Chapter - 2

Materials Management & Forecasting

q Purchasing
Types of Purchases Purchasing Process
Elements of Purchasing Process Purchasing Objectives
q Inventory Management
q Topics to be covered Inventory Models
q Introduction v Economic Order Quantity Models (EOQ)
q Types of inventory v Economic Production Quantity (EPQ)
q Functions of Inventory v Price Break Models (Discount)
q Inventory Cost v Reorder Point And Safety Stock

q Forecasting q Techniques of Forecasting

ü Importance of Forecasting ü Qualitative
ü Forecasting Range ü Quantitative
1
Ø Purchasing is the formal process of buying goods and
services.
Ø one purchaser considers:
ü Shall i purchase ? (Demand/Need)
ü Why to purchase ? (Reasonability/Purpose)
ü What to purchase? (Kind / Quality)
ü How much to purchase ? (Quantity)
ü How to purchase ? (Method)
ü From where to purchase ? (Supplier)
ü By what price to purchase ? (Cost)
Purchasing depends on:
• Inventory
• Amount of products to be produced
• Processing/manufacturing
• Cost
• Supply continuity
• Manage the purchasing process efficiently and
effectively
• Develop supply base management
• Develop strong relationships with other
functional stakeholders
• Support organizational goals and objectives
• Develop integrated purchasing strategies that
support organizational strategies
 Depending on what type of purchase you are going to make, then the
process concerned is not the same. The following examples show the
different processes that take place concerning the different purchase
types.
1. Personal Purchases
The consumer purchases for the consumption of themselves, then
they fall into this very important category class. They are ultimately
are driving the economy through the purchase of its products.
Therefore the economy becomes dependent on them.
2. Mercantile Purchasing
Facilitated by middlemen for the purpose of re-sale to meet others
requirements. Agents, wholesalers and retailers come under this
category providing their own channels of distribution to the consumer.
3. Industrial Purchasing
The purchaser is buying to convert material into finished product. It
means buying raw materials, Components, supplies and consumable
stores, spares and tools, machines and equipment and office device.
4. Institutionalized or government purchasing
Government agencies or institutions are very important, they purchase in
bulk for public utilities.

• Identify user requirements

• Evaluate need effectively and efficiently
• Identify suppliers
• Ensure payment occurs on time
• Ascertain that the need was effectively meet
• Drive continuous improvement
5
Inventory:
ü An inventory is an idle stock of material in store used to facilitate
production or to satisfy customer needs.
ü Inventory is any stored resource that is used to satisfy a current
or future need.
Inventory Management:
Scientific method of finding out how much stock should be maintained
in order to meet the production demands and be able to provide right
type of material at right time, in right quantities and at competitive
prices. (Example: KIZEN)
Inventory Management deals with the following tasks:
v Management of material stocks on a quantity and value basis.
v Planning, Record, and Documentation of all Goods Movements.
v Carrying out the Physical Inventory (Counting).
6
 q Types of Inventory
q Raw material
vPurchased but not processed
q Work-in-process
vUndergone some change but not completed
q Maintenance/repair/operating (MRO)
vReplacement parts, tools, & supplies
q Finished goods
vCompleted product awaiting shipment
vGoods-in-transit to warehouses or customers

7
Ø To meet anticipated demand.
Ø To provide a protection for variation in raw material delivery time.
Ø To allow flexibility in production scheduling.
Ø To protect against stock-outs.
Ø To take advantage of order cycles or to take advantage of quantity
discounts.

8
 Inventory Counting Systems
qA physical count of items in inventory

vPeriodic/Cycle Counting System: Physical count of

items made at periodic intervals.

vContinuous Counting System: System that keeps track

o f r e m o v a l s f r o m i n v e n t o r y c o n t i n u o u s l y, t h u s
monitoring current levels of each item.

vUniversal Bar Code - Bar code printed on a label that

has information about the item to which it is attached.

9
 q Inventory Classification
q Inventory classification is a process of classifying items into
different categories, thereby directing appropriate attention to the
materials in the context of company’s viability.

ABC Classification Example

qA Items:
vTypically 5 - 10% of the items accounting for 70 - 80%
of the inventory (Vital few). 10
 ABC Classification Example
q B Items:
v Typically an additional 30% of the items accounting for 5% -15%
of the inventory value (moderate).
q C Items:
v Typically the remaining 50% - 60% of the items accounting for
only 1% -5% of the inventory value (Trivial many).

