Chapter Notes: Inventory Control
Inventory Control
Inventory consists of materials, components, work-in-progress and finished goods kept by a business to support production and sales. In many enterprises a substantial portion of working capital is tied up in inventories. Effective inventory control seeks to maintain inventories at levels that are neither excessive nor inadequate - an optimum stock level that ensures smooth production and reliable sales fulfilment while minimising investment and carrying costs.
Objectives of Inventory Control
- Maximum customer service - ensure prompt supply and avoid stock-outs so customer orders and production schedules are met.
- Minimum inventory investment - reduce funds tied up in stock and avoid unnecessary storage costs, obsolescence and deterioration.
- Low cost plant operation - maintain stable production and efficient operations by having adequate inventories to avoid interruptions and frequency-related cost increases.
Inventory control balances these objectives so that the firm keeps sufficient stock for service and production, yet minimises the capital and running costs involved.
Functions of Inventory Control
- Maintain inventories at minimum practicable levels consistent with market and production requirements.
- Forecast requirements of materials and predict availability of supplies.
- Ensure adequate stock of finished goods for prompt delivery to customers.
- Provide management with accurate records and reports for decision-making.
- Free up cash by avoiding unnecessary purchases and overstocking.
- Minimise purchases at uneconomical rates by planning orders.
Techniques of Inventory Control
Common techniques used for inventory control include:
- ABC analysis
- Economic Order Quantity (EOQ)
- Perpetual inventory system (bin cards, stores ledger, continuous stock-taking)
- Review and control of slow-moving and non-moving items
- Input-Output (I-O) ratio analysis
- Setting of various stock levels (maximum, minimum/safety, re-order, danger)
- Material budgeting
- Establishing an effective purchase procedure
- Disposal procedures for scrap and surplus
- VED analysis (Vital, Essential, Desirable) for critical items
ABC Analysis
ABC analysis groups inventory items according to their annual consumption value so that management attention is focused where it matters most. Items are classified into three categories:
| Category | Approximate % of Items | Approximate % of Consumption Value | Control Emphasis |
|---|---|---|---|
| A items | About 10% | About 70% | Very strict control, close follow-up, handled by senior staff, low or no safety stocks |
| B items | About 20% | About 20% | Moderate control, periodic follow-up, handled by middle management, low safety stocks |
| C items | About 70% | About 10% | Loose control, simple checks, handled by junior staff, higher safety stocks |
Advantages of ABC analysis
- Regulates investment by directing funds to the most significant items.
- Allows closer control of high-value items (A items) which consume most of the inventory budget.
- Helps maintain appropriate safety stocks item-wise.
- Enables selective control that increases overall stock turnover rate.
Economic Order Quantity (EOQ)
The EOQ technique finds the order quantity that minimises the total annual cost, which is the sum of annual ordering cost and annual carrying (holding) cost.
Costs involved
- Ordering cost - cost associated with placing and receiving an order (paper work, procurement staff, inward inspection, etc.). Often assumed constant per order.
- Carrying (holding) cost - cost of holding inventory (rent, insurance, deterioration, capital cost). Usually expressed as a percentage of unit cost.
Methods for determining EOQ
- Tabular method
- Graphical presentation
- Algebraic formula (closed-form EOQ)
Tabular determination (illustration)
Prepare a table showing number of orders per year, annual ordering cost, annual carrying cost, and total annual cost. The EOQ corresponds approximately to the order frequency that gives minimum total annual cost.
Graphic method
Plot annual ordering cost and annual carrying cost against order quantity. The point where the sum (total cost) is minimum - equivalently where ordering cost curve intersects carrying cost curve - indicates the EOQ.
Algebraic formula
Let:
- D = annual demand (units)
- S = ordering cost per order (Rs per order)
- C = cost per unit (Rs per unit)
- i = annual carrying cost rate (fraction, e.g. 24% = 0.24)
- H = holding cost per unit per year = C × i
The Economic Order Quantity is given by:
EOQ = sqrt((2 × D × S) / H) = sqrt((2 × D × S) / (C × i))
Example:
Annual demand D = 1,200 units. Ordering cost S = Rs 10 per order. Unit cost C = Rs 1.00. Carrying cost rate i = 24% = 0.24.
Ans:
EOQ calculation:
H = C × i = 1.00 × 0.24 = 0.24 (Rs per unit per year)
EOQ = sqrt((2 × 1,200 × 10) / 0.24)
EOQ = sqrt(24,000 / 0.24)
EOQ = sqrt(100,000)
EOQ ≈ 316 units
Perpetual Inventory System
A perpetual inventory system updates records of store balances after every receipt and issue. This facilitates continuous stock control and swift detection and correction of discrepancies. The main components are:
- Bin card - maintained by the store-keeper to record receipts, issues and running balance for each material.
- Stores ledger - maintained in the accounting department; records quantities, rates and values and supports bin card balances.
- Continuous (selective) stock-taking - regular verification of selected items so each item is checked at least once in a specified period.
Typical bin card format
| Bin Card | |
|---|---|
| Description of material | |
| Code No. | |
| Bin No. | |
| Normal quantity to order | |
| Maximum stock level | |
| Re-order level | |
| Date / G.R. No. / S.R. No. | Receipt / Issue / Balance |
Typical stores ledger format
| Stores Ledger Account | |||||
|---|---|---|---|---|---|
| Description of material | Receipts (Qty, Rate, Amt) | Issues (Qty, Rate, Amt) | Balance (Qty, Rate, Amt) | Date | Remarks |
Advantages of a perpetual system
- Immediate detection and rectification of clerical errors and discrepancies.
