Inventory Control: Techniques and Methods of (With Formula and Example) | Cost Accounting

The following are various inventory control techniques and methods used in different industries: 1. Demand and Supply Method of Stock Control – Levels of Stock and EOQ 2. Stock Control According to Value-ABC Analysis 3. Perpetual Inventory System 4. Just-In-Time Inventory (JIT) 5. VED Analysis 6. FSND Analysis 7. Automatic Order System 8. Ordering Cycle Method 9. Min-Max Method and  a Few Others.

Technique # 1. Demand and Supply Method of Stock Control – Levels of Stock and EOQ:

This method of material control utilises the principles of planning the demand for and supply of each item of material:

i. At the lowest cost possible.

ii. With the lowest possible inventory.

iii. Consistent with operating requirements.

Optimum quantity of-purchasing and manufacturing lot sizes are determined to economise the cost of procuring, storing and consuming each item of material.

For effective demand and supply method of stock control, information of the following aspects has to be estimated for each item of raw material:

(a) Rate of consumption for a specific period.

(b) Lead time for acquiring the material.

(c) Economic ordering quantity to optimise the cost of carrying and the cost of ordering and receiving.

(d) Reserve stock to be maintained as safety stock to take care of abnormal consumption during the lead time or lead time being more than normal or a combination of both.

(e) Reorder level quantity, being the quantity to be consumed during the lead time plus reserve stock.

(f) Maximum and minimum levels of material to control-overstocking and to maintain minimum quantity being available for production requirements.

With the help of accurate estimation of the above aspects, it is possible to see that actual purchasing and consumption conform to the standards set.

The various levels of stock used in demand and supply method are explained in detail below:

(a) Minimum Stock Level:

This is the minimum quantity of material to be maintained in stores throughout the year.

The following factors are essential for fixing minimum stock level:

1. Reorder level.

2. Normal consumption of material.

3. Time required to obtain material from the time of issuing purchase order to the time of physical receipt of the material.

4. Nature of material.

(b) Maximum Stock Level:

It is that quantity above which the stock of any item should not be allowed to exceed.

Fixation of this quantity depends on several factors as given below:

1. Rate of consumption required for production.

2. Availability of storage space.

3. Cost of storage.

4. Availability of finance.

5. Extent of price fluctuations.

6. Reorder level and time required to obtain delivery of supplies.

7. Availability of quality raw material.

8. Economic ordering quantities.

9. Risk of obsolescence, evaporation and natural waste.

10. Cost of insurance.

(c) Danger Level:

This is the stock level below the minimum level. When stocks reach this level action for immediate purchase is necessary. Issues are controlled by stopping normal issues and issuing only on special instructions.

(d) Reorder Level:

It is between maximum and minimum stock levels. Once the stock level teaches reorder level, the store keeper initiates purchase requisition to obtain fresh stocks. Reorder level depends on economic ordering quantity, lead time and rate of consumption of material.

Various methods are used for calculating the levels of stock. A simple model is adopted here to arrive at the levels of stock and average level.

Economic Ordering Quantity:

This is an important item of inventory control to be decided. In these days of inflationary trend, the buying costs, carrying cost and ordering costs are very high. Firms should minimise these costs to control and reduce material cost of production. Economic ordering quantity depends on many factors like cost of purchasing and receiving, normal consumption, interest on capital, availability of storage accommodation, ordering and carrying costs. Economic ordering quantity is the reorder quantity, which is the quantity to be purchased each time an order is placed.

Economic ordering quantity aims at minimising both carrying cost and cost of ordering.

(A) Carrying costs are incurred on maintenance of materials in stores and include cost of material handling, interest on capital, obsolescence, pilferage, rent, insurance and other storage costs.

(B) Ordering costs are incurred for acquiring material into stores. These costs are incurred each time the materials are purchased. The ordering costs include cost of processing, receiving, inspection and general administration overhead cost of purchase department. As number of units per order is increased, ordering costs are reduced (i.e., placement of less number of purchase orders) but at the same time carrying costs are increased as quantity of material kept in the stores increases. With the equalisation of ordering and carrying costs, the economic ordering quantity will be ascertained where the total cost of inventory will be minimum.

