Operations management UNIT-2

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We will cover three broad headings in this UNIT: Material management, Purchase system and Inventory control

NOTES OF UNIT-1

Material Management

"The process of controlling the materials involved in the manufacturing process of a product by a company is known as Material Management."

Material management is a wide term which includes every kind of material used for producing a particular product. (It can be raw material, it can be cost of product designing, it can be packaging, it can be supply cost, it can be storage cost, it can be data Analytics, etc).

Material Management involves all these materials which are used as the input directly or indirectly to produce the final output.

Scope of Material Management

It is in:

• Material planning 
• Material budgeting
• Production control
• Material purchasing
• Inventory control of materials
• Materials purchasing
• Material distribution
• Material handling
• Traffic handling (which basically means managing the inflow and outflow of the materials during production)

Objectives of Material Management

1. Primary objectives

• Buy raw materials at the best available price
• Ensure optimum utilization of raw material
• Minimize administration cost

2. Secondary objectives

• To make the decision of "make or buy"
• To ensure quality of materials
• To work towards continuous improvement of final product.

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Purchase system

"The beginning of material management initialises through purchasing."

Purchasing can be defined as the procurement of raw materials, supplies, machines, tools, etc which will be used in the manufacturing process.

All the activities carrying out in the name of purchasing requires management and control and this is particularly known as purchase management.

Purchase management brings efficiency and effectiveness in the system of purchase which assists in carrying out the manufacturing process.

Objectives of purchasing system

1. Availing material supplies and equipment at minimum possible cost
2. Enable regular flow of production
3. Increasing asset turnover( an effective purchase management system not only looks after the purchasing process but also focuses on creating better fixed assets).
4. Develop alternate sources of supply
5. Establish cordial relations with suppliers
6. Achieve close coordination with other departments (such as finance department, personnel department, marketing department, etc)
7. Train and develop the personnel
8. Efficient record maintenance and management reporting

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Types of purchasing system

Broadly there are two types of purchase systems:

Centralised purchasing system

This system concentrates the power to purchase in only few hands OR in this system only a few production managers are responsible for carrying out all the purchasing activities.

Advantages

• Concentrated volume (as bulk purchase is done by only a few production managers, they gain the opportunity to bargain with the venders and get extra discounts)
• Avoids duplication
• Specialisation
• Lower transportation cost (because of bulk orders supplied at a time)
• No competition within the units (because only a few managers are responsible for purchasing and hence, there is least competition among them for buying materials at minimum price)

Decentralized purchasing system

This a system tends to distribute the purchasing power in many hands OR in short, managers as well as other workers can also purchase materials as per the requirement of the manufacturing process.

Advantages

• Full knowledge of requirement as purchasing is done at individual levels
• Local sourcing
• Less bureaucracy & paperwork
• Time saving

Functions of purchasing system

1. Availing materials
2. Price evaluation
3. Paper work and accounting
4. Policy compliance

Procedure of purchasing

1. Purchase acquisitions 

These are receipt of materials which are required to be purchased. This receipt is made to give a green signal for carrying out the purchasing process.

2. Potential sources of supply

After the receipts are made, the responsible managers search for the different supply sources.

3. Issue of letters inviting quotations

In general terms, quotations contain the basic information (like price, quantity, brand, etc) about the materials which a customer wants to purchase.

4. Receipt and analysis of quotations

After getting quotations from many suppliers, the Purchase Manager analyses the best offer.

5. Selection of vendor or supplier

6. Raising the purchase order

7. Follow up and delivery

8. Purchase order amendments

(only if required, such as to increase the quantity of material or to decrease, etc)

9. Analysing receiving reports for quality control

10. Scrutiny and approval of invoices

At this stage after the inspection of material quality, order is given to depart the purchased items.

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Store keeping

It is the most significant aspect of working of an organisation which lays the foundation stone for Material Managemen.

It is an internal service-oriented department which serves the purposes of production department.

