Following are the main techniques of materials control: 1. ABC Analysis 2. Determination of stock levels 3. Economic Order Quantity (EOQ) Analysis 4. Perpetual Inventory System 5. Periodic Annual Inventory Control System 6. VED Analysis.
Technique # 1. ABC Analysis:
The concept of ABC Analysis was coined by Pareto, an Indian philosopher in the nineteenth century. It is a value based system of material control. In this technique materials are analysed according to their value so that costly and more valuable materials are given greater attention and care.
All items of materials are classified according to their value—high, medium and low values, which are known as A, B and C items respectively. ABC technique is some time called as “Always better control” method.
‘A’ Items:
ADVERTISEMENTS:
These are high value items which may consist of only a small percentage of the total items handled. On account of their high cost, these materials should be under the tightest control and the responsibility of the most experienced personnel.
‘B’ Items:
These are medium value materials which should be under the normal control procedures.
‘C’ Items:
ADVERTISEMENTS:
These are low value materials which may represent a very large number of items. These materials should be under the simple and economic methods of control.
The point of classifying stock into A, B and C categories is to ensure that material management focuses on ‘A’ item where tightest control should be installed. B items may be given less attention and C items least attention.
The ABC technique is a selective control which aims at concentrating efforts on those materials where attention is needed most. This is so because it is unwise to give equal attention to all items in stock. The items are listed and ranked in the order of their descending importance showing quantity and value of each item.
This is illustrated below with arbitrary percentage figure:
In the above table it is shown that 5%—10% of the total items account for as much as 70%—75% of the total value. These are A category items which need very strict control because of their high cost significance. The second type of items represent 20%—25% of the total quantity but account for 15%—20% of the total value. These are B items which need routine type of control.
Finally, the items representing 70%—75% of total quantity but account only for 5%—10% of total value. These C items are kept under simple physical control. The rules regarding purchasing, storing and issuing of various categories of items should be formed according to value and importance of materials.
Following are the main advantages of ABC Analysis:
ADVERTISEMENTS:
1. A strict control can be exercised on those items which represent large amount of capital invested.
2. Investment in inventory is regulated and funds can be utilized in the best possible way.
3. Storage cost also will be less as only the required quantity of materials alone are purchased.
4. Quick purchase of materials can be ensured by concentrating on fewer items that are required at one time.
ADVERTISEMENTS:
5. It is based on the principle of control by exception which gives best results especially when resources and staff are less.
6. It helps in maintaining enough safety stock for ‘C’ category items.
7. