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INVENTORY MANAGEMENT

1. Economic Order Quantity (EOQ)

The prime objective of inventory management is to find out and maintain optimum level ofinvestment in inventory to minimize the total costs associated with it. The EOQ is the optimum sizeof the order for a particular item of inventory calculated at a point where the total inventory costs areat a minimum for that particular stock item. It is an optimum size of either a normal outside purchaseorder or an internal production order that minimizes total annual holding and ordering costs ofinventory. Stock-out costs are difficult to incorporate in this model, since they are based onqualitative and subjective judgment. The ordering costs are the costs of placing a separate ordermultiplied by the number of separate orders placed in the period. The carrying costs can becalculated 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. Thesafety or buffer stock has no bearing on the EOQ, only on the timing of orders. The economic orderquantity (EOQ) is an optimum quantity of materials to be ordered after consideration of thefollowing three categories of costs:

Ordering Costs: The costs of ordering inventory include the following:

§ Preparation of purchase order§ Costs of receiving goods§ Documentation processing costs§ Transport costs§ Intermittent costs of chasing orders, rejecting faulty goods§ Additional costs of frequent or small quantity orders§ Where goods are manufactured internally, the set-up and tooling costs associated with

each production run.

Carrying Costs: The carrying costs of inventory include the following:

§ Storage costs (rent, lighting, heating, refrigeration, air-conditioning etc.)§ Stores staffing, equipment maintenance and running costs.§ Handling costs.§ Audit, stock taking or perpetual inventory costs.§ Required rate of return on investment in current assets.§ Obsolescence and deterioration costs.§ Insurance and security costs.§ Costs of money tied up in inventory.§ Pilferage and damage costs.

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Stock-out Costs: The stock-out costs are associated with running out of stock which includes thefollowing:§ Lost contribution through the lost sales caused by the stock-out.§ Loss of future sales because customers go elsewhere.§ Loss of customer goodwill.§ Cost of production stoppages caused by stock-outs of WIP or raw material.§ Labour frustration.§ Over stoppages.§ Extra costs associated with urgent replenishment purchases of small quantities.

Assumptions of EOQ

To be able to calculate a basic EOQ certain assumptions are necessary:§ That there is a known, constant stockholding cost.§ That there is a known, constant ordering cost.§ Those rates of demand are known and constant.§ That there is a known, constant price per unit, i.e., there are no price discounts.§ That replenishment is made instantaneously, i.e., the whole batch delivered at once.

The following formula is used in calculation of EOQ:

EOQ = √2QO CSWhere,Q = Annual consumption C = Cost per unitO = Cost of placing an order S = Storage and other inventory carrying cost.

EOQ WITH DISCOUNTS

A particularly unrealistic assumption with the basic EOQ calculation is that the priceper item remains constant. Usually some form of discount can be obtained by ordering increasingquantities. Such price discounts can be incorporated into the EOQ formula, but it becomes muchmore complicated. A similar approach is to consider the costs associated with the normal EOQ andcompare these costs with the costs at each succeeding discount point and then ascertain the bestquantity to order. Price discounts for quantity purchase have three financial effects, two of which arebeneficial 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 costsare reduced.

Adverse effects - Increased costs arise from the extra stockholding costs caused by the average stocklevel being higher due to the larger order quantity.

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2. ABC Analysis

In this technique, the items of inventory are classified according to value of usage. Thehigher value items have lower safety stocks, because the cost of production is very high inrespect of higher value items. The lower value items carry higher safety stocks. ABC analysisdivides the total inventory list into three classes A, B, and C using the rupee volume, asfollows:

§ Items in class 'A' constitute the most important class of inventories so far asthe proportion in the total value of inventory. The 'A' items consists ofapproximately 15% of the total items, accounts for 80% of the total materialusage.

§ Items in class B' constitute an intermediate position, which constituteapproximately 35%of the total items, accounts for approximately 15% of thetotal material consumption.

