Material Cost

Inventory control : the main objectives of inventory control is to achieve maximum efficiency in
production and sales with the minimum investment in inventory.

Stock level: materials or inventory control necessitates the maintenance of every item of material at
such a level that there is neither over-stocking nor under-stocking.

Why avoid overstocking:

1. It would lock up a large amount of working capital which would be profitably utilized for some
other purpose.
2. It would involve an increased cost of carrying, such as rent, insurance & handling charges, etc.
3. It may result in loss due to theft, pilferage, etc.
4. It would result in deterioration in the quality of material.

Why avoid understocking:

1. It results in stockout and the consequent production hold-ups.

2. Failure to keep up delivery schedules results into loss of customers.

Inventory level

1. Minimum level = Reorder level – (Normal consumption x Normal Reorder period)

2. Maximum level = Reorder level + Reorder Quantity – (Minimum consumption x Minimum
Reorder period)
3. Reorder level = Maximum consumption x Maximum Re-order period

OR

Minimum level + (Normal consumption x Normal Reorder period)

4. Danger level = Normal Consumption x Reorder period for emergency purchase

5. Average level = minimum level + ½ Reorder quantity.

Economic Ordering Quantity

The purchase and storing function involved certain costs. When stock is increased, number of purchases
can be reduced. Thus, cost of storing would increase but cost of placing order would decrease and
likewise in opposite direction. The Economic Order Quantity strikes a balance between two with an
objective to minimize total cost. At EOQ the ordering cost is equal to carrying cost.

Cost of placing an order:

 Preparation of purchase order

 Cost of receiving goods
 Documentation processing cost
 Transport cost
 Cost of chasing orders, rejecting defective goods
  Additional cost of frequent or small quantity orders
 Set up cost associated with each production run.

There is inverse relationship between size of order and ordering cost. Larger the order size lower the
ordering cost.

Cost of carrying stock:

 Rent, lighting heating, refrigeration, air conditioning, etc.

 Stores staffing equipment maintenance and running cost
 Handling cost
 Obsolescence cost
 Insurance and security cost
 Cost of capital blocked in stock
 Pilferage and damage costs.

Assumptions of EOQ

 Knowledge of annual consumption.

 Rate of consumption is constant.
 Ordering cost is constant.
 Carrying cost is constant.
 Leadtime of delivery period is zero.

Computation of EOQ

1. Graphical method:

2. Tabular method:
 Different order size
I II III IV
I. Annual consumption (units) XX XX XX XX
II. Order size (units) XX XX XX XX
III. Number of orders (I ÷ II) XX XX XX XX
IV. Ordering cost per order XX XX XX XX
V. Total ordering cost (III x IV) XX XX XX XX
VI. Average inventory = order size XX XX XX XX
2
VII. Carrying cost per unit XX XX XX XX
VIII. Total carrying cost XX XX XX XX
IX. Total Cost (V + VIII) XX XX XX XX
Where total ordering cost & carrying cost matches, that’s EOQ

3. Mathematical equation method

EOQ =
No. orders placed =
A = Annual consumption
O = Ordering cost per order
C = Carrying cost= Carrying cost % x Cost of raw material

Illustrations:
1. Minimum usage 500 units per week
Maximum usage 1,500 units per week
Normal usage 1,000 per weeks
Re-ordering quantity 5,000 units
Delivery period 4 to 6 weeks
Calculate inventory levels
2. A Company requires 20,000 kg of material Y for the year. Cost of carrying one KG of material
is 20 p.a. it is estimated that expenses for placing an order would be 500 per order.
Calculate EOQ and number of orders to be placed.
3. A Manufacturer supplies the following information:

Consumption of raw material half yearly 15,000 kg

Ordering cost 44
Cost of raw material 4 per kg
Follow up cost of each order 4 per kg
Carrying cost is 8% of average inventory.
Calculate EOQ & Number of orders to be placed.
4. A company uses 10,000 units per year of an item costing 5 each. The cost of processing a
purchase order is 100 and stock holding cost amounts to 20% per year of money value of
inventory. Calculate EOQ & Number of orders to be placed.
5. Calculate EOQ:
Semi-annual consumption 6,000 units
Purchase price of input unit Rs. 25
 Ordering cost per order Rs.45
Quarterly carrying cost 3%.
6. The purchase manager of an organization has collected the following data for one of A class
items.
Interest of locked up capital 20%
Order processing cost for each order(O) Rs.100
Inspection cost per lot(O) Rs.50
Follow up cost for each order (O) Rs.80
Pilferage while handling inventory(C ) 5%
Other holding cost(C ) 15%
Other procurement cost for each order(O) Rs.170
Annual demand 1000 units
Cost per item Rs.10
Calculate EOQ
7. ABC Co. buys a lot of 125 boxes which is a three-month supply. The cost per box is 125 and
ordering cost is 250 per order. The inventory carrying cost is estimated at 20% of unit
value per annum.
You are required to ascertain:
i. Total annual cost of existing inventory policy,
ii. How much money would be saved by employing economic order quantity.
8. The complete Gardener is deciding on the economic order quantity for two brands of lawn
fertilizers. Super Grow and Nature’s own. The following is collected:

