The quantity of material you will need to buy depends on:

a. how much material you will use in production

b. how much may be lost through damage or defects

c. what you have in inventory when you place the order, and

d. the average inventory you are willing to carry

To hold total costs of materials, including purchase price and inventory carrying costs, as low as possible, it is desirable to separate purchased components into A, B, and C categories.

These categories are determined by the characteristics of the materials, their use, and their supply. The more erratically used, expensive, perishable and/or exceptionally bulky class "A" components are generally kept under tight inventory control. Status of these components is reviewed frequently and they are purchased in relatively small quantities against a production schedule (see next heading - Determining Quantity Based on Production Schedule).

Class "B" components are less expensive than the "A" components and are either erratically used or perishable or bulky. They are best controlled using perpetual inventory records which show an order point and the quantity to be bought. In this way, purchasing is a fairly routine activity except during the seasonal or annual review periods when all ordering decisions are evaluated.

Class "C" components are the least important components of the inventory. These "C" components can be kept on a simple visual control system where an order is placed whenever reserve stock has to be used. These materials are usually ordered infrequently and in fairly large quantities.

Most manufacturers who use the same component for a number of different products, use a material scheduling table, similar to the one that follows, to calculate production requirements.

Product Quantity Wire Wire Insulation Switch (AC) Socket

Desk lamp 40 1200' 50' 30' 40 40 40

Pole lamp 80 1500' 130' 50' 240 80 240

F1. tube lamp 400 1800' 100' 80' -- 400 --

Electric pencil

sharpener 300 1500' -- -- -- 300 --

______ _______ _______ _______ _______ _______

TOTALS 6000' 280' 160' 280 820 280

With such a product material schedule, the total amount of component parts used in one period, or in several periods can be determined. Such a schedule is needed only for those components, or materials, which deserve tight control. These are usually A items (B and C items are controlled without specific comparison to schedules. In their case, an order is placed when the minimum or reserve stock is reached.)

When detailed product material schedules are prepared several months in advance, they provide the information which is needed for scheduling several different deliveries from a large-quantity order which allows maximum volume discounts. Such a table is shown below:

AC Wire #3 Wire #3 Insulation Switch plug(AC) 110V Socket

January 6000' 280' 160' 280 820 280

February 5300' 310' 200' 310 900 270

March 7110' 260' 180' 270 850 260

April 3760' 405' 170' 260 875 290

Note that the quantities for the month of January were obtained from the column totals (the last row) of the January Product Material Schedule (shown before). If a quantity discount for large volume purchases is available, it may be more profitable for this manufacturer to buy several months' supply of materials at once, to obtain the greatest discount - and then arrange to have portions of the order shipped once a month, to aid in handling and storage.

When quality requirements are not obvious, or when there is a need to review what quality level is best, quality requirements can be determined through value analysis which spells out the design specifications for a product. Quality specifications can be made in many ways. They can be in the form of acceptable ranges for:

• weight
• shape
• size
• temperature resistance
• strength
• flexibility
• color, etc.

Quality specifications thus can include any physical aspect of the part to be made. They can also be expressed in terms of number of pieces per hundred which do not operate properly or do not meet the specifications.

Another aspect of quality that affects purchasing decisions concerns reliability or appearance of a component. A less attractive switch or support that functions properly may be fully adequate and therefore be preferable to a more expensive model.

Value analysis studies parts, assemblies, and/or packaging, to determine whether there are changes in components or functions which will provide the same "value" for users at less cost, or greater "value" at the same cost. Value analysis consists of the following steps:

• defining the function and purpose of the object in study; e.g., to conduct electricity, to hold a metal body together, to propel an object, to turn an axle, etc.
• determining alternate solutions: e.g., can the metal be replaced with plastic; can the weight of the object be reduced; can the housing be made with thinner material, etc.?
• determining and comparing feasibility and costs of the alternative solutions with the present component: e.g., if plastic is used instead of metal, will it hold up as well; will the performance of the product be affected; will production costs be lowered; can present machinery be adapted to create the plastic part, etc.?
• implementing the best solution
• evaluating the subsequent performance
• following up and refining the component further, if necessary

Value analysis often results in changes in component design or part material, substituting one part for another, or eliminating a part entirely. Here is a possible checklist for conducting a value analysis:

One example of determining whether a more or less expensive component should be used in a product is given below.

A certain product which sells for $150 is guaranteed by the manufacturer to be free from defects. This means that any products returned with defects during the first year have to be repaired free of charge. Last year there were 60 repairs, 45 of them due to one component, part P-38. Repairs related to this P-38 component cost $12 per unit.

There is one P-38 part in each unit and last year 500 units were sold.

In recent years, sales have been tapering off due to growing customer discontent with the product defect.

