Inventory Management: Control Levels, Methods and EOQ model!
The objective of inventory management is to minimize the total of inventory carrying and ordering costs while ensuring that ‘stock-outs’ do not occur and the surplus stocks are not accumulated and carried.
Inventory Management Control Levels:
Firms establish control levels for standard materials, which are in regular use. Control levels cannot be established where the rate of consumption is erratic, market of the material is uncertain, or the material is not in common use.
Firms establish safety stock level. Safety stock provides the cushion against the stock- out position. It is the stock in excess of the expected usage during the lead time.
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1. Reordering Level:
This is the level at which the store keeper initiates purchase requisition.
Reordering level = Maximum reorder period × Maximum usage
Alternatively,
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Reordering level = Safety stock + Average reorder period × Average usage
The reorder period (also called lead time) is the time taken to obtain requirement from the time the need is ascertained.
2. Minimum Level:
This is the level at which the purchase department initiates actions to expedite supply.
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Minimum level = Reordering level – (Average re-order period × Average usage)
3. Maximum Level:
This is the level at which the consumption pattern and the reorder period are reviewed.
Maximum level = Reordering level + Reordering quantity – (Minimum reorder period × Minimum usage)
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At this level emergent purchase actions are initiated. It is fixed somewhere below the minimum level.
Methods for Inventory Management:
1. Economic Order Quantity (EOQ):
Reorder quantity is the quantity to be covered in a single purchase order.
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The following factors are considered to determine the reorder quantity:
i. Consumption pattern
ii. Reorder period
iii. Availability of resources
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iv. Nature of the material, e.g., risk of deterioration or evaporation
v. Risk of price fluctuations
vi. Risk of obsolescence
vii. Storage space available
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viii. Seasonal considerations as to the price and availability of supplies
ix. Quantity discount
x. Carrying cost and ordering cost
The most important single factor which influences the decision on reorder quantity is the total of carrying cost and ordering cost. Carrying cost and ordering cost move in opposite directions. Carrying cost increases, while ordering cost decreases, with increase in the reorder quantity. EOQ model aims at minimizing the total of carrying cost and ordering cost.
The model assumes the following:
i. Demand and purchase order lead time are known with certainty.
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ii. Cost per unit is unaffected by order size and, therefore, it is irrelevant in determining EOQ.
iii. The cost of stock-out is prohibitively high and, therefore, stock is replenished before stock-out occurs.
iv. Ordering cost per order is constant and does not vary with the size of the order.
v. The carrying cost varies directly with the average inventory.
Above assumptions are simplistic and are the main weaknesses of the EOQ model.
2. ABC Analysis (Selective Control Plan)—Pareto Analysis:
ABC analysis is the application to stock holding of Pareto’s Law derived by a nineteenth century Italian economist who observed that a minority of the population owned the majority of his country’s wealth. Applied to stocks, Pareto’s law shows that the majority of inventory value will be represented by relatively few items.
ABC analysis is a control technique that divides items into categories of importance to enable the firm to use different control systems for each group of materials. The most elaborate procedures of controlling stock may be applied only to the most important items.
Generally, only a small number of items (say, 10% of the total number) account for substantial usage (say, 70% of total cost), while a large number of small value items (say, 70% of the total number) accounts for a very small usage (say, 10% of the total cost). The first is classified as Category ‘A’ and the second as Category ‘C’.
The in-between items (say, 20% in number representing 20% of total cost) are classified as Category ‘B’ items. Simple and less expensive controls are applied to Category ‘C’ items, while rigorous controls are applied to Category ‘A’ items.
ABC classification does not rank stocks in terms of their criticality. Sometimes shortage cost may be very high for Category ‘C’ items. E.g., delayed dispatch of a very high value equipment (e.g. compressor) for want of some small value components might result in a very high opportunity cost of the funds locked up in an otherwise 100% complete equipment.
However, building of a slightly higher ‘Safety stock level’, disciplined recording of transactions and proper monitoring of stock level would effectively avoid the shortage position.
The following procedure may be useful for classifying items under Categories A, B, and C:
(a) Rank all the items according to their annual usage value in a descending order putting the highest value item as first.
(b) Show cumulative percentage of total consumption against each stock item.
(c) Similarly, show against each item, cumulative percentages of the total number of items.
(d) A decision is taken about the percentages of total usage value that should be covered by the various categories.
It must be noted that ABC plan is drawn on the basis of total cost (i.e. average number of units consumed average price of the units) as against the unit cost of each item of raw material consumed. In other words, an item whose unit cost is highest among the items consumed may not get included in Category ‘A’ if average consumption, in quantity, is very low. On the other hand, an item whose unit cost is not very high may get included in Category ‘A’, if consumption, in quantity, is high.
The two-bin system of inventory controls has many variations of the basic procedure. Under this system, for each item, two bins are maintained. If materials are not kept in bins, two separate piles are made for each material. One of the two bins contains enough stock for usage during the period between receipts of fresh supply of the material to the date of placing the next order.
The other bin contains quantity to cover normal usage during reorder period plus ‘safety stock’. Purchase requisition is issued immediately when the second bin is tapped.
