Inventory consists of stock of raw materials, work-in-progress, spare pa consumables for production and finished goods for sale. Thus, inventory com includes control over raw materials, spare parts, consumables, partly finished goods, and finished goods. The following are the common techniques of inventory control:
1. Determination of various levels of materials
2. Economic Order Quantity
3. ABC Analysis
4. Perpetual Inventory System
1. Determination of Various Levels of Materials
The store-keeper plays an important role in deciding upon the various levels materials. In order to ensure that the optimum quantity of materials is purchased stocked neither less nor more, the store keeper applies scientific techniques of material management. Fixing of certain levels for each item of materials in one of techniques.
These levels are not permanent but require revision according to the change in the factors which determine these levels. The following levels are generally fixed.
(a) Re-order Level
(b) Maximum Level
(c) Minimum Level
(d) Average Level
(e) Danger Level
(a) Re-order Level:
This level is that level of material at which it is necessary to initiate purchase requisition for fresh supplies. This is normally the point lying between the maximum and the minimum levels. Fresh orders must be placed before the actual stocks touch the minimum level.
This level is fixed in such a manner that the quantity of materials represented by the difference between the re-order level and the minimum level will be sufficient to meet the requirement of production till such time as the order materialises and materials are delivered. The following factors are taken into account for fixing the Re-order level:
(i) Rate of consumption of material
(ii) Lead time, i.e., time required to receive the delivery of fresh purchase.
(iii) Re-order quantity
(iv) Minimum level
Re-order level can be calculated by applying the following formula:
Re-order level = Minimum level + consumption during period required to get fresh delivery
Another formula for Re-order level is:
Re-order level = Maximum consumption x Maximum Re-order Period Illustration-1
Calculate Re-order level for a material from the following information: Minimum level – 1,000 units Maximum level – 6,000 units Time required to get fresh delivery – 15 days. Daily consumption of the material – 100 units.
Re-order level = Minimum Level + Consumption during the period required to get fresh delivery
= 1,000 units + (100 x 15) = 2,500 units.
Calculate Re-order Level from the following particulars: Minimum consumption – 80 units’ Maximum consumption – 120 units Re-order period – 10-12 days
Re-order Level = Maximum consumption x maximum Re-order period = 120 units x 12 = 1,440 units
(b) Maximum Level:
The maximum level is that level of stock which can be held at any time. In other words, it is the level beyond which stock should not be maintained. The purpose is to avoid over-stocking and thereby using working capital in a proper way. This level is fixed after taking into account the following factors:
(i) Rate of consumption
(ii) Lead time
(iii) Availability of capital
(iv) Storage capacity
(v) Cost of maintaining stores including insurance cost
(vi) Nature of commodity
(vii) Possibility of price fluctuation
(viii) Possibility of change in fashion, habit, etc.
(ix) Restrictions imposed by Govt., local authority or trade associations
(x) Re-order level it
(xi) Re-order quantity
Maximum level can be calculated by applying the following formula:
Maximum Level = Re-order level + Re-order Quantity – (Minimum consumption x Minimum Re-order period)
(c) Minimum Level:
This is the level below which the stock of an item should not fall. This is known as safety or buffer stock. An enterprise must maintain minimum quantity of stock so that the production is not hampered due to non-availability of materials. This level is fixed after considering the following factors:
(i) Re-order level
(ii) Lead time
(iii) Rate of consumption
The formula for calculating minimum level is:
Minimum level = Re-order level – (Normal consumption x Normal Re-order period)
(d) Average Level:
Average level can be calculated by applying the following formula:
Maximum level + Minimum level Average level = ———————————————- –
Or Average level = Minimum level + of Re-order Quantity.
(e) Danger Level:
Usually stock should not be lower than the minimum level. But if for any reason, stock comes down below the minimum level, it is called danger level. When the stock reaches danger level, it is necessary to take urgent action on the part of the management for immediate replenishment of stock to prevent stock-out situation. The danger level can be calculated by applying the following formula:
Danger Level = Average consumption x Maximum Re-order period for emergency purchases
From the following particulars, calculate the maximum level, minimum level, re-order level and average level:
Normal consumption – 300 units per day Maximum consumption – 420 units per day Minimum consumption – 240 units per day Re-order quantity – 3,600 units
Re-order period – 10-12 days
2. Economic Order Quantity (EOQ)
The economic order quantity, known as EOQ, represents the most favorable quantity to be ordered each time fresh orders are placed.
The quantity to be ordered is called economic order quantity because the purchase of this size of material is most economical. It is helpful to determine in advance as to how much should one buy when the stock level reaches the re-order level. If large quantities arc purchased, the carrying costs would be large.