- Allows selective verification of items without disturbing regular operations.
- Enables timely action on shortages and prevents stock-outs.
- Acts as a deterrent to theft and dishonesty by providing a continuous record.
- Helps avoid chronic overstocking or understocking by monitoring stock levels against maximum and minimum limits.
- Facilitates preparation of interim financial statements (profit & loss, balance sheet) when required.
Review of Slow and Non-moving Items
Slow-moving, dormant and obsolete items increase inventory cost and should be identified and controlled. Definitions:
- Slow-moving items - items with a low rate of consumption over a period.
- Dormant items - items temporarily not required, often due to seasonal demand fluctuations.
- Obsolete items - items that have become unusable due to design changes, process changes, expiry, or technological obsolescence.
Such items should be valued at the lower of cost, replacement price or net realisable value. Steps to detect and manage these items include periodic reporting, special review for obsolescence, and calculating movement ratios or turnover rates to identify items for disposal or special action.
Input-Output (I-O) Ratio Analysis
The I-O ratio measures the relation between the quantity of material input to a production process and the quantity of that material contained in the finished output. It helps monitor material usage efficiency and identify losses.
Formula:
I-O ratio = (Input quantity / Output quantity) × 100
Example:
If 2.0 kg of raw material is put into the process and the finished product contains 1.6 kg of that material then:
Ans:
I-O ratio = (2.0 / 1.6) × 100 = 125%
Advantages:
- Measures efficiency of the manufacturing process.
- Helps compare actual consumption with standard consumption.
- Permits computation of raw material cost in the finished product by multiplying unit raw material cost by the I-O ratio.
When substitute raw materials are available, compare the effective cost in the finished product, which is: (unit price × I-O ratio) for each alternative. Choose the material giving the lowest effective cost per unit in the finished product.
Example calculation:
- Material A1: rate Rs 15/kg, I-O ratio 110% → cost in finished product = 110/100 × 15 = Rs 16.50
- Material A2: rate Rs 12/kg, I-O ratio 140% → cost in finished product = 140/100 × 12 = Rs 16.80
Choose A1 because Rs 16.50 < Rs 16.80.
Setting of Various Stock Levels
To control inventory, several stock level concepts are defined and maintained:
Maximum stock level
The upper limit for stock of an item beyond which it should not normally rise. Factors considered when setting it include rate of consumption, storage space, available capital, nature of material, market trends, risk (fire, obsolescence), and lead time.
Approximate relation:
Maximum level = Re-order level + Re-order quantity - Minimum consumption during re-order period
Minimum stock level (Safety stock)
The lower limit below which stock should not normally fall. It protects against uncertainties such as higher-than-normal usage or delays in supply.
Minimum stock level is determined considering:
- Average consumption during lead time
- Variations in consumption
- Normal lead time and any anticipated delays
Re-order level
The level of stock at which a new order should be placed to replenish stock before it reaches the minimum level. Re-order level is slightly above the minimum to allow for ordering and delivery time.
Formula:
Re-order level = Average consumption during re-order period + Minimum consumption during any delay period
When stock reaches the re-order level, the purchasing process should be started so that stock arrives before minimum level is reached.
Danger level
A level below the minimum stock level. If stock falls to danger level, urgent action is required to obtain supplies and prevent production stoppage or sales loss.
Use of Material Budgeting
Material budgeting involves preparing purchase budgets for the organisation and for individual items. When preparing a material budget consider:
- Trends in sales (compare current month sales with corresponding month in previous year).
- Adjustments for past over-buying or under-buying.
Purchases made are subtracted from the purchase budget in a purchase journal so that procurement staff can monitor whether they are buying too much or too little with respect to planned budgets.
Establishing an Effective Purchase Procedure
Purchase procedure is the sequence of steps for procuring materials. Typical steps:
- Recognition of need and preparation of requisition.
- Identification of possible suppliers and selection based on price, quality and terms.
- Placing the order with the selected supplier.
- Receipt of goods, inspection and recording of inward deliveries.
- Verification of invoice and payment processing.
- Recording the transaction in stores and accounting records.
Good purchase policies and clear purchase manuals help standardise the procedure and support inventory control. The purchase order also serves as a legal document in case disputes arise.
Scrap and Surplus Disposal
Scrap is residue obtained incidentally in manufacturing that has small recoverable value (for example, powder or fines from tablet processing, broken containers). Surplus items are materials or components no longer required (rejected components, defective parts, obsolete materials, expired goods in a drug store).
Disposal procedures should ensure proper classification, valuation and authorised disposal to recover value and avoid accumulation of useless stock.
VED Analysis
VED analysis classifies items by their criticality rather than value. The categories are:
- V - Vital: items whose absence will halt production or critical services. Maintain adequate stocks and very close control.
- E - Essential: items required for production but whose absence causes inconvenience or reduced efficiency; maintained with moderate control.
- D - Desirable: items whose absence does not critically affect production or service; can be stocked at lower levels.
In a drug store, some formulations or brands that appear frequently in prescriptions would be classified as Vital, others that are often used but less frequently as Essential, and less commonly required brands as Desirable. VED analysis helps set priorities for procurement and stock levels based on criticality.
Summary
Inventory control is about achieving a balance between service levels and investment in stock. Techniques such as ABC and VED classification, EOQ calculations, perpetual inventory records, I-O ratio analysis, correct setting of stock levels, material budgeting and disciplined purchase procedures together enable efficient inventory management, reduce costs, prevent stock-outs and improve overall operational effectiveness.
