Chapter 9
Materials: Controlling, Costing, and Planning
Quantitative Models
Inventories serve as a cushion between production and consumption of goods. They exist in various forms:
materials awaiting processing; partially completed products or components; and finished goods at the factory,
in transit, at warehouse distribution points, and in retail outlets. At each of these stages, a sound economic
justification for the inventory should exist, because each additional unit carried in inventory generates some
additional costs.
Planning Materials Requirements
Materials planning deals with two fundamental factors the quantity and the time to purchase. Determination of
how much and when to buy involves two conflicting kinds of cost the cost of carrying inventory and the cost of
inadequate carrying. The nature of these conflicting costs is illustrated in the following comparison:
Economic Order Quantity
The economic order quantity (EOQ) is the amount of inventory ordered at one time that minimizes annual
inventory cost. If a company buys materials infrequently and in large quantities (the opposite of the just-in-time
approach), the cost of carrying the inventory is high because of the sizable average investment in inventory. If
purchases are made in small quantities, with frequent orders, correspondingly high ordering costs can result.
Therefore, the optimum quantity to order at a given time is determined by balancing two factors: (1) the cost of
possessing (carrying) materials and (2) the cost of acquiring (ordering) materials.
The costs of carrying inventory are often expressed as percentages of the average inventory investment,
because the most common variable cost is interest or the cost of cap-the level of inventory. In the case of
warehousing or storage, for example, only those costs ital. Other costs can be estimated and should be limited to
only those costs that vary with that vary with changes in the number of units ordered should be included. In
contrast, the cost of labor and equipment used in the storeroom is generally a fixed cost, which is not relevant to
the decision.
It is difficult to determine the costs of not carrying enough inventory; yet they must be considered in
determining order quantities and order points. These costs include ordering costs. (The fixed costs of ordering
are not relevant; only the variable or out-of-pocket cost of procuring an order should be included). Ordering
costs include preparing a purchase requisition, purchase order, and receiving report; handling the incoming
shipment; communicating with the vendor; and accounting for the shipment and payment. Other costs of not
carrying enough inventory include the missed opportunities for savings in freight and quantity discounts.
Although only variable costs are relevant in computing EOQ and order point, it is desirable to reduce both
variable and fixed inventory costs. Fixed costs, such as some the costs of storage space, can be reduced by the
just-in-time approach as discussed in Chapter 10. Techniques for analyzing cost behavior, described and
illustrated in Chapter 3, can help in estimating the amount of carrying and ordering costs. Depending on many
factors, it can cost from $10 to $200 or more to process an order. The annual cost of holding inventory can be
from 10 to 35 percent of the average inventory investment.
Chapter 9
Materials: Controlling, Costing, and Planning
Differential calculus makes it possible to compute EOQ by formula by using information about the quantity
required, unit price, inventory carrying cost percentage, and cost per order, to. One formula variation is as
follows:
As the last equation shows, the EOQ is the square root of a fraction whose numerator is twice the product of
annual unit demand and cost per order and whose denominator is the product of unit price and the annual
carrying cost percentage. A simpler way to describe the denominator is the cost to carry a unit in inventory for
one year. The result is an order quantity that makes the total annual ordering cost exactly equal to the total
Chapter 9
Materials: Controlling, Costing, and Planning
annual carrying cost. Within the constraints of the specified amounts of order cost and carrying cost, the EOQ
lowers the total annual cost of inventory as much as possible.
The EOQ formula assumes a uniform rate of materials usage. That assumption is sometimes overlooked, and the
EOQ formula is misused as a result. In deriving the EOQ formula, the assumption is made when the average
number of units in inventory is expressed as EOQ/2, as shown on page 9-12. Only if the rate of usage is uniform
can the average inventory be calculated as simply one-half of the order size.
To illustrate use of the EOQ formula, assume an annual requirement of 2,400 units, a cost per unit of $.75, an
ordering cost of $20 per order. and a carrying cost percentage of 20 percent. Applying the formula to these data,
the EOQ is:
EOQ=
√ 2 ×2,400 × $ 20
$ 0.75 ×20 %
√
¿
$ 96,000
$ 0.15
¿ √ 640,000
¿ 800 units
Quantity Discounts
Some purchase prices are discounted if larger quantities are ordered. Larger shipments also can generate
freight savings. These changes result in a lower unit cost and thus can alter the EOQ calculation. Buying in larger
quantities also alters the frequency of orders and thus changes the total ordering cost, and it involves a larger
investment in inventories, all of which have an impact on the EOQ calculation.
