CONTROL OF MATERIAL COSTS
Both Direct and Indirect Material Cost required to be controlled. For this Purpose,
We will consider How many units should be ordered?
What level of units we should hold? So that we will not run out of stock.
Topics for Control of Material Costs
1. Economic Order Quantity (EOQ)
2. Stock level management
3. Just In Time (JIT)
ECONOMIC ORDER QUANTITY (EOQ)
For EOQ, following costs related to stock / material / inventory are required:
1. Holding Cost
2. Ordering Cost
3. Stock Out Cost
4. Purchase Cost
1. Holding Cost
Cost for holding the stock until issued for production.
For examples:
Opportunity cost of capital,
Warehousing Costs,
Incremental Insurance Cost,
Deterioration Costs,
Labour Costs of warehouse staff,
Opportunity Cost: Cost that is forgone because we have invested money in stock.
If we didn’t invest this money in stock, we could use it elsewhere and get benefit / profit.
2. Ordering Cost
Clerical cost of placing an order.
For examples:
Cost of purchasing department,
Cost of goods receiving department,
Cost of staff dealing payables,
3. Stock Out Cost
Penalty cost of running out of stock.
Penalty is that if we run out of stock, we will not be able to produce goods and then will not be able to sell. So we will lose profit because of running out of stock.
For example:
Forgo current revenue (from current customers),
Forgo future revenue (current customers will not come in future as well, because we have ‘Forgone Goodwill’),
Cost of quick stock order (we don’t have stock for emergency orders and we ordered for quick stock),
Cost of Idle times (we don’t have stock and labour is receiving money without work)
Assumption for EOQ: For EOQ, we have to assume that we are not out of Stock.
4. Purchase Cost
Assumption for Purchase Cost: It does not change with the level of activity. It remains constant.
Economic Order Quantity
EOQ is a statistical relationship between some variables (Holding cost, Ordering Cost) and we measure degree of certainty of every variable in it. So if we want to minimise the overall cost, we have to minimise the holding and ordering costs.
Relationship between Order Quantity and Holding Cost (Ch)
If quantity of the stock ordered rises (OQ), the holding cost (Ch) also rises because we have to hold more stock (so more holding cost) and
If quantity of the stock ordered falls (OQ), the holding cost (Ch) also falls because we have to hold less stock (so less holding cost) thus
There is a Direct relationship between these two variables.
Relationship between Order Quantity (OQ) and Ordering Cost (Co)
If quantity of the stock ordered (OQ) rises, the ordering cost (Co) falls because less orders will be placed; and
If quantity of the stock ordered (OQ) falls, the ordering cost (Co) rises because more orders will be placed; so
There is an Inverse relationship between these two variables.
For example:
Order Quantity Orders Per Annum
100 100
1,000 10
(Mnemonic: 2 Cod ‘fish’ over chip ‘to eat’)
Co = Cost per Order
D = Demand PA
Ch = Cost of holding one unit PA
Q = Order Quantity
Time for D and Ch must be same i.e. PA
Always calculate this time over one year
PA = Per Annum
Exercise
Calculate EOQ:
Quantity required per year 32,000 units;
Order Costs are $15 per order;
Inventory Holding Costs are estimated at 3% of Inventory value per year;
Each Unit currently costs $40;
EOQ = √ ((2 Co D) / Ch)
D = 32,000 units
Co = $15
Ch = $40 x 3% = $1.2
EOQ = √ ((2 x 15 x 32,000) / 1.2) = 894 units app.
We should have to demand 894 units per order to minimum ordering and holding costs.
ANNUAL COSTS OF HOLDING AND ORDERING
Annual Stock Holding Costs
If we have fixed quantity of 200 units, our Holding Cost may vary according to the number units in the warehouse until next order quantity is received and average will be at 50% of the total order quantity.
Average Quantity = Quantity (Q) / 2 (at one time)
ANNUAL COST OF HOLDING STOCK
= Average quantity x Cost of holding one item per year
= Economic order quantity per order / 2 x Cost of holding one item per year
= Q / 2 x Ch
ANNUAL COST OF ORDERING STOCK
= Number of orders to be given in a year x Cost of ordering per order
= Total Annual Demand / Economic Order Quantity per order x Cost of Ordering per order
= D / Q x Co
Dividing Annual total demand by Quantity per order (D/Q) will give us number orders to be given in a year.
Holding Cost = Q/2 x Ch = 894 / 2 x $1.2 = $536
Ordering Cost = D/Q x Co = 32,000 / 894 x $15 = $536
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Total minimum Holding and Ordering costs =$1,072
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BULK DISCOUNTS
If we get more units in an order, we will get discount on bulk purchase.