The employee who supervises the materials kept in the storeroom is known as store keeper or store manager

Advantages of store keeping

• Requires minimum investment
• Provides continuous flow of material
• Ensures protection and preservation of materials
• Enables good quality at minimum cost
• Reduces the chances of accidents
• Ensures minimum wastage

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Material planning functions

Material planning department is basically responsible to plan all the future purchase orders of required materials and to maintain the minimum sufficient stock of all required items.

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Purchasing methods

There have been numerous methods to raise up a purchase order:

1. Purchasing by requirement

Also known as "Hand to mouth" buying, this purchasing is only done whenever there is a need for materials.

2. Purchasing for specified period

This purchasing is done to attain sufficient quantity of different materials which will necessarily be used in the production for sometime.

3. Market purchasing

This method is used to take the complete benefit of current market situation and price variations.

4. Speculative purchasing 

This purchasing is done to achieve greater profits as additional units of materials are purchased when the prices are low for that material in the market.

5. Contract purchasing

This method is used for contractual based purchasing which sets the price of a material with the supplier for a particular time period such as 3 to 4 years.

6. Group purchasing

In this method different materials are brought in groups or lots within a single order instead of buying them separately.

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Importance of purchasing system

• It provides efficient administration
• Ennsures better quality of final product
• Ensures timely delivery of the raw materials required
• Helps to increase profitability
• Assures full and optimum utilisation of capital

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Inventory control

The process used by the managers to check the number of inventory items and control them in an efficient manner is a known as inventory control.

It can be also referred as

 "the scientific method of finding how much stock should be maintained in order to meet the production demands and how can the inventory department will be able to provide right type of material at right time in right quantities at competative prices."

The word inventory denotes stock of goods.

In terms of accounting, inventory only refers to stock of finished goods BUT here we are talking in terms of manufacturing concern and in this, inventory refers to work in progress, store inventory, raw materials, etc.

Need for inventory

Inventory is needed to fulfill the: 

1. Transaction motive to meet the daily requirement of production system.
2. Precautionary motive when in case company faces shortage of materials due to unpredictable circumstances.
3. Speculative motive this is when company maintains inventory to grab the opportunity for making profit when the price rises for some of the materials in the market.

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Elements of inventory

1. Raw materials
2. Work in progress
3. Consummables 
4. Finished goods
5. Stores & spares (these are the tools and machines which are used in the daily production activity)

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Types of inventory

1. Movement inventories

These are the inventory in transportation mode which means this have been ordered from the production department and are being supplied by the supplier but had not reached the storeroom yet.

2. Buffer inventories

These are the extra stocks maintained to protect against fluctuation in demand and supply.

3. Anticipation inventories

These are maintained to meet the future requirements of the production

4. Decoupling inventories

These are the intermediate inventories.

To understand better, let's say a product of a machine is used by another machine as input hence, it is important to maintain intermediate inventory of that product so that both machines can work simultaneously.

5. Cycle inventories

These are the inventories which keep on getting used and ordered simultaneously.

6. Independent demand inventory

It consists of finished products which are kept for a forecasted demand.

7. Dependent demand inventory

These are the inventories of derived demand, such as, general parts of machine, nut bolts, etc.

8. Seasonal inventory

It is made to meet the anticipated instability in demand due to seasonal variations.

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Benefits of holding inventory

1. Avoiding lost sales (the loss a firms suffers when it has no storage of finished goods is avoided by holding inventories).
2. Lower purchase cost (for getting quantity discount in order to hold inventory the Purchase Manager orders in bulk with extra discounts).
3. Reducing order cost (because of bulk ordering).
4. Achieving efficient production run (as holding inventory ensures continuous flow of materials).
5. Reducing risk of limited production

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Relevant inventory cost

1. Ordering cost/ Set-up cost

The cost incurred when the inventory is reordered is known as ordering cost. It is also known as procurement cost.

