipping orders
also provide information regarding materials and movement requirement. Obviously then,
transportation and traffic involves movement documentation and initial transport planning.
Rail transport
It is more suited for raw material transport than finished goods and rail freight- rates are
lower than truck- rates for long distance, but usually higher than water and pipeline
transports. Moreover, rail transport is more flexible than trucks. But, locally and regionally,
it may be different story. A truck can leave at any time and arrive at a destination at a
desired time, but rail movements are bounded by time- table and sometimes, also by the
necessity of the freight- build up of a complete train. However, rail ways are ideal for
movement of raw materials, such as coal, steel, ores, etc. food- grains are also economically
handled by the rail ways.
Road Transport

Unlike rail transport, the user can contract carriers as well as common carriers for short
haules. Even for long distance trucks usually give rapid movement service, as the operate
on a flexible time schedule, leaving and arriving according to customer- needs.
Moreover, service area flexibility offered by rail transport is limited by existing rail way
trucks. There are a large number of road transport organizations operating in the country
with fleets of trucks. They are ideally suited for transport of the order of five to fifteen
tones over both short and long distances. Since road transport is a very important mode of
inland transport in Ethiopia for facilitating faster movement of goods and materials.

Air Transport
This is the fastest and the most expensive mode of transport and subject to the constraint
of limited port facilities and depends on other modes for pick-up and delivery. Speed of
movement is the primary advantage of air-transport, but it is only suitable for high- value
and highly perishable traffic. Some times, the speed advantage may reduce over all cost
requiring smaller inventories to be maintained and this means less warehousing service.

Pipeline Transport
This is a highly specialized mode, almost exclusively used by the petroleum industry.
The routes are un directional. The system is closed with out any flexibility advantage,
unlike other transport systems.
Post Parcel
Post parcel is available between al essential points in the country, but carrier is limited to
small packages only. Moreover, many commodities are not accepted and transit time
varies widely. The primary benefit is door- to door delivery at relatively low cost.

Route Selection, Rate Verification and Audit

Especially in the case of imports buying, route selection is of at most importance, not
only from the point of freight economy, but also for time taken. Generally, FOB contracts
the buyer has the right to select routes, but the rates depend up on the volume, nature of
materials , discount, space requirements, distance to be covered, services required for
stopovers and governmental regulations. But, the terms such as, FOB, CIF, etc. also
influence the final rate stricture.