INVENTORY MANAGEMENT
THE MANAGEMENT OF STOCK
To enhance continuous production, most companies carry stocks of raw
materials, work in progress and finished goods, which may amount to a
substantial proportion of the total assets of the business.
Some businesses attempt to control stocks on a scientific basis by balancing the
costs of stock shortages against those of stock holding.
(a) We can use the economic order quantity (EOQ) model to decide the optimum
order size for stocks which will minimize the costs of ordering stocks plus
stockholding costs.
(b) If discounts for bulk purchases are available, it may be cheaper to buy stocks in
larger order sizes so as to obtain the discounts.
(c) Uncertainty in the demand for stocks and/or the supply lead time may lead a
company to decide to hold buffer stocks (thereby increasing its investment in
working capital) in order to reduce or eliminate the risk of stock-outs’ (running
out of stock)
STOCK COSTS
There are four broad categories of cost that are incurred anytime materials are
purchased and stored in the warehouse.
1. Purchase cost
2. Carrying cost
3. Ordering cost
4. Stock-out cost
1. PURCHASE COST
That is the supplier’s quotation.
2. CARRYING COST
This comprises the entire amount incurred to take care of the materials after they
have been purchased and stored in the warehouse e.g
(a) Cost of capital tied down on materials in the warehouse
(b) Cost of pilferage, breakages, deterioration
(c) Rent
(d) Cost handling
(e) Insurance
3. ORDERING COST
By ordering cost, we mean the amount spent in procuring the materials up to the
point it is stored in the warehouse. Examples of ordering cost are:
a. Transport cost
b. Administrative cost involved in procuring the materials
c. Purchasing department operating cost.
4. STOCK-OUT COST
This is the amount incurred for carrying out inadequate number of materials in
store at any point in time. Examples are:
(a) Lost sales
(b) Loss of goodwill
(c) Payment of wages to idle workers
STOCK MODELS
There are several different types of stock model, and these can be classified under
the following headings.
(a) DETERMINISTIC STOCK MODELS
A deterministic model is one in which all the ‘parameters’ are known with
certainty. In particular, the rate of demand and the supply lead time are known.
(b) STOCHASTIC STOCK MODELS
A stochastic model is one in which the supply lead time or the rate of demand for
an item is not known with certainty. However, the demand or the lead time
follows a known probability distribution (probably constructed from a historical
analysis of demand or lead time in the past).
BASIC TERMS IN INVENTORY MANAGEMENT
(a) Lead time or procurement time: is the time expressed in days, weeks or
months which elapse between ordering and eventual delivery. A supply lead
time of one week means that it will take one week from the time an order is
placed until the time it is supplied.
(b) Physical stock: is the number of items physically in stock at the time of
inventory.
(c) Free stock: is the physical stock added to awaiting orders less unfulfilled
demands.
(d) Maximum stock: is the selected stock level to indicate when stocks have risen
too high.
(e) Stock-out: refer to a situation where there is a demand for an item of stock
but the warehouse is out of stock.
(f) Buffer stock or safety stock or minimum stock: is the level to indicate when
stock has gone too low and is usually held to safeguard against stock-outs.
(g) Economic Order Quantity (EOQ) or Economic Batch Quantity (EBQ): is the
ordering quantity of an item of stock which minimizes the costs involved.
(h) Re-order quantity: is the number of units of item in one order.
(i) Re-order level: is the level of stock at which a new order for more units of
items should be placed.
(j) Demand: is the number of units of stock required within a particular period of
time.
ECONOMIC ORDER QUANTITY MODEL (EOQ)
There are two fundamental objectives:
(i) To determine the quantity that should be purchased anytime a fresh order
is made.
(ii) To reduce to the barest minimum all costs that is associated with
replenishment.
ASSUMPTIONS OF EOQ
1. Purchase price is constant i.e there is no discount whatsoever.
2. Annual demand is known with certainty and it is uniformly consumed
throughout the whole year.
3. The lead-time is zero
4. There is instantaneous build up of inventory.
The symbols used are:
D: the annual demand
Q: the re-order quantity
C: the ordering cost for single order
H: the cost of holding a unit of stock for one year.
NB:
(i) Number of orders in a year is d/Q
(ii) Ordering cost in a year is c. d/Q
(iii) Average stock is Q/2
(iv) Holding cost per annum is h.Q/2
(v) Length of inventory cycle is 52/No. of order i.e 52Q/d weeks or 12Q/d
months
(vi) Total cost per annum = ordering cost p.a + holding cost p.a i.e cd/Q + Qh/2
QUESTION 1
Data on a given stock item are as follows:
Normal usage 2,400 per week
Minimum usage 1,600 per week
Maximum usage 3,500 per week
Lead time 20-23 weeks
EOQ 50,000
Required:
Calculate the various control levels.
QUESTION 2
The demand for an item is 60,000 per annum. The cost of an order is N25 and
holding cost per item is N2.00 per annum. You are required to find
(a) The number of orders per year and the associated ordering cost
(b) The length of inventory cycle
(c) Total cost per annum
QUESTION 3
ABC Ltd uses a particular component at the rate of 24,000 per year. There are
obtained from an outside supplier at a basic cost of 25K each. Replenishment
orders can be obtained promptly, though it entails sending a man and a lorry to
collect the components, this would cost N20, this is assumed to be the only cost
of ordering. The storage cost of stock is 15% of the cost of the component.
Required:
(a) What is the EOQ?
(b) What is the total controllable cost?
(c) What is the total cost of this order?
QUESTION 4
Green Trees plc uses 32,000 units of a particular component in a year. The basic
purchase price is N100 and cost per order is N200. Carrying cost is 20% of the
purchase price. The company is offered the following discounts on the purchase
price:
Order Quantity Discount
1000 - 1,499 Less 2%
1,500 - 1,999 Less 4%
2000 and over Less 5%
Required: Calculate the appropriate order quantity.
EOQ with Gradual Replenishment (Stock Holder Manufacturer)
In this situation, the manufacturer serves as the stock holder. i.e the
manufacturer holds stocks of finished goods and hence production is not
continuous. If r represent the production rate per annum, then
Q= 2cd
h (1 – d/r)
QUESTION 5
A firm has decided to manufacture its own items of stock at the rate of 16,000
items per month. Demand for the item is at the rate of 8,000 in one month. Each
production run costs N40 and holding cost per item is 80K per month. Determine:
(a) The Economic Production Run
(b) The length of the inventory cycle
(c) Number of production runs per month
(d) Total cost of production per month.
EOQ with Stock-Out
When stock-out is allowed, the stock-out costs must be known. If cs represents
the stock-out per item, then Q= (2cd/h)(h + cs/cs)
QUESTION 6
The demand for an item is 1,000 units per week. It costs N30 to place an order
and holding cost per item is N1.50 per annum. Cost associated with stock-out is
90K per item. Calculate the EOQ.
