LESSON

13
INVENTORY MODEL
CONTENTS
13.0 Aims and Objectives 13.1 Introduction 13.2 Need of Inventory Control 13.3 Advantages of Material Controls 13.4 Essential Factors of Material Control 13.5 ABC Analysis Technique 13.6 Process of Inventory Control 13.7 Minimum Stock Level 13.8 Maximum Stock Level 13.9 Ordering Level or Re-order Level 13.10 Average Stock level 13.11 Danger Level 13.12 Let us Sum Up 13.13 Lesson-end Activities 13.14 Keywords 13.15 Questions for Discussion 13.16 Terminal Questions 13.17 Model Answers to Questions for Discussion 13.18 Suggested Readings

Aims and Objectives

Inventory can be defined as the stock of goods, commodities or other resources that are stored at any given period for future production. In real, inventory control is a process itself, with the help of which, the demand of items, scheduling, purchase receiving, inspection, storage and despatch are arranged in such a manner that at minimum cost and in minimum time, the goods can be despatched to production department. Inventory control makes use of available capital in a most effective way and ensures adequate supply of goods for production.

13.2 NEED OF INVENTORY CONTROL

The main objectives of Inventory Control are as follows: 1. For Effective Cost Accounting System: Cost accounting system is useful only when there is a tight control over cost and inventory cost is a major part of total production cost. 2. To Check Waste and Wastage: Inventory control not just only ensures uninterrupted material supply to production department but also ensures the control from purchasing to supply of finished goods to customers. So in this way it checks waste and wastage whether it is about time, money or material. 3. To Check Embezzlement and Theft: Inventory control is to maintain necessary records for protecting theft and embezzlement. 4. For the Success of Business: Customers satisfaction is very much important for the success of business and customers satisfaction is directly related to the goods supplied to them. If the goods supplied to customers are low in cost with good quality at right time, it ensures the success of business. Inventory Control helps in achieving this goal. 5. For the Life of the Business: In absence of Inventory Control there are many risks of losses.

6. To Check National Wastage: Inventory control checks the wastage of nations resources such as raw minerals, ores, etc.

13.3 ADVANTAGES OF MATERIAL CONTROLS

They are as follows: 1. It helps to minimise loss by obsolescence, deterioration damage etc. 2. It helps to protect against thefts, wastages, etc. 3. It helps managers in decision making. 4. To minimise capital investment in inventory. 5. To minimise cost of material purchasing. 6. To increase the storing capacity. 7. To maintain reasonable stocks of materials. 8. To facilitates regular and timely supply to customers. 9. To ensures smooth production operations. 10. To check national wastage.

13.4 ESSENTIAL FACTORS OF MATERIAL CONTROL

For the success of material control following factors should be kept in mind. 1. Proper Co-ordination: There should be a proper co-ordination between all the departments who uses materials, such as purchase department, store department inspection department, accounts department, production department and sales department, so that there is neither a scarcity of material nor excess of material. 2. Centralisation of Purchasing: The important requirement of a successful inventory control system is the appointment of intelligent and experienced personnel in purchase department, these personnel should be expert in their field and negotiating the deals. 3. Proper Scheduling: All the requisitions made by production department should be scheduled, so material could be issued them by time and production should not be stopped. 4. Proper Classification: Classification and identification of inventories by allotting proper code number to each item and group should be done, to facilitate prompt recordings, locating and dealing. 5. Use of Standard Forms: Standards forms should be used so that any information can be send to all department within no time. 6. Internal Check System: Audit should be done by an independent party to check effectiveness of inventory control system. 7. Proper Storing System: Adequate and well organised warehouse facilities with well-equipped proper handling facilities must be there. Such facilities will reduce the wastage due to leakage, wear and tear, sustained dust and mishandling of materials. Store location should be in between the purchase department and production department, so that cost of internal transportation can be minimised. 8. Proper Store Accounting: An efficient inventory control necessitates maintenance of proper inventory records. Any typical information regarding any particular item of inventory may be taken from such records. 9. Proper Issuing System: There should be a well organised issuing system of material so that production process do not suffer. 10. Perpetual Inventory System: Daily stock position should be taken in this system. 11. Fixing of Various Stock Levels: Minimum stock level, maximum stock level, reorder point, safety level etc, should be pre-determined to ensure the continuity of smooth production. 12. Determination of Economic Order Quantity: Economic order quantity should be determined to minimised the cost of inventory.

13. Regular Reporting System: The information regarding the stock position, materials quantity etc, should be available to management regularly.

