Various Inventory Control Techniques

Economic Order Quantity:

The prime objective of inventory management is to find out and maintain optimum level of investment in inventory to minimize the total costs associated with it. The economic order quantity (EOQ) is the optimum size of the order for a particular item of inventory calculated at a point where the total inventory costs are at a minimum for that particular stock item.

It is an optimum size of either a normal outside purchase order or an internal production order that minimizes total annual holding and ordering costs of inventory. Stock-out costs are difficult to incorporate into this model. Since they are based on qualitative and subjective judgment.

The ordering costs are the costs of placing a separate order multiplied by the number of separate orders placed in the period. The carrying costs can be calculated based on the assumption that annual cost of carrying a particular stock item on average, half the stock is on hand all the time in addition to the safety or buffer stock.

The fewer the orders, the lower costs of ordering, but the greater the size of the order the greater the costs of carrying. The safety or buffer stock has no bearing on the EOQ, only on the timing of orders.

The EOQ is an optimum quantity of materials to be ordered after consideration of the following three categories of costs:

Ordering Costs:

The costs of ordering inventory include the following:

(a) Preparation of purchase order,

(b) Costs of receiving goods,

(c) Documentation processing costs,

(d) Transport costs,

(e) Intermittent costs of chasing orders, rejecting faulty goods,

(f) Additional costs of frequent or small quantity orders, and 

(g) Where goods are manufactured internally, the setup and tooling costs associated with each production run.

Carrying Costs:

The carrying costs of inventory include the following:

(a) Storage costs (rent, lighting, heating, refrigeration, air-conditioning etc.),

(b) Stores staffing, equipment maintenance and running costs,

(c) Handling costs,

(d) Audit, stock taking or perpetual inventory costs,

(e) Required rate of return on investment in current assets,

(f) Obsolescence and deterioration costs,

(g) Insurance and security costs,

(h) Costs of money tied up in inventory, and 

(i) Pilferage and damage costs.

Stock-Out Costs:

The stock-out costs are associated with running out of stock which include the following:

(a) Lost contribution through the lost sales caused by the stock-out,

(b) Loss of future sales because customers go elsewhere,

(c) Loss of customer goodwill,

(d) Cost of production stoppages caused by stock-outs of WIP or raw material,

(e) Labour frustration,

(f) Over stoppages, and 

(g) Extra costs associated with urgent replenishment purchases of small quantities.

Graphical Determination of EOQ:

The EOQ can be determined graphically as illustrated in figure 4.1.

The following formula is used in calculation of EOQ:

Where,

A = Annual consumption C = Cost per unit

B = Cost of placing an order S = Storage and other inventory carrying cost

Assumptions of EOQ:

To be able to calculate a basic EOQ certain assumptions are necessary:

1. That there is a known, constant stock holding cost.

2. That there is a known, constant ordering cost.

3. That rates of demand are known and constant.

4. That there is a known, constant price per unit, i.e., there are no price discounts.

5. That replenishment is made instantaneously, i.e., the whole batch delivered at once.

Illustration:

The annual demand for an item is 3,200 units. The unit cost is Rs. 6 and inventory carrying charges 25% p.a.

If the cost of one procurement is Rs. 150, determine:

(a) Economic order quantity (EOQ).

(b) Number of orders per year.

(c) Time between two consecutive orders.

Solution:

(b) Number of Orders = 3,200 units/800 units = 4 orders in a year

(c) Time between Two Consecutive Orders = 12 months/4 orders = 3 months

EOQ with Discounts:

A particularly unrealistic assumption with the basic EOQ calculation is that the price per item remains constant. Usually some form of discount can be obtained by ordering increasing quantities. Such price discounts can be incorporated into the EOQ formula, but it becomes much more complicated.

A similar approach is to consider the costs associated with the normal EOQ and compare these costs with the costs at each succeeding discount point and then ascertain the best quantity to order. Price discounts for quantity purchase have three financial effects, two of which are beneficial and one adverse.

Beneficial effects – Savings will come from:

(a) Lower price per item, and

(b) The large order quantity means that fewer orders need to be placed and hence, ordering costs are reduced.

Adverse Effects:

Increased costs arise from the extra stock holding costs caused by the average stock level being higher due to the larger order quantity.

Fixation of Inventory Levels:

Various levels of inventory are fixed to see that no excess inventory is carried and simultaneously there will not be any stock outs.

The following inventory levels are fixed for each item of stock:

Reorder Level:

It is the level of stock availability when a new order should be raised. The stores department will initiate the purchase of material when the stock of material reaches at this point.

This level is fixed between the minimum and maximum stock levels and the following formula is useful for this purpose:

Maximum Usage x Maximum Lead Time

Minimum Stock Level:

It is the lower limit below which the stock of any stock item should not normally be allowed to fall. Their level is also called ‘safety stock’ or ‘buffer stock level’. The main object of establishing this level is to protect against stock-out of a particular stock item and in fixation of which average rate of consumption and the time required for replenishment, i.e., lead time are given prime consideration.

Reorder Level – (Average or Normal Usage x Average Lead Time)

Maximum Stock Level:

It represents the upper limit beyond which the quantity of any item is not normally allowed to rise to ensure that unnecessary working capital is not blocked in stock items. Maximum stock level represents the total of safety stock level and economic order quantity.