On the other hand, if small quantities are purchased at frequent intervals the ordering costs would be high. The economic order quantity is fixed at such a level as to minimise the cost of ordering and carrying the stock. It is the size of the order which produces the lowest cost of material ordered.
While determining the economic order quantity, the following three cost factors are taken into consideration:
(i) The cost of the material
(ii) The inventory carrying cost
(iii) The ordering cost
Carrying costs are the costs of holding the inventory in the stores. These are:
(i) Rent for the storage space.
(ii) Salaries and wages of the employees engaged in store keeping department.
(iii) Loss due to pilferage and deterioration.
(iv) Insurance charges.
(v) Stationery used in the stores.
(vi) Loss of interest on the capital locked up in materials.
Ordering costs are the costs of placing orders for the purchase of materials. These are:
(i) Salaries and wages of the employees engaged in purchasing department.
(ii) Stationary, postage, telephone expenses, etc. of the purchasing department.
(iii) Depreciation on equipments and furniture used by the purchasing department.
(iv) Rent for the space used by the purchasing department.
While placing orders for purchasing materials, the total cost to be incurred is kept in view. As discussed earlier, if an order is placed for a large quantity at a time, the ordering cost is less but the carrying cost would be more.
On the other hand, if orders are placed for small quantities, the ordering cost is more but the carrying cost would be less; thus the economic order quantity is determined at a point when the ordering costs and the carrying costs are equal. Only at this stage the total of ordering cost and carrying cost is minimum.
Determination of Economic Order Quantity: The economic order quantity is determined by using the following formula:
Where, EOQ = Economic order quantity.
C = Annual consumption or usage of material in units.
0 = Cost of placing one feeder including the cost of receiving the goods.
1 = Cost of carrying one unit of inventory for one year.
Assumptions in the Calculation of Economic Order Quantity:
The economic order quantity is based on the following assumptions:
Quantity of the item to be consumed during a particular period is known with certainty.
The pattern of consumption of material is constant and uniform throughout the period.
Cost per unit is constant and known and quantity discount is not involved.
Ordering cost and carrying cost are known and they are fixed per unit and will remain constant throughout the period.
From the following information, calculate the economic order quantity: Annual consumption – 10,000 units Cost of material per unit – Rs.10 Cost of placing and receiving one order – Rs.50 Annual carrying cost of one unit – 10% of inventory value.
Where, C = Annual consumption of materials in units = 10,000 units
O = Cost of placing one order including the cost of receiving = Rs.50 I = Carrying cost per unit per annum = 10% of Rs.10 = Re.1.
Economic order quantity can also be calculated by using the tabular method. A comparison of total costs at different order sizes is made to determine the economic order quantity. The order size having the least total cost is accepted as economic order quantity. At this point, both carrying costs and ordering costs would be equal.
Taking the figures from the illustration 4, calculate the economic order quantity by using the tabular method.
The above table reveals that the cost of placing order for materials and the carrying costs are exactly equal when the order quantity is 1,000 units. At this point, the total cost is also the least. Hence, the economic order quantity is 1,000 units and the number of orders per year would be 10.
3. ABC Analysis
This technique of inventory control is also known as Always Better Control technique. ABC analysis is an analytical method of control which aims at concentrating efforts on those areas where attention is needed most.
This is a principle of selective control. The emphasis of ABC analysis technique is that the management should concentrate its energy in controlling those items that mostly affect the organisational objects. Manufacturing concerns find it useful to group the materials into three classes on the basis of investment involved.
Materials having higher values but constitute small percentage of total items, are grouped in ‘A’ category. On the other hand, a large percentage of items of materials which represent a smaller percentage of the values, are grouped in ‘C’ category. Items of materials having moderate value ‘and moderate size are grouped in ‘B’ category. On the basis of physical quantities and value of arterials used, the following table illustrates the above classification:
After the items of materials are classified into A, B and C category, control can be exercised in a selective manner as follows:
(i) Greater care and strict control should be exercised on the items of category ‘A’ as any loss or breakage or wastage of any item of this category many prove to be very costly. Economic order quantity and re-order level should be carefully fixed for such category of items.
(ii) Moderate and relaxed control is required for the items of category ‘B’.
(iii) There is not much need for exercising control over the items of category ‘C’ Periodic or annual verification is required for this category of materials.
The graphical representation of ABC analysis is given below:
Advantages of ABC Analysis:
The advantages of ABC analysis are given below:’
Close and strict control of costly items is ensured.
Investment in inventory can be regulated and funds can be utilised in the, best possible way.
Economy is achieved in respect of stock carrying cost.
It helps to keep enough safely stock for ‘C’ category items.
Clerical cost can be reduced and inventory is maintained at optimum level.
Scientific and selective control helps in maintenance of high stock turnover rate.