13.5 ABC ANALYSIS TECHNIQUE

Where there are a large number of items in the inventory, it becomes essential to have an efficient control over all items of stores. However comparatively, great care should be given to items of higher value. The movements of certain manufacturing concerns may consist of a small number of items representing a major portion of inventory value and a large number of items may represent a minor portion of inventory value. In such cases, a selective approach for inventory control should be followed. The most modern technique for controlling the inventory is a value item analysis popularly known as ABC analysis which attempts to relate, how the inventory value is concentrated among the individual item. This analysis is based on Paretos law. Paretos law states that a fewer items of higher usage having high investment value should be paid more attention than a bulk of items having low usage value and having a low investment in capital. Under this analysis, all items of stores are divided into three main categories A, B and C. Category A includes the most important items which represent about 60 to 70 per cent of the value of stores but constitute only 10 to 15 percent items. These items are recognised for special attention category B includes lesser important items representing an investment value of 20 to 25 percent and constitute a similar percentage of items of stores. Category C consists of the least important items of stores and constituted 60 to 70 percent of stores items representing only a capital investment between 10 to 15 percent. Close attention is paid to items falling in category A and the best items of category C. This classification of items into A, B and C categories is based upon value, usage, rate and criticality of items and these variables are given due weightage in categorising the items the term ABC implies Always Better Control. Steps in ABC Analysis Though no definite procedure can be laid down for classifying the inventories into A, B and C categories as this will depend upon a number of factors such as nature and varieties of items specific requirements of the business place of items in the production etc. These factors vary from business to business to business and items to item. However, following procedure can be followed: (i) First, the quality of each material expected to be used in a given period should be estimated. (ii) Secondly, the money value of the items of materials, so chosen should be calculated by multiplying the quantity of each item with the price. (iii) Thirdly, the items should be rearranged in the descending order of their value irrespective of their quantities. (iv) Fourthly, a running total of all the values and items will then be taken and then the figure so obtained should be converted into percentage of the gross total. (v) Fifthly and lastly, it will be found that a small number of a first few items may amount to a large percentage of the total value of the items. the management, then, will have to take a decision as to percentage of the total value or the total number of items which have to be covered by A, B and C categories. Advantages of ABC Analysis These are as follows: 1. Increase in Profitability: ABC analysis ensures a close control over the items of A, B and C categories and due to control over A category items, the capital investment over inventory reduces. 2. Other Uses: The technique of ABC analysis is based on the principle of management by exception and can be used in areas like, distribution, sales, etc.

13.7 MINIMUM STOCK LEVEL

The minimum stock level represents the lowest quantitative balance of materials in hand which must be maintained in hand at all times so that the assembly time may not be stopped on accounts of non-availability of materials. The minimum stock level may be calculated by the use of the following formula: Minimum Stock Level = Re-ordered level (Average rate of consumption Lead time)

Factors Affecting Minimum Stock Level

These are as follows: 1. Lead Time: This is the time lag required to obtain the delivery of fresh supplies. If this time is more than the minimum inventory level will be high. 2. Inland or Importable Inventory: If the material is to be import then the lead time will be more implying minimum inventory level is to be kept high. 3. Availability of Inventory: If the material is not easily available then the minimum stock level to be kept high. 4. Possibility of Interruption in Production: If the production process is smooth then it is easy to determine the minimum stock level, but, if production is not smooth due to some reasons such as strike, power, etc. Then it is not easy to find out exact level of minimum stock. 5. Nature of the Material: Materials that are regularly stored must maintain a minimum level. If on customers order a special item of material is to be purchased, no minimum level is required to be fixed for that. 6. The Maximum Time Required from the Date of Order to the Date of Actual Delivery: It is known as the Lead Time. The longer the lead time the lower is the minimum level, provided the reorder point remains constant. 7. Rate of Consumption of the Material: The minimum rate, the maximum rate and the normal rate of consumption are to be taken into consideration.

13.8 MAXIMUM STOCK LEVEL

Maximum stock level represents the maximum quantity of inventory which can be kept in store at any time. This quantity is fixed keeping in view of disadvantages of overstocking. Computation of Maximum Stock Level: The following formula is used: Maximum Level = Re- order level + Re-order quantity Minimum consumption Minimum Re-order period Or = Re-order level + Re-order Quantity (Average rate of usage Lead Time) Factors Affecting the Maximum Stock Level These are as follows: 1. Rate of consumption of the material. 2. The lead time. 3. The maximum requirement of the material at any point of time. 4. Nature of the Material: The materials which deteriorate quickly are stored as minimum as possible. 5. Storage space available for the material. 6. Price Economy: Seasonal materials are cheap during the harvesting reasons. So maximum purchase is made during that season and as a result the maximum level is high. 7. Cost of storage and insurance. 8. Cost of the material and the finance available. When the material is costly the maximum level is likely to be relatively low. If the price is likely to go up maximum level should be high. 9. Inventory Turnover: In case of slow moving materials the maximum level is low

and in case of quick moving material it is high. 10. Nature of Supply: If the supply is uncertain the maximum level should be as high as possible. 11. Economic Order Quantity (EOQ): Maximum level largely depends in economic order quantity, because unless otherwise contra indicated the economic order quantity decides the quantity ordered and hence decides the maximum level.