§ 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. Theabove categorization is represented in the table given below:

Class of items %of items %of valueA 15 80B 35 15C 50 5

100 100

The ABC analysis of inventory class 'A' is made up of inventory items which are either veryexpensive or used in massive quantities. Thus these items, though few in number contribute a highproportion of the value of inventories. Class 'B' items are not so few in number, but also they arenot 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 theyare either very inexpensive items or used in very small quantities so that they do not constitutemore than a negligible fraction of the total value of inventories. The control of inventory throughABC analysis is exercised as follows:

§ 'A' class items merit a tightly controlled inventory system with constantattention by the purchase and stores management. A larger effort per item ononly a few items w ill cost only moderately, but the effort can result in largesavings.

§ 'B' class items merit a formalized inventory system and periodic attention bythe purchase and stores management.

§ For 'C class items still relaxed inventory procedures are used.

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The table given below shows how an organisation treats the various classes of items according totheir consumption value. For 'A' class items, the inventory policy, i.e. order quantity and re-orderpoint 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 andlarger stocks can be maintained. The review of these items may be done quarterly or half-yearly. Incase of 'C class items, generally one year supply can be maintained. Periodic review once a yearmay be sufficient.

'A' Class Items(High consumption value)

‘B’ Class Items(Moderate consumption value)

'C Class Items(Low consumption value)

1. Very strict control. 1. Moderate control. 1. Loose control.

2. No safety stocks or verylow safety stocks.

2. Low safety stocks. 2. High safety stocks.

3. Maximum follow-up andexpediting.

3. Periodic follow-up 3. Follow-up and expediting inexceptional cases.

4. Rigorous value analysis. 4. Moderate value an 4. Minimum value analysis.

5. Must be handled bysenior officers.

5. Can be handled bymanagement.

5. Can be fully delegated.

The technique tries to analyze the distribution of any characteristics by stock values of importancein order to determine its priority. This technique can be applied in all facets of organisation. Manyorganisations are applying this technique in materials management and spare parts management toidentify the contribution made by the materials/spares in the total inventory value. On the basis ofstock value, materials procurement strategy and consumption strategy is decided.

3. VED Analysis

VED analysis divides items into three categories in the descending order of their critically asfollows:§ 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 storedadequately to ensure smooth operation of the plant.

§ 'E' means essential items. Such items are considered essential for efficient running butwithout these items the system would not fail. Care must be taken to see that they are alwaysin stock.

§ 'D’ stands for desirable items which do not affect the production immediately but availabilityof 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 basedon their critically, it can be used for those special raw materials which are difficult to procure.

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4. FNSD Analysis

Age of inventory indicates duration of inventory in organisation. It shows moving position ofinventory during the year. If age of inventory is minimum it means, the turnover position of thatparticular item of inventory is satisfactory. If the age of any particular item of inventory, itindicates the slow moving of stock which may be due to lower demand for the product,inefficiency in shocking 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 excesscarrying costs. FNSD analysis divides the items into four categories in the descending order oftheir usage rate as follows:

§ 'F' stands for fast moving items and stocks of such items are consumed in ashort span of time. Stocks of fast moving items must be observed constantlyand replenishment orders be placed in time to avoid stock-out situations.

§ 'N' means normal moving items and such items are exhausted over a period ofa war or so. The order levels and quantities for such items should be on thebasis of a new estimate of future demand to minimize the risks of a surplusstock.

§ 'S' indicates slow moving items, existing stock of which would last for twoyears 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 replenishmentorders are placed.

§ 'D' stands for dead stock and for its existing stock no further demand can beforeseen. Dead stock figures in the inventory represents money spent thatcannot be realized but it occupies useful space. Hence, once such items areidentified, efforts must be made to find all alternative uses for it. Otherwise, itmust be disposed off.

Prepared by: Dr Sarbesh Mishra NICMAR’s CISC

Hyderabad – 500 084.