Suppose the annual usage of an item is 3,600 units costing $1 each, with no quantity discount available; the
carrying cost is 20 percent of the average inventory investment; and the cost to place an order is $10. The EOQ
is:
EOQ=
√ 2 ×3,600 × $ 10
$ 1 ×20 %
√
¿
$ 72,000
$ 0.20
¿ √ 360,000
¿ 600 units
Now assume the following quantity discounts become available:
Order Size Quantity Discount
3,600 units 8.0%
Chapter 9
Materials: Controlling, Costing, and Planning
1800 6.0
1200 5.0
900 5.0
720 4.5
600 4.0
450 4.0
The following table illustrates the effect of quantity discounts by comparing total costs for various order
quantities. Notice that the order quantity the minimizes total cost (900 units per order) differs from the EOQ
computed when no quantity discount is available (600 units per order).
List price per unit $1 $1 $1 $1 $1 $1 $1
Quantity discount 8% 6% 5% 5% 4.5% 4% 4%
Discount price per unit $0.92 $0.94 $0.95 $0.95 $0.955 $0.96 $0.96
Size of order in units 3,600 1,800 1,200 900 720 600 450
Average inventory in units 1,800 900 600 450 360 300 225
Cost of average inventory $1,656.00 $846.00 $570.00 $427.50 $343.80 $288.00 $216.00
Annual cost of materials (a) $3,312.00 $3,384.00 $3,420.00 $3,420.00 $3,438.00 $3,456.00 $3,456.00
Carrying cost (20% of average) (b) $331.20 $169.20 $114.00 $85.50 $68.76 $57.60 $43.20
Cost to order (c) $10.00 $20.00 $30.00 $40.00 $50.00 $60.00 $80.00
Total cost per year (a) + (b) + (c) $3,653.20 $3,573.20 $3,564.00 $3,545.50 $3,556.76 $3,573.60 $3,579.20
With quantity discounts, the cost of materials is not a constant because it is affected by the size of the discount.
Therefore, the objective is to identify an order quantity that minimizes not just the sum of the ordering and
carrying costs ((b) + (c) in the table), but the sum of these costs plus the cost of the materials ((a)+ (b) + (c)).
Because variable carrying cost in the example fluctuates directly with the average inventory investment,
carrying cost is affected by the quantity discount.
The EOQ Formula and Production Runs
The EOQ formula also can be used to compute the optimum size of a production run, in which case CO
represents an estimate of the setup cost, and CU represents the variable manufacturing cost per unit.
To illustrate, assume that stock item A88 is manufactured rather than purchased; the setup cost (CO), such as
the cost of labor to rearrange and adjust machines, is $62; variable manufacturing cost (CU) is $2 per unit;
annual requirements are6,000 units; and the carrying cost is 20 percent. The optimum size of a production run
is computed as follows:
EOQ=
√ 2 ×6,000 × $ 62
$ 2 ×20 %
Chapter 9
Materials: Controlling, Costing, and Planning
¿
√ $ 744,000
$ 0.40
¿ √ 1,860,000
¿ 1,364 units
Determining the Time to Order
The EOQ formula addresses the quantity problem of inventory planning, but the question of when to order is
equally important. The question is controlled by three factors:
(1) time needed for delivery.
(2) rate of inventory usage, and
(3) safety stock.
Unlike the economic order quantity, the order point has no generally applicable and acceptable formula.
Determining the order point would be relatively simple if precise predictions were available for both rate of
usage and lead time (the interval between the time an order is placed and the time the materials are on the
factory floor ready for production). For most stock items, there is a variation in either or both of these factors
that almost always causes one of three results:
(1) if lead time or usage is below expectation during an order period, the new materials arrive before the
existing stock is consumed, thereby adding to the cost of carrying inventory;
(2) if lead time or usage is greater than expected, a stockout will occur, with its many forms of costs, including
lost customers;
(3) if average or normal lead time and usage are used to determine an order point, a stockout can be expected
on every other order. Forecasting materials usage requires the expenditure of time and money.
In materials management, forecasts are an expense as well as an aid to balancing the cost to acquire and the
cost to carry inventory. Because perfect forecasts are rarely possible, an inventory cushion or safety stock is
often the least costly protection against a stockout. The basic problem is to determine the safety stock quantity.
If the safety stock is greater than needed, the carrying cost will be unnecessarily high; if too small, frequent
stockouts will occur and inconveniences, disruptions, and additional costs will result. The optimum safety
stock is that quantity that results in the smallest total cost of stockouts plus safety stock carrying cost. This
carrying cost is calculated in the same way as for EOQ. The annual cost of stockouts depends on the frequency
of their occurrence and the cost of each stockout. If the action taken in the event of a stockout is to stop the job
for which there is a materials shortage and start up a new job, the stockout cost equals the setup cost required
for the change. In contrast, if production cannot be shifted to another product, it may be necessary to shut down
the facility until the materials resupply arrives, in which case the stockout cost depends on the length of time
the facility is shut down. On average, the shutdown period is likely to be longer, and stockout cost higher, for
smaller quantities of safety stock than for larger quantities.