Ordering cost is also similar to the set-up cost but ordering cost is recurring in nature and set up cost is only incurred at initial stage.

Set-up cost also includes:

Order cost, purchasing or manufacturing or variable cost as well as transportation cost.

2. Carrying cost

Carrying cost refers to the cost which is incurred due to storing additional item in the inventory. This is popularly known as holding cost or storage cost.

It consist of:

1. Opportunity cost which can be understood as the loss of the capital used in holding a particular inventory instead using it for investment and generating profits.

2. Warehousing cost is the amount paid in the form of fee for storage of goods.

3. Shortage / stock-out cost

The shortage or stock-out cost can be referred to the cost related to not catering the customers.

Stock out indicates the shortage of material which has the potential of losing a sale or losing a customer's goodwill when a firm is not able to provide the required products to the customer.

It includes following cost:

1. Lost sales cost when a customer buys unavailable item from another firm, then the first firm loses the sale.

2. Back order cost shortage of materials impact the future sales of a firm.

4. Purchase cost

It is the cost incurred for acquiring a material at the time of purchase. It is also known as the nominal cost of inventory.

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Economic order quantity/EOQ model

Ordering costs and carrying costs are taken into consideration while determining economic order quantity.

Imbalance between these 2 costs can affect the profit adversely, so balance needs to be maintained besides keeping both of them at a minimum level.

The point at which ordering cost = carrying cost is called economic order quantity.

Assumptions of EOQ model

• Supply is always available
• Quantity to be procured is predecided
• Prices of goods are constant

Advantages of EOQ model

• Mathematical approach is more reliable
• The formula does not need to be moderated

Weakness of EOQ model

• Erratic usage as it assumes that usage of material can be predicted and evenly distributed throughout the year.
• Faulty basic information
• Costly calculation
• No formula is a substitute for common sense.

Economic Lot Size/EOQ with quantity discounts

The standard EOQ model is based on the assumption that the unit cost remains constant.

However in real life scenario, discounts are based on the ordered quantity.

For example, an order with higher units is likely to receive higher discount, lowering the cost per unit.

There are several advantages and drawbacks of bulk purchasing.

The advantage is attached to discount model is to lower unit cost. At the very same time, the drawback increases carrying cost of inventory, ties up capital and chances of obsolete stock and spoilage increases.

Maximum stock level

In this, the traders or the stockist tend to hold the stock to a large extent and realize gain from the  price fluctuation and not the industry.

Material control fixes an upper limit beyond which the inventory levels are not allowed to be passed on.

Such a maximum ceiling is known as maximum stock level.

Minimum stock level

It stipulates a point below which the inventory level is not allowed to fall. It rules out the possibility of stock out and stopage of production.

This minimum stock includes a buffer or safety stock as well.

Danger level

It depicts the most alarming level beyond which the stock level is not allowed to fall in any circumstance.

If the stock reaches this level, then the situation demands immediate action to procure the materials.

Average stock level

It is the average stock held by the organization.

Re-order point level

The point at which the store keeper makes a fresh order for the purchase of material is known as the re-order level.

Generally, it lies between the maximum and the minimum stock level.

It is fixed in such a way that by the time the purchase order reaches, the inventory level does not fall below the minimum level and after the receipt, it again reaches the maximum level.

Buffer/Safety stock

This type of stock is maintained to meet conditions when there is unforeseen upsurge and usage.

The demand for material cannot be determined perfectly as it fluctuates from time to time.

Safety stock tends to be higher when various elements such as lead time and usage rate are highly variable.

In order to reconcile between inventory carrying cost and stock out cost, the optimum level of safety stock is generally lower than the level which would provide a complete defense against the instance of stockout.

Need for safety/reserve/buffer stock

• To reduce the risk in volatile condition
• Increase the level of customer satisfaction
• Bulk purchase helps in reducing unit cost
• Seasonal fluctuation is well handed

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