INVENTORY MANAGEMENT TECHNIQUES
August 9, 2008
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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
Inventory management
August 9, 2008
Minimum inventory Level
This is that level of an item of material, below which the actual stock should not normally be allowed to fall. It is fixed to ensure that the required quantity of each item of material is available in the stores at all times. To fix the minimum level, the following is taken into account:
- The average rate of consumption of the material
- The time required to obtain fresh supplies
- The reorder level
- The production material requirements
- The minimum quantity of materials which can be procured advantageously.
The minimum stock level is calculated as:
Re-order level – Average expected demand for the stock item during the lead time. This can be stated as:
Re-order level – (Normal consumption x Normal delivery time) where normal delivery time is taken as the average of maximum and minimum time taken for delivery.
Re-order level
This is the stock level fixed between maximum and minimum stock levels, at which an order for the replenishment of stock must be placed. The re-order level is generally higher than the minimum level to cover any emergency which may arise as a result of abnormal usage of materials or unexpected delay in obtaining fresh supplies. To fix this level, the following is taken into account:
- The consumption rate of material
- The margin of safety
- The normal delivery time or lead time
- The minimum level to be maintained
- Cost of storage and interest on capital employed in materials
- Provision for emergencies such as delay in supply and abnormal wastage.
Re-order level is calculated as:
Maximum consumption x maximum delivery time Or
Re-order level = Minimum Stock + Average consumption during normal delivery time. The re-order level is revised frequently considering any factors that are likely to change supply and demand for goods.
Maximum inventory Level
This is the level that should never be exceeded. This is to avoid undue investment of capital leading to a loss of interest, obsolescence of materials, and additional overheads in the form of higher rents, etc. It is determined by taking into consideration the following factors:
- Normal consumption rate of materials
- Time required to obtain new supplies
- Amount of working capital available
- Availability of storage space
- Economic order quantity
- Cost of storage
- Risk of deterioration
- seasonal considerations as to price and availability of material
- Insurance costs
- Other inherent risks associated with the materials and any restrictions that may be imposed by government.
Maximum order level can be determined by using the following formula:
Re-order level + Re-order quantity – (minimum consumption x minimum time for delivery)
Or
Maximum level= Re-order level – Consumption during the time required to get fresh supplies at minimum rate + Economic Order Size.
DANGER LEVEL
Some firms also use the danger level in respect of materials. Danger level is fixed at a point below the minimum level and represents the limit at which special steps must be taken to obtain emergent supplies of material i.e. sending a man personally to bring the required materials. When the stock of a particular item of materials reaches danger level, no further issues are made by the store keeper except on the special requisition approved by the works manager.
Danger Level = Normal consumption per day /per month etc X Time required to obtain emergency supplies.
Average stock level = Minimum Stock level + ½ (Re-order Quantity)
Inventory Control Systems
Red-line method: the simplest, since a red-line is drawn at the lower level inside an inventory bin then inventory is stacked and when the red-line shows, more inventory is ordered.
Two-bin method: Inventory is stacked in two bins. When the working bin is empty, inventory is drawn from the second bin and an order for additional inventory is placed.
Computerized inventory control system: the inventory is computerized and as inventory is withdrawn, they are recorded in the computer and the inventory balance revised. Orders are placed when the reorder point is reached.
Just-In-Time System: it automatically coordinates a manufacturer’s production with suppliers’ production so that raw materials arrive from suppliers just as they are needed in the production process. Also related to Outsourcing.
The Inventory policy must be coordinated with the firm’s manufacturing and procurement policies since the ultimate goal is to minimize total costs and inventory is just one part of the total costs.
Inventory Management
August 9, 2008
Inventory can be classified as supplies, raw materials, work-in-process and finished goods which are essential to a businesses’ operations. Inventory management depends heavily on sales because inventory is purchased earlier than sales can be made and poor inventory levels leads to either lost sales or excessive carrying costs. Any changes in the products’ demand should be worked into the company’s purchasing and manufacturing schedules thus coordination among the sales, purchasing, production and finance departments is important.
The goal of inventory management is to:
- Ensure that the inventories needed to sustain operations are available
- Hold the costs of purchasing and carrying inventories to the lowest possible level
Inventory costs are divided into three categories:
- Carrying costs: are associated with inventory and include cost of capital tied up, storage and handling costs, insurance, depreciation, taxes, losses due to deterioration, obsolescence, or theft. They rise in direct proportion to the average amount of inventory held.
- Ordering costs: include the costs of placing and receiving orders. Are considered to be fixed costs and decline as the number of orders decrease.
- Low inventory costs: results in the loss of sales, customer goodwill and disruption of production schedules.
OBJECTIVES OF INVENTORY CONTROL
- To ensure uninterrupted production. This is essential for smooth flow of production.
- To provide for required quality of materials - to ensure quality production.
- To minimize wastages and losses of materials due to carelessness in storing, issuing and handling.
- To control investment in inventories – to ensure optimum investment of capital in the purchase of materials.
REASONS FOR HOLDING INVENTORY
Stocks are held to increase sales and profits. When stock is held, production can continue uninterrupted to meet customer demands. However, holding stock can be expensive. The objective of a stock policy should be to minimize the total annual costs associated with stock. The total costs associated with stocks include:
- Purchase costs
- Holding stock
- Ordering stock
- Stock-outs (the costs of being without stock when it is needed).
Holding costs include interest on capital, the costs of storage space and equipment, administration costs and losses from deterioration, pilferage and obsolescence.. These costs can be minimized by keeping stock levels to a minimum.
Order costs are incurred every time stock is purchased from a supplier. Order costs include the buyer’s time spent contacting the supplier, and the storekeeper’s time spent checking the goods received. These costs can be reduced by placing orders only at infrequent intervals. But this would mean that the order quantities would have to be large to avoid stock-outs between the orders and this would increase holding costs. To minimize order costs and holding costs, businesses purchase materials in their economic order quantity (EOQ). The EOQ is the purchase order quantity that minimizes total order costs plus stockholding costs.
Stock-outs also incur costs. Customers might go elsewhere if the goods they require are out of stock. Similarly, production will be disrupted when there is no material to use. Buffer stock is a basic level of stock held for emergencies to cover unexpected demand for the stock item.