When the purchase price remains constant, the economic ordering quantity will be determined based on the following formula:

Sometimes, consumption of material may not be given in units but only in value. In such cases, the formula for EOQ is slightly altered.

This formula is applicable only when consumption of material is not given in units.

Technique # 2. Stock Control According to Value-ABC Analysis:

It is ‘Management by exception’ system of Inventory control. In this Always Better Control (ABC) technique of inventory control, the materials are classified and controlled according to value of the materials involved. It is also called proportional parts value analysis. Thus, high value items are paid more attention than low value items. The materials are classified under ‘A’, ‘B’ or ‘C’ designation on the basis of their value and importance.

‘A’ category consists of a few items of high value. Category ‘B’ includes more items of medium value and category ‘C’ includes all other materials of small value.

The general classification of items under ABC categories are as given below:

From the above classification, it is clear that ‘A’ items are of minimum quantity and of maximum value out of total quantity and value of materials. They have to be controlled to the fullest possible extent by all methods of inventory control from the time of purchase till they are consumed in production. ‘B’ and ‘C’ items are of major portion of total quantity of raw materials but having minimum capital investment. Therefore, they are to be managed through less stringent controls.

Advantages:

1. Effective control is applied on the high value items rather than concentrating on ail items. This results in reduction in value of material losses.

2. Optimum investment in materials as minimum required quantity of ‘A’ items with high value are purchased.

3. Storage cost is kept at minimum amount as high value materials representing minimum quantity are kept in stores.

Limitations of ABC Analysis:

(a) In big firms using numerous materials, dividing them into ABC categories may be cumbersome and difficult process.

(b) Division of materials into ABC categories may become a subjective process since it is difficult to lay comprehensive and precise criteria for such division.

(c) Very little attention to B & C categories of materials may affect their availability in time.

Technique # 3. Perpetual Inventory System:

The ICMA defines perpetual inventory as “A system of records maintained by the control department which reflects the physical movement of stocks and their correct balance”. According to Wheldon “perpetual inventory system is a method of recording stores balances after every receipt and issue to facilitate regular checking and to obviate closing down for stock taking”.

It is clear from the above definitions that perpetual inventory system:

(a) Is a method or system of recording materials?

(b) Reflects the physical movement of materials and records the balance of material after every receipt and issue;

(c) Facilitates regular checking and avoids the need for closing down for stock taking.

The records forming part of the system are:

(1) Bin card maintained by the store keeper in which all the physical quantities of receipts, issues and balance are recorded;

(2) Stores ledger cards maintained by the costing department in which quantities as well as values of receipts, issues and balance are recorded.

Physical verification of the stores is also made by a programme of ‘continuous stock taking’. Any shortage or surplus noted is immediately rectified. Discrepancies due to unavoidable causes are tolerated but those due to avoidable causes are given attention by fixing responsibility to individuals. Thus, bin card, stores ledger card and physical verification together constitute the perpetual inventory system.

Merits of Perpetual Inventory System:

1. It is not required to close the operations to verify stocks as it has been done throughout the year.

2. Profit and Loss A/c and Balance Sheet can be prepared at any time as stores ledger accounts reveal stock quantity and value at any time of the year.

3. Continuous stock taking ensures reliable check on stocks.

4. As stock verification is done systematically more reliable figures are revealed.

5. Continuous stock taking acts as vigilance on the work of store keeper and accountant to maintain accurate records and quantities.

6. Production is planned according to the quantity of raw material available as the perpetual inventory reveals the information about stocks at all times of the year.

7. Parallel maintenance of bin card and stores ledger card facilitates operation of internal check system.

8. Shortage of stocks due to pilferage, damages, theft and other causes are revealed immediately and necessary efforts can be made to avoid or minimise such losses in future.

9. Investment in stores is controlled by comparing actual stocks with maximum and minimum levels.

10. Correct stock figures are made available to insurance company to claim against loss on account of fire.

Discrepancies in Physical Stock:

Perpetual Inventory system ensures the accuracy of inventory records by physical verification of stocks. The balance of stock shown by bin cards or stores ledger may be different from actual stock as revealed by continuous or periodic stock verification. This difference may be due to avoidable and unavoidable causes.