Maximum stock level can be expressed in the formula given below:

Reorder Level + Economic Order Quantity – (Minimum Usage x Minimum Lead Time)

Danger Level:

It is fixed below the minimum stock level and if stock reaches below this level, urgent action for replenishment of stock should be taken to prevent stock out position.

Average Consumption x Lead Time for Emergency Purchases

Average Stock Level:

It is the average of minimum and maximum stock levels.

(Minimum Stock Level + Maximum Stock Level)/2

or Minimum Stock Level + 1/2 Reorder Quantity

The stock movements and the fixation of stock levels is explained in Figure 4.2:

VED Analysis:

VED analysis divides items into three categories in the descending order of their critically as follows:

(1) ‘V’ stands for ‘vital items’ and their stock analysis requires more attention, because out-of- stock situation will result in stoppage of production. Thus, ‘V’ items must be stored adequately to ensure smooth operation of the plant.

(2) ‘E’ means ‘essential items’. Such items are considered essential for efficient running but without these items the system would not fail. Care must be taken to see that they are always in stock.

(3) ‘D’ stands for ‘desirable items’ which do not affect the production immediately but availabi­lity of such items will lead to more efficiency and less fatigue.

VED analysis can be very useful to capital intensive process industries. As it analyses items based on their importance and it can be used for those special raw materials which are difficult to procure.

FNSD Analysis:

Age of inventory indicates duration of inventory in organization. It shows moving position of inventory during the year. If age of inventory is minimum it means, the turnover position of that particular item of inventory is satisfactory.

If the age of any particular item of inventory, it indicates the slow moving of stock which may be due to lower demand for the product, inefficiency in stocking policy, excessive stocking etc. The excessive investment in stocks means, high investment is locked-up in inventory leads to lower profitability of the firm due to excess carrying costs.

FNSD analysis divides the items into four categories in the descending order of their usage rate as follows:

(1) ‘F’ stands for ‘fast moving items’ and stocks of such items are consumed in a short span of time. Stocks of fast moving items must be observed constantly and replenishment orders be placed in time to avoid stock-out situations.

(2) ‘N’ means ‘normal moving items’ and such items are exhausted over a period of a year or so. The order levels and quantities for such items should be on the basis of a new estimate of future demand, to minimize the risks of a surplus stock.

(3) ‘S’ indicates ‘slow moving items’, existing stock of which would last for two years or more at the current rate of usage but it is still expected to be used up. Slow moving stock must be reviewed very carefully before any replenishment orders are placed.

(4) ‘D’ stands for ‘dead stock and for its existing stock no further demand can be foreseen. Dead stock figures in the inventory represents money spent that cannot be realized but it occupies useful space. Hence, once such items are identified, efforts must be made to find all alternative uses for it. Otherwise, it must be disposed off.

ABC Analysis:

In this technique, the items of inventory are classified according to value of usage. The higher value items have lower safety stocks, because the cost of production is very high in respect of higher value items. The lower value items carry higher safety stocks.

ABC analysis divides the total inventory list into three classes A, B and C using the rupee volume, as follows:

(i) Items in class ‘A’ constitute the most important class of inventories so far as the proportion in the total value of inventory. The ‘A’ items consist of approximately 15% of the total items, accounts for 80% of the total material usage.

(ii) Items in class ‘B’ constitute an intermediate position, which constitute approximately 35% of the total items, accounts for approximately 15% of the total material consumption.

(iii) Items in class ‘C’ are quite negligible. It consists remaining 50% items, accounting only 5% of the monetary value of total material usage.

The numbers are just indicative and actual break up will vary from situation to situation. The above categorization is represented in the table given below:

Figure 4.3 shows ABC analysis of inventory class ‘A’ is made up of inventory items which are either very expensive or used in massive quantities. Thus these items, though few in number contribute a high proportion of the value of inventories. Class ‘B’ items are not so few in number, but also they are not too many either. Value wise also, they are neither very expensive nor very cheap. Moreover, they are used in moderate quantities.

Class ‘C’ contains a relatively large number of items. But they are either very inexpensive items or used in very small quantities so that they do not constitute more than a negligible fraction of the total value of inventories.

The control of inventory through ABC analysis is exercised as follows:

i. ‘A’ class items merit a tightly controlled inventory system with constant attention by the purchase and stores management. A larger effort per item on only a few items will cost only moderately, but the effort can result in large savings.

ii. ‘B’ class items merit a formalized inventory system and periodic attention by the purchase and stores management.

iii. For ‘C’ class items still relaxed inventory procedures are used.

The table given below shows how an organization treats the various class of items according to their consumption value. For ‘A’ class items, the inventory policy, i.e., order quantity and reorder point should be carefully determined and the close control over the usage of materials is desirable.

For ‘B’ class items, the economic order quantities and reorder level calculations can be done and larger stocks can be maintained. The review of these items may be done quarterly or half-yearly. In case of ‘C’ class items, generally one year supply can be maintained. Periodic review once a year may be sufficient.

The technique tries to analyse the distribution of any characteristics by stock values of importance in order to determine its priority. This technique can be applied in all facets of organization.

Many organizations are applying this technique in materials management and spare parts management to identify the contribution made by the materials/spares in the total inventory value. On the basis of stock value, materials procurement strategy and consumption strategy is decided.