11
 q Inventory Control
qInventory control is concerned with :
vMinimizing the investment in inventory (Inventory
cost).
vMaximizing the service levels to customer’s and it’s
operating departments.
Inventory planning and control

12
 Inventory Costs
i) Holding costs: are the costs of holding or “carrying”
inventory over time. Such as:
vHousing costs (including rent or depreciation,
operating costs, taxes, insurance)
vMaterial handling costs (equipment lease or
depreciation, power, operating cost)
vLabor cost

13
ii) Ordering costs : the costs of placing an order and
receiving goods, Fixed, constant dollar amount incurred
for each order placed.
vDeveloping and sending purchase orders
vProcessing and inspecting incoming inventory
vInventory inquiries, Utilities, phone bills, and so on for
the purchasing department
vSalaries and wages for purchasing department
employees
vSupplies such as forms and paper for the purchasing
department.
iii) Shortage costs: Loss of customer goodwill, back order handling,
and lost sales.

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 q Inventory Models
q Inventory models deals with determining optimum inventory level
that should be kept to keep the inventory cost to the minimum and
customer satisfaction or service level to the maximum.
vWhen to order?
vHow much to order?
vHow much and when to produce?
vLevel of inventory
qInventory Models
vEconomic Order Quantity (EOQ)
vEconomic Production Quantity (EPQ)
vPrice Discount Models/Price Break Models
15
 i) Economic Order Quantity (EOQ)
q Is an optimizing method used for determining order
quantity and reorder points. Part of continuous review
system which tracks on-hand inventory each time a
withdrawal is made.
q Assumptions:
v Only one product is involved
v Annual demand requirement is known and constant.
v Lead time does not vary.
v Each order is received in a single delivery.
§ Infinite production capacity

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 EOQ Model
1. You receive an order quantity Q 4. The cycle then repeats.

Q Q Q

R
2. You start using L L
them up over time.
Time
3. When you reach down to a level of
R = Reorder point inventory of R, you place your next
Q = Economic OQ Q sized order.
L = Lead time
17
EOQ Model Costs

18
 EOQ Costs
Total Annual Costs = Annual Ordering Costs + Annual Holding
Costs

 D  Q 
TC EOQ   S    H 
Q   2 
Where
TC  total annual cost
D  annual demand
Q  quantity t o be ordered
H  annual holding cost
S  ordering or setup cost
q The optimal or minimum cost occurs at the intersection point of holding cost and ordering
cost. So using calculus the Q value at this point can be computed.
Reorder level (R) can be computed as demand during lead
time times lead time.
R= d*L
R= d*L + ss (safety stock)
19
 Inventory Model Terms
qReorder point (R): Level of inventory on hand at
which the next order should be placed.
qCycle Interval (T): the total time between one order
receipt period and next order receipt.
qOrder frequency (N): total number of orders per year
(per full inventory cycle).

qCycle Inventory (Q/2): Average inventory kept per

cycle interval.

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 EOQ example
q Annual Demand = 1,000 units;
q Holding cost per unit per
q Days per year considered in average
365; year = $2.50;
q Daily demand = 1000/365; q Lead time = 7 days;
q Cost to place an order = $10;
q Cost per unit = $15;
Given the information above, what are the EOQ, reorder point (R),
Cycle inventory, Order frequency (N) and Cycle interval (T)?

Cycle Inventory = Q/2 = 45 Units

N = D/Q = 11.1 Orders

T= Q/d = 32.85 days

 ii) Economic Production Quantity (EPQ)
q An optimizing method used for determining production quantity
and reorder points.
q Production done in batches or lots.
q Capacity to produce a part exceeds the part’s usage or demand
rate.
qAssumptions of EPQ are similar to EOQ except orders
are received incrementally during production.
vOnly one item is involved
vAnnual demand is known
vUsage rate d is constant
vUsage occurs continually
vProduction rate p is constant
vLead time does not vary 22
 Economic Production Quantity (EPQ)
q The Maximum Inventory (Imax) is total production during
production phase (Q) minus depletion (Q(d/p)).

