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Direct and Indirect material cost, Material purchase procedure, Inventory control (Stock levels, EOQ)

Here's an explanation of direct and indirect material costs, material purchase procedures, and inventory control techniques:

Direct Material Cost

Direct material costs are the costs of raw materials and components that can be directly traced to the production of a specific product or service. These materials become an integral part of the finished product and are easily identifiable.

  • Examples: Wood for a wooden chair, steel for a car body, fabric for a dress, or flour for bread.

Indirect Material Cost

Indirect material costs are the costs of materials that are necessary for the production process but cannot be easily or economically traced to a specific product unit. These materials are typically consumed in the manufacturing process but don't form a direct part of the finished good. They are usually treated as part of manufacturing overhead.

  • Examples: Adhesives, lubricants for machinery, cleaning supplies for the factory, nails or screws (in small quantities) used in furniture making, or sandpaper.

Material Purchase Procedure

The material purchase procedure is a systematic process that organizations follow to acquire the necessary materials, supplies, and services. A well-defined procedure ensures efficiency, cost-effectiveness, and quality. Here are the typical steps involved:

  1. Recognition of Need: The process begins when a department identifies a requirement for specific materials. This is usually initiated by a Purchase Requisition (PR) form, detailing the item, quantity, specifications, and required delivery date.
  2. Verification and Approval of Purchase Requisition: The PR is reviewed by relevant authorities (e.g., department head, finance) to ensure it aligns with budget, policies, and actual needs. Multiple levels of approval may be required based on the value of the requisition.
  3. Supplier Identification and Selection:
    • The purchasing department identifies potential suppliers from an approved vendor list or by conducting market research.
    • Request for Quotation (RFQ) or Tender is sent to multiple qualified suppliers to obtain competitive bids.
    • The bids are then evaluated based on price, quality, delivery terms, supplier reliability, and after-sales service.
    • The best-fit supplier is selected.
  4. Issuance of Purchase Order (PO): A formal Purchase Order (PO) is created and sent to the selected supplier. The PO is a legal document that specifies the agreed-upon items, quantities, prices, delivery schedule, payment terms, and other conditions.
  5. Follow-up and Expediting: The purchasing department monitors the order status to ensure timely delivery. This may involve communicating with the supplier, sending reminders, or expediting the order if there are delays.
  6. Receiving and Inspection:
    • Upon arrival, the goods are received by the receiving department.
    • They are then inspected against the PO and the delivery challan/invoice to verify quantity, quality, and specifications.
    • A Goods Receipt Note (GRN) or similar document is prepared to acknowledge receipt and acceptance of the materials.
  7. Invoice Verification and Payment:
    • The supplier's invoice is received and matched with the PO and GRN to ensure accuracy.
    • Any discrepancies are resolved.
    • Once verified, the finance department processes the payment to the supplier according to the agreed-upon terms.
  8. Record Keeping: All relevant documents (PR, PO, RFQ, GRN, invoice, payment records) are properly filed and maintained for future reference, auditing, and analysis.

Inventory Control (Stock Levels, EOQ)

Inventory control, also known as stock control, is the process of managing and regulating the supply, storage, and distribution of stock to ensure the right amount of supply is available to meet demand while minimizing costs. It aims to strike a balance between having enough stock to avoid shortages and avoiding excessive stock that ties up capital and incurs holding costs.

Stock Levels

Maintaining optimal stock levels is crucial for efficient inventory control. Key stock levels include:

  1. Maximum Stock Level: The upper limit of inventory that an organization should hold. Exceeding this level can lead to increased holding costs, obsolescence, and storage issues.

    • Formula: Maximum Stock Level = Reorder Level + Reorder Quantity - (Minimum Consumption $\times$ Minimum Lead Time)

  2. Minimum Stock Level (Safety Stock/Buffer Stock): The lowest quantity of inventory that should be maintained to prevent stock-outs during unexpected increases in demand or delays in lead time. It acts as a safety net.

    • Formula: Minimum Stock Level = Reorder Level - (Average Consumption $\times$ Average Lead Time) OR Minimum Stock Level = Average Consumption $\times$ Replenishment Lead Time (assuming stable lead times and demand)

  3. Reorder Level (Ordering Level): The inventory level at which a new order should be placed to replenish stock. It ensures that new stock arrives before the existing stock runs out.

    • Formula: Reorder Level = Maximum Consumption $\times$ Maximum Lead Time OR Reorder Level = (Average Daily Usage $\times$ Lead Time in Days) + Safety Stock

  4. Danger Level: A level below the minimum stock level, indicating that stock is critically low and emergency measures (like urgent purchases) are needed to avoid a complete stock-out and production stoppage.

    • Formula: Danger Level = Average Consumption $\times$ Max. Re-order Period for Emergency Purchase

  5. Average Stock Level: The average quantity of inventory held over a specific period. This helps in understanding the typical inventory levels and calculating inventory turnover.

    • Formula: Average Stock Level = (Minimum Stock Level + Maximum Stock Level) / 2 OR Average Stock Level = (Opening Stock + Closing Stock) / 2

Economic Order Quantity (EOQ)

The Economic Order Quantity (EOQ) is an inventory management formula that calculates the optimal order quantity a company should purchase to minimize its total inventory costs, which include ordering costs and holding (carrying) costs. The model assumes constant demand and lead time.

  • Ordering Costs: Costs associated with placing and receiving an order (e.g., administrative costs, transportation costs, setup costs).
  • Holding Costs (Carrying Costs): Costs associated with storing inventory (e.g., warehouse rent, insurance, obsolescence, spoilage, opportunity cost of capital tied up in inventory).

The EOQ aims to find the point where the sum of ordering costs and holding costs is minimized.

  • EOQ Formula: $$EOQ = \sqrt{\frac{2DS}{H}}$$ Where:
    • D = Annual Demand (in units)
    • S = Ordering Cost per order
    • H = Holding Cost per unit per year
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