Example
Quantity required per year 32,000 units;
Order Costs are $15 per order;
Inventory Holding Costs are estimated at 3% of Inventory value per year;
Each Unit currently costs $40;
A discount for bulk of 10% on each unit is applied if we order 1600 or more units.
Solution
EOQ Units Bulk Discount Units
(894 units) (1600 units)
Holding Cost (Q/2 x Ch)
(for one year)
894 / 2 x $1.2 536
1600 / 2 x 1.08 864
($40 – (10% x $40)) x 3%=1.08
Ordering Cost (D/Q x Co)
(for one year)
32,000 / 894 x $15 536
32000 / 1600 x $15 300
Purchase Cost
(for one year)
32,000 x $40 1,280,000
32,000 x $36 1,152,000
($40 – (10% x $40))=36
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1,281,072 1,153,164
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We save on discount = 1,281,072 – 1,153,164 = 127,908
Re-order Level (Ordering Point or Ordering Level): This is that level of materials at which a new order for supply of materials is to be placed. In other words, at this level a purchase requisition is made out. This level is fixed somewhere between maximum and minimum levels.
Calculate Re-order level?
STOCK LEVELS
A series of levels of stock to ensure we minimise the amount of stock we hold while at the same time avoid the risk of stock out.
We want to keep certain level of stock so that we may not run out of stock.
How much stock we want to hold just in case?
How much stock we should have in our stock to use?
If we talk about EOQ, we know that how much stock we want and when this stock will reach our warehouse but it real world, some uncertain things may happen which may cause late arrival of stock. EOQ gives us certain number of units where the holding and ordering cost are at lowest level in relation to each other. We have not considered the degree of uncertainty of reaching the stock in time. It may be possible that stock arrives late and we run out of stock.
To avoid stock out, we follow certain rules to determine that:
When we should order stock? or
When should we take preventative actions?
In nutshell:
♦ Keep the stock at lowest level
♦ Don’t run out of stock
Degree of Uncertainty
There are 2 elements of uncertainty in case dealing with stock
1. How much stock we use in a given / certain day? We use more stock or less stock on given day.
2. Uncertainty in provision of supplying of the stock. For this purpose we consider Lead Time.
Lead Time: Time between giving / placing the order and time of receiving the goods in warehouse for use.
Re-order Level (Ordering Point or Ordering Level): This is that level of materials at which a new order for supply of materials is to be placed. In other words, at this level a purchase requisition is made out. This level is fixed somewhere between maximum and minimum levels.
Re-order level = Maximum daily or weekly or monthly Usage (demand) x Maximum lead time
The above formula is used when usage and lead time are known with certainty.
Maximum Stock Level: As the stock may fluctuate up and down, therefore there must be a maximum efficient level of stock.
Maximum Stock level = Re-order Level – (Minimum Usage x Minimum Lead time) + Re-order Quantity (or Order Quantity (EOQ))
Minimum stock level: Minimum stock level may be zero. Zero level is the time just before when the next order entered into warehouse. The purpose of this is to calculate the ‘Buffer stock’ / ‘safety stock level’. If we go below this level we are at stock out (means at danger ☻)
Minimum Stock level = Re-order level – (Average Usage x Average Lead time)
Example
Order Quantity (Re-order quantity) = 12,000 units (e.g EOQ or Any other method for order quantity)
Maximum Minimum
Usage (demand) /day 1,000 units 400 units
Lead time 10 days 2 days
Calculate Re-order level?
Re-order level = Maximum daily or weekly or monthly Usage (demand) x Maximum lead time
= 1,000 units x 10 days
= 10,000 units
Maximum Stock level = Re-order Level – (Minimum Usage x Minimum lead time) + Re-order Quantity
= 10,000 - 400 x 2 + 12,000
= 10,000 - 800 + 12,000
= 21,200 units
It means that if we have stock level above 21,200 units, we are inefficient. Now we find this amount by taking uncertainty into account.
Minimum Stock Level = Re-order level – (Average Usage x Average Lead time)
= 10,000 units - (((1,000+400)/2) x ((10+2)/2))
= 10,000 units – (700 x 6)
= 5,800 units
OTHER ISSUES RELATED TO STOCK LEVELS
1. 2 Bin system: We have two different places (bins) for keeping the stock. When one place (bin) is become empty, we place the order and start using the bin /place.
2. Just in Time (JIT): It considers that we have not inventory or stock. If we have stock in our store, we are inefficient. It is concerned with the process. If the process not is running, we have stock in the store. It means we are inefficient.
3. Free Stock / Spare Stock: The stock left over after fulfilling at commitments.
Free Stock = Physical stock +Stock on orders – Stock for customers’ orders committed.
