Fixation of Inventory Levels | Cost Accounting - B Com PDF Download

Stock Level: 
Type 1. Minimum Level:
This represents the quantity which must be maintained in hand at all times. If stocks are less than the minimum level, then the work will stop due to shortage of materials.
Following factors are taken into account while deciding minimum stock level:
(i) Lead Time:
A purchasing firm requires some time to process the order and time is also required by the supplier/vendor to execute the order. The time taken in processing the order and then executing it is known as lead time. It is essential to maintain some inventory during this period to meet production requirements.
(ii) Rate of Consumption:
It is the average consumption of materials items in the industry. The rate of consumption will be decided on the basis of past experience and production plans.
(iii) Nature of Material:
The nature of material also affects the minimum level. If a material is required only against special orders of the customer then minimum stock will not be required for such materials. Wheldon has given the following formula for calculating minimum stock level: Minimum stock Level = Re-ordering Level – (Normal Consumption x Normal Reorder Period)
(iv) Re-ordering Level:
When the quantity of materials reaches a certain level then fresh order is sent to procure materials again. The order is sent before the materials reach minimum stock level.
Reordering level is fixed between minimum level and maximum level. The rate of consumption, number of days required to replenish the stocks, and maximum quantity of materials required on any day are taken into consideration while fixing reordering level.
Re-ordering level is fixed with following formula:
Reordering Level = Maximum Consumption Rate x Maximum Reorder period.

Stock Level: 
Type 2. Maximum Level
It is the quantity of materials beyond which a firm should not exceed its stocks. If the quantity exceeds maximum level limit then it will be termed as overstocking. A firm avoids overstocking because it will result in high material costs. Overstocking will lead to the requirement of more capital, more space for storing the materials, and more charges of losses from obsolescence.

Maximum stock level will depend upon the following factors:
1. The availability of capital for the purchase of materials in the firm.
2. The maximum requirements of materials at any point of time.
3. The availability of space for storing the materials as inventory.
4. The rate of consumption of materials during lead time.
5. The cost of maintaining the stores.
6. The possibility of fluctuations in prices of various materials.
7. The nature of materials. If the materials are perishable in nature, then they cannot be stored for long periods.
8. Availability of materials. If the materials are available only during seasons then they will have to be stored for the future period.
9. Restrictions imposed by the government. Sometimes, government fixes the maximum quantity of materials which a concern can store. The limit fixed by the government will become the deciding factor and maximum level cannot be fixed more than that limit.
10. The possibility of changes in fashions will also affect the maximum level.

Wheldon has suggested the following formula for calculating maximum stock level:
Maximum Stock Level = Reordering Level + Reordering Quantity – (Minimum Consumption x Minimum Reordering period)

Stock Level: 
Type 3. Danger Level:
It is the level below which stocks should not fall in any case. If danger level approaches then immediate steps should taken to replenish the stocks even if more cost is incurred in arranging the materials. Danger level can be determined with the following formula:
Danger Level = Average Consumption x Maximum reorder period for emergency purchases.

Stock Level: 
Type 4. Average Stock Level:
The Average stock level is calculated such as:
Average Stock Level = Minimum stock Level + 1/2 of Reorder Quantity.
Example:
From the following information, calculate minimum stock level, maximum stock level and re-ordering level:
(i) Maximum Consumption = 200 units per day
(ii) Minimum Consumption = 120 units per day
(iii) Normal Consumption =160 units per day
(iv) Reorder period = 10-15 days
(v) Reorder quantity = 1,600 units
(vi) Normal reorder period = 10 days.
Solution:
Reordering Level = Maximum Consumption x Maximum Reorder period
= 200 units X 15 = 3,000 units Minimum Stock Value = Reordering Level – (Normal Consumption x Nominal Reordering Period)
= 3,000 – (160 X 10) = 3,000 – 1,600 = 1,400 units
Maximum Stock Level = Reordering Level + Reorder Quantity – (Minimum Consumption x Reorder period) = 3,000 + 1,600 – (120 X 10) = 3,000 + 1,600 – 1,200 = 2,400 units.
The three other factors must also be explained very carefully.

Illustration 1: [Fixation of stock levels]:
Two components A and B are used as follows:
Normal usage 50 units per week each
Minimum usage 25 units per week each
Maximum usage 75 units per week each
Reorder Quantity A 300 units; B 500 units
Reorder Period A 4 to 6 weeks, B 2 to 4 weeks

Calculate for each components:
(a) Reorder level,
(b) Minimum Level,
(c) Maximum level,
(d) Average Stock Level.
Solution:
(a) Reorder Level = Maximum Rate of Consumption x Maximum Reorder Period.
A = 75 x 6 = 450 units
B = 75 x 4 = 300 units
(b) Minimum Level = Reorder Level – (Average Rate of consumption x Average Reorder Period)
A = 450 – (50 – 5) = 200 units
B = 300 – (50 x 3) = 150 units
(c) Maximum Stock Level
= (Reorder Level + Reorder Quantity) – (Minimum Consumption Rate x Minimum Reorder Period)
A = (450 + 300) – (25 x 4) = 650 units
B = (300 + 500) – (25 x 2) = 750 units
(d) Average Stock Level = (Maximum Stock Level + Minimum Stock Level)/2
A = (650 + 200)/2 = 425 units
B = (750 + 150)/2 = 450 units
Average Stock Level can also be calculated by the formula.
Minimum Stock Level + ½ of Reorder Quantity
A = 200 + ½ x 300 = 350 units
B = 150 + ½ x 500 = 400 units

Illustration 2:
If the minimum stock level and average stock level of raw material A are 4,000 and 9000 units respectively, find out its reorder quantity.
Solution:
Average stock level = Minimum stock level + ½ of Reorder Quantity
9000 = 4000 + of Reorder Quantity
½ Reorder Quantity = 9000 – 4000 = 5000
Reorder Quantity = 10,000 units