Particulars Fertilizers
Super Grow Nature’s Own
Annual demand 2000 Bags 1280 Bags
Relevant ordering cost per purchasing order 1200 1400
Annual relevant carrying cost per bag 480 560
Required:
- Compute EOQ for Super Grow and Nature’s Own.
- For the EOQ, what is the sum of the total annual relevant ordering costs and total
annual relevant carrying costs for Super Grow and Nature’s Own?
- For the EOQ, compute the number of deliveries per year for Super Grow and Nature’s
Own.
9. KL Limited produces product “M” which has a quarterly demand of 8,000 units. The product
requires 3 kgs quantity of material X for every finished unit of product. The other
information are follows:
Cost of material X : 20 per kg
Cost of placing an order: 1,000 per order
Carrying cost: 15% per annum of average inventory
Required
- Calculate EOQ for material X
- Should the company accept an offer of 2 percentage discount by the suppliers, if he
wants to supply the annual requirement of material X in 4 equal quarterly installments?
10. From the following information, calculate Economic Order Quantity and Number of orders
to be placed in the year according to Formula Method and Tabular Method.
A company manufactures a product from raw material which is purchased at 80 per kg.
The company incurs a cost of placing an order of 250 plus freight of 1150 per order. The
incremental carrying cost of inventory of raw material is 2 per kg per annum. In addition,
the cost of working capital finance on investment in inventory of raw material is 5 per kg
per annum. The annul production of product is 50,000 units and 5 units are obtained from
one kg of raw material. Consider Order size: (a) 10,000 units, (b) 5000 units, (c) 2000 units,
(d) 1250 units
11. A firm’s inventory planning period is one year. Its inventory requirements for this period is
1600 units. Assume that its order costs are 50 per order. The carrying costs are expected
to be 1 per unit per year for an item.
The firm can procure inventories in various lots as follows: (1) 1600 units; (2) 800 units; (3)
400 units; (4) 200 units; (5) 100 units. Which of these order quantities is the economic order
quantity? Use Table method & Equation method.
12. The following details are available:
a. Inventory requirements per year 6000 units
b. Cost per unit (other than carrying & ordering cost) 5.
c. Carrying cost per item for one year 1.
d. Cost of placing each order 60
e. Alternative order sizes (units): 2000, 1200, 1000, 600 and 200

Determine EOQ.

13. The purchase department of your organization has received an offer of quantity discounts
on its order of material as under:
Price per tonnes Tonnes

1400 less than 500

1380 500 and less than 1000
1360 1000 and less than 2000
1340 2000 and less than 3000
1320 3000 and above
The annual requirement of the material is 5,000 tonnes. The delivery cost per order is
1,200 and the annual stock holding cost is estimated at 20% of average inventory.
The purchase department wants you to consider the following purchase options and advise
which among them will be the most economical ordering quantity, presenting the relevant
information in tabular form.
The purchase quantity options to be considered are 400 tonnes, 500 tonnes, 1000 tonnes,
2000 tonnes and 3,000 tonnes.
Stock verification

Sr. Periodic Inventory System Perpetual Inventory system

No.
1. This system is based on physical It is based on books record.
verification
This system provides information about It provides continuous information
stock and cost of goods sold at a about stock and cost of sales
particular date
This system determines first, inventory It determines first, cost of goods sold
and, computes cost of goods sold as and, computes stock as balancing
balancing figure. figure.
Cost of goods sold includes loss of Closing stock includes loss of goods as
goods as goods not in stock are all unsold goods are assumed to be in
assumed to be sold. inventory.
Under this method, inventory control is Inventory control is possible under
not possible. system.
This system is simple and less It is complex and costlier method.
expensive
It requires closure of business for Inventory can be determined without
counting of stock stopping the operations of the
business.