Production and Depletion, no production

usage only usage

ROP

t1 t2

T L t1= production and

usage period
t2= usage period
23
 Economic Production Quantity (EPQ)
The total cost at economic
production is the sum of
holding and setup costs. At
the optimal point holding cost
and set up costs are equal.
Hence we can derive EPQ
formula as follows:

D  I  The cycle interval (T) is the sum of t1

TC EPQ   S    MAX H 
Q   2  and t2.
t1 = Q/p
 d t2 = Imax/d
I MAX  Q  1  
 p By substitution
2 DS
T= Q/d
EPQ 
 d 
H  1   R = dL (Usage rate*Set up time) 2
 p 
R = dL + ss (Safety stock) 4
 EPQ Example
q Annual demand = 18,000
units qAnnual holding cost = $18 per
unit
q Production rate = 2500
qSetup time= 5 days
units/month
qNo. of operating days per
q Setup cost = $800 month = 20

Given the information above, what are the EPQ, Imax, Cycle
inventory, reorder point (R), Order frequency (N) and Cycle
interval (T), t1, t2?
2 DS
EPQ 
 d  = 2000 units R = d*L= (1500/20)*5 = 375 Units
H  1  
 p 
T = Q/d = 2000/1500= 1.33 months
Imax = 800 units
N = 12/1.333 = 9 production cycles
t1 = Q/p = 0.8 month
t2 = Imax/d = 0.53 month TC = holding c ost + se t up c ost = 2
$14,400 5
 iii) Price Break (Quantity Discount) Models
q Reduced prices are often available when larger quantities are
purchased.
q Trade-off is between reduced product cost and increased holding
cost.

26
Example: Letthe annual demand of item X is 5000 units, Ordering
cost is $49 per order, Holding cost is 20% of unit price per item
per year. Determine the optimal order quantity that minimizes
the total cost.

Here the value of holding cost depends on the amount of units

to be ordered, and it varies for each discount. For the above
example: H = iP and Total product cost per year is = PD,
where i is percentage of holding cost.
 Price Break (Quantity Discount) Models
Price break model procedure
v Calculate the EOQ for each price break.
v Determine whether the EOQ is feasible at that
price, check whether the EOQ is in the
discount range.
v Will the vendor sell that quantity at that price?
v If yes, stop – if no, continue.
v If EOQ is not feasible select the next higher
quantity, minimum on the discount range.
v Calculate the total costs (including total item
cost) for the feasible EOQ model of each
price break.
v Compare the total cost of each option &
choose the lowest TC alternative.
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 Price Break (Quantity Discount) Models
2DS
Q* =
iP

2(5,000)(49)
Q1* = (.2)(5.00) = 700 cars order

2(5,000)(49)
Q2* = (.2)(4.80) = 714 items order, adjusted to 1000 items.

2(5,000)(49)
Q3* = (.2)(4.75) = 718 items order, adjusted to 2000 items.

29
 Price Break (Quantity Discount) Models
q The total cost of each price break is computed as follows including
the annual product cost and holding cost for each range which
depends on product price.
TC = QH/2 + DS/Q + PD

Discoun Annual Annual Annual

t Unit Order Product Ordering Holding
Number Price Quantity Cost Cost Cost Total
1 $5.00 700 $25,000 $350 $350 $25,700

2 $4.80 1,000 $24,000 $245 $480 $24,725

3 $4.75 2,000 $23.750 $122.50 $950 $24,822.50

Choose the price and quantity that gives the lowest total cost
Buy 1,000 units at $4.80 per unit, Discount number 2.
30
 q Forecasting
Forecasting is Predictions about future economic activity
depending on the present or past events or data
Importance of Forecasting
qMarketing managers:
v To determine optimal sales force allocations.
v Set sales goals.
v Plan promotions and advertising.
q Planning for capital investments:
v Predictions about future economic activity.
v Estimating cash inflows accruing from the investment.
q The personnel department:
v Planning for human resources.
qUniversities:
v Forecast student enrollments.
v Cost of operations

31
 Principles of Forecasting
qMany types of forecasting models that differ in complexity
and amount of data & way they generate forecasts:
vForecasts rarely perfect because of randomness.
vForecasts more accurate for groups vs. individuals.
vForecast accuracy decreases as time horizon increases.
q Forecasting Ranges:
i) Short-range forecasts: Usually less than 3 months.
vConcerned with the daily operations of a business
firm.
vDaily demand or resource requirements, Job
scheduling and worker assignment. 32
ii) medium-range forecast:
Encompasses anywhere from 3 months to 2 years.
v Yearly production and Sales planning and reflect peaks and
valleys in demand and the necessity to secure additional
resources for the upcoming year.
iii) long-range forecast:
Ø Encompasses a period longer than 1 or 2 years.
Ø Long-range forecasts are related to management's attempt to:
v Plan new products for changing markets.
vBuild new facilities.
v Secure long-term financing.
q In general, the further into the future one seeks to predict,
forecasting becomes more difficult.
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 q Steps of Forecasting
1. Decide what needs to be forecasted.
v Level of detail, units of analysis & time horizon
required.
2. Evaluate and analyze appropriate data.
v Identify needed data & whether it’s available.
3. Select and test the forecasting model.
v Cost, ease of use & accuracy.
4. Generate the forecast.
5. Monitor forecast accuracy over time.