Avoidable Causes:

1. Clerical Errors – Wrong postings, non-posting of entries, wrong casting, etc., are the clerical errors which can be rectified.

2 Pilferage and theft.

3. Damages due to mis-handling of material.

4. Issue of excess or short quantity due to faulty weighing or counting of the material.

Unavoidable Causes:

1. Losses due to shrinkage and evaporation.

2. Shortage due to breakdown of fire and riots.

3. Sometimes, materials may be lost due to ‘breaking up of bulk’ material into smaller parts for issue.

4. Actual balances may be more due to absorption of moisture.

Operation of Perpetual Inventory System:

(a) The entries for receipt or issue of the material are made in the bin card and stores ledger account and the balance is ascertained.

(b) Stores received but not inspected are not mixed up with regular stocks.

(c) Stock taking is done continuously. The stores records are compared and entered in stock verification report for suitable treatment.

Technique # 4. Just-In-Time Inventory (JIT):

Business concerns are giving maximum attention to reducing stock levels by establishing cordial relationship with suppliers to arrange for frequent delivery of quantities. This is called Just in-time purchasing. The objective of just-in-time purchasing is to obtain delivery of material immediately before their use. This is possible with the co-operation of the supplier.

The company guarantees to purchase large quantities. The supplier guarantees good quality materials at reasonable prices. This arrangement helps in directly delivering the material to the shop floor instead of receiving into stores. Moreover the stock consists of few items at more or less same prices where LIFO, FIFO and average cost price will be the same.

Just in time buying of raw materials recognises the disadvantage associated with high inventory cost with high inventory levels. Hence JIT advocates making timely purchases as and when need for raw materials arise. The purchases are made from proven suppliers who can make ready delivery of goods as and when need arises.

EOQ model assumes constant order quantity, whereas Jit buying policy assumes different quantity for each order if demand fluctuates. Similarly EOQ lays stress on carrying costs whereas Jit lays emphasis on all the costs and moves outside the assumptions of EOQ model. Jit purchasing provides special significance to cost of quality and timely deliveries rather than considering price alone as main factor affecting choice of suppliers.

Main Advantages of JIT Purchasing:

(a) The investment in stocks is minimum.

(b) The clerical work relating to issues is minimised. As purchase price of different lots will not fluctuate much, the issue price is same. This results in reduction of clerical cost.

(c) Good rapport with vendors has several long term benefits.

(d) Carrying cost of inventories is practically negligible.

Technique # 5. VED Analysis:

Vital, essential and desirable analysis is done mainly for control of spare parts. Spares are controlled on the basis of their importance.

Vital spares are crucial for production. Non-availability may stop production. The ‘Stock out cost’ of these spares is very high.

Essential spares are spares the ‘stock out’ of which cannot be sustained for more than a few hours and cost of loss of production is high.

Desirable spares are needed but their absence for a short time may not lead to stoppage of production.

Some items of spares though negligible in value may be vital for production. Such items may not be given importance under ABC analysis method which operates on value based control.

Technique # 6. FNSD Analysis:

Under FMSD analysis the stores items are divided under four categories. The basis of classification is their usage rate. Descending order of usage is followed where by ‘F’ stands for fast moving items that are consumed quickly. ‘N’ stands for normal moving items which are exhausted over a period of a year or so. ‘S’ stands for slow moving items which are not consumed frequently but are expected to be exhausted over a period of two years or more. ‘D’ stands for dead items and the consumption of such items is nil.

Stock control under FNSD is done by continuous monitoring of all the four categories of items. Fast moving items are properly ordered to avoid ‘Stock-out’ of such items. Normal moving items are reviewed at regular intervals and orders for restoring shall be made as per a planned schedule.

Stock of slow moving items of stores are reviewed very carefully to avoid over stocking of such items. Dead stock items are taken as obsolete items which have become outmoded and have no further use. Alternative uses should be found for dead stock items or else they should be disposed of at the earliest so that their value may not deteriorate further.