The P-38 component costs $10 each. However, a higher quality component (B-52) is on the market, at a cost of $12 a piece. This B-52 component is guaranteed by the supplier to reduce the defect rate to less than 2%.

What would you do if you were the manufacturer? Would you replace the P-38 component with the B-52 component, or not?

Factors to be considered when determining whether to replace the P-38 component with the more expensive B-52 component are as follows:

The additional cost for the higher quality component is $12 for the B-52, less $10 for the P-38, or $2 per unit.

The additional cost for the higher quality per year is 500 parts used each year x $2/per part, or $1,000 per year.

The cost of repairing P-38 parts each year are: 45 repairs made per year x $12 per repair, or $540 to repair P-38 parts each year.

The number of B-52 repairs which would be required each year are: 500 units used per year x 2% repair rate, or approximately 10 repairs on B-52 components each year.

The annual cost of repairing the B-52 components is: 10 repairs made per year x $12 per repair, or $120 to repair B-52 components each year.

The net costs saved on annual repairs is then: $540 to repair P-38 components, less $120 to repair B-52 components, or $420 would be saved each year by using the higher quality B-52 component.

The net cost each year of using the higher quality B-52 component is: $1000 per year of the additional cost of using the B-52 component less $420 per year saved on repairs. It would cost $580 per year to utilize the higher quality B-52 component in manufacturing.

The decision, thus, is a difficult one and would amount to a reduction in profit of approximately $1.15 on 500 units sold. If it will stop the loss of sales, or even reverse it, the new component may be worth the extra net cost.

A similar analysis, in a different situation, could show a much better picture and result in a gain, either from the use of a higher quality or a lower quality component.

Frequently it is possible to obtain less costly components which require some redesign or manufacturing process change with a significant initial investment. These decisions, too, require detailed analysis to calculate the advantages they may bring.

ON-THE-JOB ACTIVITY

Use the summary checklist shown earlier to conduct a value analysis of several items which you use or manufacture within your business and where you believe that savings may be possible. If you cannot easily identify such items, select components or products which are widely used so that even small economies you achieve are likely to bring large dollar savings.

An important aspect of value analysis is to determine whether it would be more economical for your firm to manufacture a component part or to buy the part from a supplier.

Even if you have a supplier who gives you a good price on materials you purchase in fairly large quantities, it may be worthwhile to determine how much it would cost your firm to make such materials. Sometimes such an analysis provides valuable insights for negotiating price with a supplier. In this way, you have a better knowledge of what the breakdown of costs are to manufacture the component, and will be in a better position to realistically evaluate the price and discount schedule which the supplier offers. Obviously, if your firm can make the same part less expensively than it could buy it from a supplier, you should seriously consider manufacturing it yourself.

Many small businesses will make parts where they feel they have the know how and equipment and will buy where the technology is beyond their expertise, or where the part cannot be handled with existing equipment. However, since capabilities improve and technology changes from year to year, it is important to consider the make-versus-buy decision on a regular basis.

Companies in highly competitive industries often have to find ways to make as many of their own parts as possible to reduce costs. Firms in growth industries, on the other hand, usually can make better use of their capital to expand product lines, rather than investing it in equipment, materials and additional space for making components.

If, at first glance, a make - buy decision seems obvious, look again: Can better suppliers than current ones be found?

Can a lower price, without loss of quality, be obtained?

Consider all costs involved in production:

• Labor
• Material
• Overhead - make sure the normal overhead is applicable and that the 'real' overhead is not exceptionally high or low; for instance, waste or space requirements should not be significantly higher than normal
• General administrative costs

Will you depreciate the required capital as quickly as you would if you invested it elsewhere?

Consider that production efficiency may be low at first, since you will need time to iron out any bugs in the operation.

Consider whether the required quantities will be large enough to justify the set-up costs and manpower training needed to produce the component, but not so large so as to disrupt production schedules.

Determine whether the demand for the part is stable, seasonal or temporary.

Be sure your company can produce the desired quality with the contemplated production process.

Check for patent considerations which would require you to obtain a license in order to make the part.

Determine whether present knowledge and personnel are adequate for producing the part, or a special skill is involved.

Determine whether you can use present equipment, or whether new equipment must be leased or bought.

If, at first glance, it looks better to buy a component rather than make it, look again!

Consider all costs involved in buying the component:

• Packaging costs
• Freight and shipping expenses
• Receiving costs
• Any extra handling costs

Determine whether the supplier is reliable.

Determine whether the supplier can meet the quality standards for producing the component.

Check to see if the supplier guarantees the quality of the component.

Check the supplier's defect rate for producing this component, and how much would it cost you to make repairs on returned items due to the defective component.

Determine whether you will normally receive deliveries on time.