34
 q Types of forecasts
v Economic forecasts
§ Address business cycle – inflation rate, money supply, and etc.
v Technological forecasts
§ Predict rate of technological progress.
§ Impacts development of new products.
v Demand forecasts ; Predict sales of existing product.

q Forecasting methods
q Qualitative Methods
v Used when situation is unclear and little data exist.
-New products -New technology -Innovative products
v Involves intuition, experience.
§ Forecasts generated subjectively by the forecaster.
§ Educated guesses.
 Forecasting methods
q Quantitative Methods
v Used when situation is ‘stable’ and historical data exist.
§ Existing products
§ Current technology
v Involves mathematical techniques or mathematical modeling.
§ e.g., forecasting sales of color televisions.
§ Commodity products that are sold every day.
 1. Qualitative Forecasting Methods
v Individual Expert:
§ Individual market experts can be hired to watch for industry
trends, to estimate future demand for products.
v Executive Opinions/Group Consensus:
§ The subjective views of executives or experts from sales,
production, finance, purchasing, and administration are averaged
to generate a forecast about future sales.
vDelphi Method:
vBased on sequential questionnaires.
vRequires one person to administer and coordinate the process and
poll the team members (respondents) through a series of sequential
questionnaires
vConsumer Surveys; Surveys regarding specific consumer purchases.
Surveys may consist of telephone contacts, personal interviews, or
questionnaires as a means of obtaining data. 37
 2. Quantitative Forecasting Techniques
q Quantitative analysis typically involves two approaches:
I. Causal models
II. Time-series methods
I. Causal/Regression Methods:
vCausal models establish a quantitative link between observable
or known variable (like advertising expenditures) with the
demand for some product.
Causal models
qCausal models establish a cause-and-effect relationship between
dependent and in dependent variables.
q A common tool of causal modeling is linear regression:
q Additional related variables may require multiple regression
modeling.
v Y- Dependent Variable
Y  a  bX 38
v X- Independent Variable
II. Time Series Forecasting Methods
q Time series forecasting methods are:
vBased on analysis of historical data.
q Set of evenly spaced numerical data:
vObtained by observing response variable at regular time periods.
q Forecast based only on past values:
vAssumes that factors influencing past and present will
continue influence in future.

Time Series Patterns

§Trend §Random
§Seasonal §Cyclical 39
 q Time Series Patterns
q Historic data may exhibit one of the following pattern:
v Level (long-term average) – data fluctuates around a constant
mean.
v Trend – data shows an increasing or decreasing pattern.
v Seasonality – effects are similar variations occurring during
corresponding periods, can be quarterly, monthly, weekly, daily,
or even hourly indexes.
v Cycle – are the long-term fluctuates about the trend line.
q Irregular variations - caused by unusual circumstances.
q Random variations - caused by chance, cannot be predicted.

40
Time Series Patterns

41
 q Time Series Models
q Time Series : a set of observations measured at
successive times or over successive periods.
1. Naïve or Projection
2. Simple Moving Average
3. Weighted Moving Average
4. Exponential Smoothing
1. Naïve or Projection
qThe forecast for the period t, F t , is simply a projection of previous
period t-1 demand, At-1.
v Ft = At-1
v E.g. If the actual demand of period t is 120, then the forecast of
the period t+1 is 120.
42
 2. Simple moving average (SMA)
qThis method, although easy to use, doesn’t make use of data that is
easily available to most managers; thus, using more of the historical
data should improve the forecast.

43
q Simple Moving Average (MA)
q To determine the length of n:
vHigher value of n - greater leveling, lower awareness.
vLower value of n - less leveling, more awareness.
v A large value of n is appropriate if the underlying pattern of
demand is stable.
v A smaller value of n is appropriate if the underlying pattern is
changing or if it is important to identify short-term fluctuations.