Technique # 7. Automatic Order System:

This method of inventory control is done with the help of computers. Orders for fresh purchases are automatically placed when the inventory reaches ‘order point quantity’ (OPQ). For each type of material, records are maintained by data processing in the form of receipts and issues. When the records show order point the staff concerned place order for necessary quantity. This system ensures that materials are always promptly replaced.

Technique # 8. Ordering Cycle Method:

In this method, the review of materials held in stock is done in a regular cycle. The length of cycle depends on the nature of material. Materials which are expensive and essential have a shorter review cycle and non-vital materials have longer review cycle. At the time of review order is placed to bring the inventory to the desired level.

Ordering cycle method is also called ’90-60-30 cycle’ method. The maximum stock level is equal to 90 days’ supply. When the inventory reaches 60 days’ supply an order is placed for 30 days’ supply. The reorder point is equal to 60 days’ supply and reorder quantity would be equal to 30 days’ supply.

Technique # 9. Min-Max Method:

The demand and supply method is an improvisation of min-max method. In the min-max method, each item of material is fixed with its maximum and minimum levels. When the quantity reaches minimum level, an order is placed for such a quantity as would make the inventory reach is maximum level.

Technique # 10. Inventory Turnover Ratio:

Kohler defines inventory turnover ratio as “a ratio which measures the number of times a firm’s average inventory is sold during a year”. In his view the ratio is an indicator of a firm’s inventory management efficiency. A high inventory turnover ratio indicates fast movement of material. A low ratio on the other hand indicates over investment and blocking up of working capital.

The Inventory turnover is calculated on the sales or cost of sales. It is measured in terms of value of materials consumed to the average inventory during a period. It indicates number of times the inventory is consumed and replenished. If the numbers of days in a year are divided by turnover ratio, the number of days for which the average inventory is held can be ascertained.

The turnover ratio differs from industry to industry. On the basis of the ratio, a decision is made to reduce investment on slow moving materials and stop overstocking of undesirable material.

Technique # 11. Input-Output Ratio Analysis:

This is yet another method of inventory control. Input output ratio is the ratio of the quantity of material to production and standard material content of the actual output. This is possible in industries where the product and raw material are being expressed in same quantitative measurement such as kilograms, Metric tonnes, etc.

The input-output ratio analysis indicates whether the consumption of actual material when compared with standards is favourable or adverse. The raw material cost of the finished product can be arrived at by multiplying material cost per unit by the input-output ratio.

The ratio is obtained as given below:

Standard cost of Actual quantity/Standard cost of Standard quantity

Technique # 12. Material (Inventory) Cost Reports:

Material control is effected by coordinating the functions of all the departments involved with material namely purchasing department, stores department, production department and costing department. Management needs information to analyse and take appropriate decisions. Material cost reports communicate facts relating to materials to the attention of various levels of management.

Material control is concerned with three aspects, vis., purchase control, stores control and consumption control. Departments concerned with these aspects have the responsibility to function effectively in the specific area of their activity. The extent of efficiency of different departments is reported frequently to enable the management at different levels to check inefficiency and achieve desired level of activity.

Designing appropriate material reports will ensure effective communication of material control aspects to the concerned levels of management. Types of reports and frequency of reporting is based on individual requirements of organisations.

The following are some of the reports generally prepared:

(i) Material Consumption Report:

This report is prepared weekly and sent to works manager. It provides information regarding quantity of materials used against standard quantity specified. It helps in controlling consumption of materials and elimination of wastage, spoilage, defectives and scrap.

(ii) Material Purchase Efficiency Report:

This report is prepared monthly and sent to purchase committee. It contains information in respect of actual purchase prices of materials and standard prices of materials and the variance there on. The purpose of the report is to watch price movements and control cost of material.

(iii) Purchasing Report:

This report is prepared once in a month. It is also submitted to the purchase committee. It contains information in respect of actual purchases, consumption and stock figures. Objective of this report is to show the effect of policies laid down for purchasing.

(iv) Inventory Report:

This report is prepared as and when required for the top management. It reveals information regarding slow moving, dormant, and obsolete stocks. The objective of the report is to control the losses and investment in material.

(v) Stock Verification Report:

This report contains details regarding discrepancies between physical balance and record’s balance of stocks. This report is sent to storekeeper. The purpose of the report is to control storage of material.