This system is simple and, in addition to being helpful in inventory control, facilitates easy handling, physical counting, and control of the materials.
JIT Production:
Just-in-time is a management philosophy which aims at eliminating waste from every aspect of manufacturing and its related activities. The term JIT in the context of production refers to the approach of producing only what is needed, when it is needed, and in just the amount needed. In other words, JIT production means producing required parts, at the required time, in the required amount, at each step of the production process in the most economical manner.
JIT philosophy aims at reducing waste. Waste is defined by Fujio Cho of Toyota as ‘anything other than the minimum amount of equipment, materials, parts, space and worker’s time, which are absolutely essential to add value to the product’. Thus waste is any resource used in excess of the minimum amount required to add value to the product.
More specifically, JIT seeks to achieve the following goals:
(a) Elimination of non-value-added activities
(b) Zero inventory
(c) Batch sizes of one
(d) Zero breakdown
(e) A 100% on-time delivery service
In practice, although firms using JIT may not achieve these goals fully, JIT creates an environment of continuous improvement.
The following are the three key features of JIT production:
(a) The production line is run on a demand-pull basis, so that activity at each workstation is authorized by the demand of downstream workstations. Thus, parts move through production system based on end unit demand, focusing on maintaining a constant flow of parts rather than batches of WIP.
(b) Set-up time and manufacturing lead time are minimized. Demand-led production may require manufacturing small quantities of the product at a time and producing small batches is economical only if set-up times are small.
(c) The production line is stopped if parts are absent or defective work is discovered. In absence of buffer stock, emphasis is placed on doing the job right the first time. The focus is on eliminating the root causes of defect, waste, or rework. JIT goes hand in hand with total quality.
(d) Production is organized in work cells. It reduces material handling costs.
JIT production is perhaps most appropriate where large volume products are made, or where it is easy to switch machinery from making one product to another.
In a JIT environment:
(i) Absence of large materials and work-in-progress inventory enables managers to control inventory visually through personal inspection,
(ii) Cost of holding work-in-progress constitutes a lower percentage of total cost of production;
(iii) There is no need for an elaborate cost accounting system of stores requisition, material transfers notes, rework accounting, and so forth.
All the above provide a tremendous cost advantage to firms adopting JIT production.
Work Cells (Manufacturing Cells):
‘Work cells’ or ‘manufacturing cells’ refers to the system of organizing manufacturing process in a cluster.
Main features of work cells are:
(a) Organizing related manufacturing process in clusters
(b) Grouping of all the different types of equipment used to manufacture a given product
(c) Grouping all activities from raw material stage to the finished goods stage in the same cell
‘Work cell’ system reduces movement of materials and work-in-progress, and provides visual control. This reduces cost of material handling and supervision and improves quality of production.
JIT purchasing demands working in close cooperation with vendors. Usually firms work with a few vendors and develop a kind of partnership with them. Firms using JIT purchasing enter into long-term contracts with them to enable vendors to plan their annual production.
JIT purchasing aims at achieving smooth flow of materials in vendors’ factories. They pay premium for on-time delivery of high-quality goods in the exact quantity required. Thus, the responsibility for checking quality and quantity is placed on vendors.
Proponents of JIT purchasing argue that firms following conventional purchasing policy overestimate ordering cost and underestimate holding cost of inventories.
The argument seems plausible if we include in the holding cost, the cost of quality (e.g. inspection cost of incoming materials, cost of returning defective materials, scrap cost, rework cost, cost of idle capacity arising due to defective materials), the cost of delayed delivery (e.g. expediting cost, contribution margin of lost sales, cost of idle capacity), and the cost of early delivery (e.g. incremental carrying cost). All these costs should be viewed as derived holding cost.
Ordering cost comes down significantly for firms which use computer-aided integrated system for production and material planning.
Let us consider how these factors affect EOQ model.
Thus, under JIT perception, EOQ is much lower as compared to EOQ under conventional perceptions.
Under JIT environment, EOQ model has lost its relevance because the focus is on synchronization of delivery and usage. A firm compares reduction in costs of quality, costs of delayed delivery, costs of early delivery, and ordering costs (e.g. cost of negotiations, cost of placing purchased order, and cost of processing documents for making payments against each transaction) with premium payable to suppliers to estimate the net benefit from JIT purchasing. Firms using JIT purchasing have reported significant savings in cost.
Kanban is a Japanese word meaning ‘display’ or ‘instruction card’. In a factory setting, the card describes the part number, the quantity of parts that should accompany the card, the source of supply, the delivery location, the reorder point on the shelf stack, and the lead time negotiated between the internal customer and producer or the plant and an external subcontractor.
Firms use ‘Kanban’ or any similar communication system as a production control tool. The downstream process (subsequent step in the production process) details part from the upstream process (previous step in the production process) according to the information described in the detached Kanban card (move card).
People in the production process produce parts according to the information described on the Kanban card (production card). If there is no Kanban card, there will be no production or transfer of materials.
The Kanban card is always attached to the bin except when it is in transit to order production or transportation of parts. Kanban system works efficiently only if 100% quality parts are produced.
Kanban, when used in conjunction with JIT, reduces lead time, decreases inventory, and improves productivity by linking different processes together.