44
Example: A company sells storage shed, Determine the forecast of
January using 3 month simple moving average.

45
3. Weighted moving average (WMA)

46
q Weighted Moving Average:
v Where wt-1 is the weight applied to the actual demand
incurred during period t-1, and so on.
v Intuitively, the expectation would be that the more
recent demand data should be weighted more heavily
than older data; so, generally, one would expect the
weights to follow the relationship wt ≥ wt-1 ≥ wt-2 ≥ ….
v The sum of the weights is one.

47
q Weighted Moving Average: Consider the weights 3/6, 2/6, 1/6 for
periods t-1, t-2 and t-3 respectively which are added to one.
Determine the forecast of January.

48
3. Exponential smoothing:
q Nice properties of a weighted moving average would be one where
the weights not only decrease as older and older data are used, but one
where the differences between the weights are “smooth”.
q Obviously the desire would be for the weight on the most recent data
to be the largest.

49
 q Why use exponential smoothing?
v Uses less storage space for data
v More accurate
v Easy to understand
v Little calculation complexity
q The smoothing constant “� ” expresses how much our forecast
will react to observed differences.
v If � is low: there is little reaction to differences.
v If � is high: there is a lot of reaction to differences.
q Selecting Smoothening Constant (α):
v The appropriate value of the smoothing constant, � , however,
can make the difference between an accurate forecast and an
inaccurate forecast.
50
 Time Series Model
qIn picking a value for the smoothing constant, the objective is to obtain
the most accurate forecast.
v Several values of the smoothing constant may be tried, and the one
with the lowest MAD could be selected.
Exponential smoothing: Example

52
 Time Series Model
qExponential smoothing: Selecting smoothing constant.

The smoothing constant with less MAD should be selected, thus α = 0.1
53
 Selecting the Right Forecasting Model
q Selecting the right forecasting methods depends on:
1. The amount & type of available data
v Some methods require more data than others
2. Degree of accuracy required
v Increasing accuracy means more data
3. Length of forecast horizon
v Different models for 3 month vs. 10 years
4. Presence of data patterns

54
 Selecting the Right Forecasting Model
qForecasting during product life cycle

55
 q Measuring Forecast Error
q Forecasts are never perfect
q Need to know how much we should rely on our chosen forecasting
method.
q Measuring forecast error:
q Note that: E t  A t  Ft
v Over-forecasts = negative errors
v Under-forecasts = positive errors.
q Large values of negative or positive errors shows there is bias in
the forecast.

56
 q Measures of Forecast Error
q Mean Absolute Deviation (MAD)
vMeasures the total error in a forecast without regard to sign
q Cumulative Forecast Error (CFE)
vAlso called running sum of forecast error (RSFE)
vMeasures any bias in the forecast
q Mean Square Error (MSE)
vPenalizes larger errors

 A - Ft 
2
t
MSE = t =1 RMSE
= MSE
n
n

CFE   actual  forecast  RSFE  

i 1
(A t  F t )

n Ideal values = 0 (i.e., no forecasting error) 57

 q Measuring Accuracy: Tracking signal

q The tracking signal is a measure of how often our estimations have

been above or below the actual value. It is used to decide when to
re-evaluate using a model.

RSFE
TS 
MAD
q Positive tracking signal: most of the time actual values are
above our forecasted values
q Negative tracking signal: most of the time actual values are
below our forecasted values

Usually 3 ≤ TS ≥ 8, out of this range investigate!

58
Measuring Forecast Accuracy and Error
Weighted (n=3,
Simple t-1=0.45, Exponential Exponential Exponential
S.N Actual Naïve
(n=3) t-2=0.35, (α=0.1) (α=0.5) (α=0.8)
t-3=0.2)
1 110 105 105 105
2 100 110.0 105.5 107.5 109.0
3 120 100.0 105.0 103.8 101.8
4 140 120.0 110.0 108.5 106.5 111.9 116.4
5 170 140.0 120.0 115.0 109.8 125.9 135.3
6 150 170.0 143.3 137.0 115.8 148.0 163.1
7 160 150.0 153.3 152.5 119.2 149.0 152.6
8 190 160.0 160.0 161.0 123.3 154.5 158.5
9 200 190.0 166.7 161.5 130.0 172.2 183.7
10 190 200.0 183.3 178.5 137.0 186.1 196.7
11 190.0 193.3 193.5 142.3 188.1 191.3
MAD 17.8 23.3 26.6 38.4 18.1 16.6
CFE 80.0 163.3 186.0 372.9 166.1 107.9
RMSE 58.3 74.5 81.8 141.5 72.5 61.1
TS 4.50 7.00 7.00 9.71 9.17 6.52 5
9