13.9 ORDERING LEVEL OR RE-ORDER LEVEL

This is the fixed point between the maximum stock level and minimum stock levels at which time the order for next supply of materials from vendor is to be done. This is mainly depends upon two factors: 1. Rate of Maximum usage. 2. Maximum Re-order period or Maximum Delivery Time. Computation of Ordering Level or Re-order Level. The formula is as follows: Ordering level or Re-order level = Maximum usage per day Maximum Re-order period or Maximum Delivery Time Or = Maximum Level + (Normal usage of Average rate of consumption Average Re-order period or Average Delivery Time)

Assumptions of Re-order point

1. The time of delivery remains fixed. 2. Load time remains fixed. 3. The average rate of consumption of materials does not changes.

13.10 AVERAGE STOCK LEVEL

Average stock level is the average quantity of stock for a given time of period. Computation of Average Stock Level. The formula is as follows:

13.11 DANGER LEVEL

In addition to the minimum, the maximum and recording levels there is another level called Danger Level. This level is below the minimum level and when the actual stock reaches this level immediate measure is to be taken to replenish stock. When the normal lead time is not available, the purchase quantity cannot be accurately determined. So, it is fixed in such a way that the actual stock does not fall below danger level by the actual lead time. This means, that the minimum level contains a cushion to cover contingencies. Some concerns fix danger level below the re-ordering level but above the minimum level. If action for purchase is taken as soon as the stock reaches the re-ordering level, the danger level bears no importance except that, when the stock reaches the danger level (but not yet the minimum level) a reference may be made to the purchase department to ensure that delivery is received before the actual stock reaches the minimum level. When the danger level is fixed below the minimum, it being reaches by the actual stock, the defect in the system is identified and corrective measure becomes necessary. When the danger level is fixed above the minimum, it being reached by the actual stock, preventive

measure is to be taken so that the stock may not go below the minimum level. It is the point or level of stock which the material stock should never be allowed to reduce. It is generally a level below the minimum level. As soon as the stock of material reaches this point, urgent action is needed for replenishment of stock. Determination of Danger Level. This done as follows: Danger Level = Two days of normal consumption Re-order Quantity: The quantity which is ordered at re-order point is called re-order quantity. This is determined on the basis of minimum stock level and maximum stock level. This is normally used in notation of economic order quantity.

Numerical Solved Examples

Example 1: Calculate (i) Re-order Level; (ii) Minimum Level; and (iii) Maximum Level for each Component A and from the following information: Normal Usage 50 Units per week each Minimum Usage 25 Units per week each Maximum Usage 75 Units per week each Re-order Quantity A: 300 Units; B : 500 Units Re-order Period A : 4 to 6 weeks; B : 2 to 4 weeks

Example 2: From the following particulars, calculate: (a) Re-order Level (b) Minimum Level, (c) Maximum Level, (d) Average Level: Normal Usage 100 units per day Minimum Usage 60 units per day Maximum Usage 130 units per day Economic Order Quantity 5,000 units Re-order Period 25 to 30 days

Example 3: A manufacturer buys costing equipment from out side suppliers Rs. 30 per unit. Total annual needs are 800 units. The following data is available: Annual Return on Investment 10% Rent, Insurance etc. per unit per year Re. 1 Cost of Placing an order Rs. 100 Determine Economic Order Quantity.

Example 4: Fair Deal Limited uses Rs. 1,00,000 materials per year. The administration cost per purchase in Rs. 100 and the carrying cost is 20% of the average inventory. The company has a purchase policy on the basis of economic order quantity but has been offered a discount of 0.5% in the case of purchase five times per year. Advise the company whether it should accept new offer or not?

Example 5: A pharmaceutical factory consumes annually 6,000 kgms. of a chemical costing Rs. 5 per kgm. Placing each order costs Rs. 25 and the carrying cost is 6% per year per kgm. of average inventory. Find the Economic Order Quantity and the total inventory cost. The factory works for days in a year. If the procurement time is 15 days and safety stock 200 kgms., find the re-order point and maximum and average inventories levels. If the supplier offers a discount of 5% on the cost price for a single order of annual requirement, should the factory accept it?

Example 6: A trading company expects to sell 15,000 mixers during the coming year. The cost per mixer is Rs. 200. The cost of storing a mixer for 1 year is Rs. 5 and the ordering cost is Rs. 540 per order. Find the Economic Order Quantity. Would it be profitable to the company to accept a discount offer of 30% on a single order per year. The storing cost continuing to be Rs. 5 per mixer per year.

Example 7: A manufacturer requires 1,000 units of a raw material, per month. The ordering cost is Rs. 15 per order. The carrying cost in addition to Rs. 2 per unit, is estimated to be 15% of average inventory per unit per year. The purchase price of the raw material is Rs. 10 per unit. Find the Economic Lot Size and the total cost. The manufacturer is offered as 5% discount in purchase price for order for 2,000 units or more but less than 5,000 units. A further 2% discount is available for order of 5,000 or more units. Which of the three ways of purchase he should adopt?

On the basis of above analysis we find that the T.I.C. is minimum (Rs. 1,17,515) in second alternative. Hence the company should adopt this alternative.