Inventory Management Techniques
August 9, 2008
The ABC approach
This is a simple approach where inventory is divided into three or more groups. The rationale is that a small portion of inventory in terms of quantity might represent a large portion in terms of inventory value. For example one group may represent a small percentage of expensive high-tech components while another group may represent a large percentage of relatively inexpensive basic components. In between the two groups there would be a group of components that are of medium value. The first group is referred to as Group A items (small percentage but with a high value). This group is monitored closely and inventory levels are kept relatively low. Group B represents the in between items while group C represents the crucial but inexpensive items that are usually in large quantities, e.g. nuts and bolts.
ECONOMIC ORDER QUANTITY
Economic Order Quantity is that size of the order which gives maximum economy in purchasing any item of material. In order to determine the economic or optimum order quantity, an analysis of the various costs associated with the ordering quantity is made. These costs may be divided into two parts:
a) Material acquisition costs
b) Material carrying costs
Material acquisition costs arise on account of having to process an order. A part of the wages and operating expenses for departments like production control, purchasing, receiving and stores is incurred for purchasing and possessing the materials.
Material carrying costs include interest charges on investment in materials, insurance costs, storage costs etc. These two types of costs behave quite differently.
The material acquisition costs are related to the number of orders placed during a given period. On the other hand, carrying costs, which are variable or semi-variable in nature, tend to change nearly in direct proportion to the level of stock carried in the manufacturing concern.
The formula for economic order quantity is:
Where Co is the cost of placing an order of the stock item
CH is the annual cost of holding one unit of the stock for one year.
D is the annual demand for the stock item
Q is the order quantity
Annual stock holding costs are the average stock quantity multiplied by the annual cost of holding one unit of stock for one year.
INVENTORY TAKING
Inventory or stock taking means the process of determining the value of inventory at any particular date. For this purpose, two methods are adopted:
1. Perpetual Inventory method
This is the recording as they occur, the receipts, issues and the resulting balances of individual items of stock in quantity and value. A simple record called a “bin card” is maintained for each stores item and is updated with receipts into and issues of materials from stores. This method is mostly used with continuous stock-taking system. Recorded balances are compared with physical balances. This method ensures a continual, detailed and reliable check of the stock items and helps the investigation of any discrepancies as they occur.
2. Periodic Inventory method
Under this method, all inventories are counted at one time at regular intervals such as one year or six months. The physical quantities of inventories on hand are ascertained at the end of each year. This may take a few hours or several days depending on each organization. Mostly business is closed for the annual stock taking. The method avoids the continuous stock taking but makes it more difficult to investigate any discrepancies.
INVENTORY VALUATION METHODS (ISSUE PRICING)
The methods that may be used to value material issues from stores are as follows:
1. FIFO (First In, First Out). This method assumes that the earliest units of the stock item received into the stores are the first to be issued out (sold or consumed) and that the stocks remaining in stores are the latest purchases or production. The method is more realistic and gives fair valuation of stock. The main disadvantage of the method is that it does not reflect the current economic values in times of price fluctuations.
2. LIFO (Last In, First Out). This method assumes that the latest (most recent) units of stock item received into the stores are the first ones to be issued out (sold or consumed). The stocks remaining in the sores are assumed to be those which were purchased or produced earliest. The method reflects the current economic value of stocks sold or charged to production but in some cases it is not realistic.
3. Weighted Average Cost (AVCO) method. Under this method, the total value of all items in stock is divided by the number of items in stock and the resultant figure is the weighted average cost price. All issues from stores are then valued at that price until a new consignment of stock units is received into the stores when a new weighted average cost price is calculated. The method is simple and logical but it is not close to current valueofgoods.
Weighted average cost = Total Cost of items in stock / Total Quantity of items in stock
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