To illustrate, assume a company uses an item for which it places 10 orders per year, the cost of a stockout is $30,
the carrying cost is $.50 per year per unit, and the following probabilities of a stockout have been estimated for
various levels of safety stock:
Safety Stock (in Probability of Stockout
Units)
0 40%
50 20
100 10
Chapter 9
Materials: Controlling, Costing, and Planning
200 5
The total carrying cost and stockout cost at each level of safety stock are determined as follows:
A B C D E
Safety Stock (in Expected Total Stockout Total Carrying Total Stockout and
Units) Stockout per Year Cost ($) Cost ($) Carrying Cost ($)
0 4.0 120 0 120
50 2.0 60 25 85
100 1.0 30 50 80
200 0.5 15 100 115
Notes: B= number of orders per year (i.e., 10) x probability of stockout
C= B x cost of one stockout (i.e., $30)
D = A x cost to carry one unit in inventory for one year (i.e., $.50)
E = C+ D
In this illustration, the optimum level of safety stock is 100 units, because the total stockout and safety stock
carrying cost is minimized at this level.
Order Point Formula
Order points are based on usage during the time necessary to requisition, order, and receive materials, plus an
allowance for protection against stockout. The order point is reached when the available quantity is just equal
to the foreseeable needs; that is, when the sum of inventory on hand and quantities due in equals the sum of
lead time usage quantity and safety stock quantity. In equation form, the order point can be expressed as:
1+ QD = LTQ + SSQ
Where:
I = Inventory balance on hand
QD = Quantities due in (before depletion of I) from orders previously placed, materials transfers, and returns to
stock
LTQ = Lead time quantity, which equals normal lead time in months, weeks, or days, multiplied by a normal
month's, week's or day's use
SSQ = Safety stock quantity
If the weekly usage of a stock item is 175 units, and the lead time is normally four weeks but possibly as long as
nine weeks, then the order point is 1,575 units: 700 units usage during normal lead time (175 units x 4 weeks)
plus 875 units of safety stock (175units x 5 weeks). Assuming a beginning inventory of 2,800 units with no
orders outstanding, the usage, order schedule, and maximum inventory levels are:
Units in beginning inventory 2,800
Usage to order point (1,225 ÷ 175 weekly usage = 7 weeks) (1,225)
Order point 1,575
Usage during normal lead time (700 ÷ 175 weekly usage = 4
(700)
weeks)
Maximum inventory or safety stock at date of delivery, assuming
875
normal lead time and usage
Order quantity units received 2,090
Maximum inventory, assuming normal lead time and usage 2,965
Figure 9-3 depicts materials planning under the above assumptions and shows that a stockout will not occur
unless lead time exceeds nine weeks, assuming normal usage.
Chapter 9
Materials: Controlling, Costing, and Planning
In most businesses, a constant normal usage is not likely to occur because usage depends on production and
production depends on sales. For instance, if the usage rate is as high as 210 units per week, with lead time
normally four weeks but possibly as long as nine weeks, then the safety stock is 1,190 units and the order point
1,890 units, calculated as follows:
Normal usage for normal lead time of four weeks (175 units × 4 weeks) 700 units
Safety stock:
Normal usage for five weeks’ delay (175 units × 5 weeks) 875
Usage variation ((210 – 175) × 9 weeks) 315 1,190
Order point 1,890 units
Assuming a beginning inventory of 2,800 units with no orders outstanding, the usage. order schedule, and
maximum inventory levels would be:
Units in beginning inventory 2,800
Usage to order point (910 ÷ 210 maximum weekly usage = 4.3 weeks) (910)
Order point 1,890
Normal usage for normal lead time (700 ÷ 175 normal weekly usage = 4 weeks) (700)
Maximum inventory or safety stock at date of delivery, assuming normal lead time and usage 1,190
Order quantity units received 2,090
Maximum inventory, assuming normal lead time and usage 3,280
Computer Simulation for Materials Requirements Planning
Materials requirements planning (MRP) is a computer simulation for managing materials requirements based
on each product's bill of materials, inventory status, and process of manufacture. A master schedule of items to
be produced and their due dates are entered into the computer, which then accesses the bill of materials,
Chapter 9
Materials: Controlling, Costing, and Planning
materials delivery lead times, and quantities of inventory on hand and on order. The computer program
calculates the needed quantity for each material and the amount and timing of demands on each work location.
These demands, when compared with machine and personnel capacities, determine the feasibility of meeting
the master schedule. If work overloads cannot be resolved, the master schedule must be revised. Only when the
master schedule is determined to be feasible is it released, along with purchase orders and operating schedules.
In this way, the feasibility of production schedules can be tested prior to their release.
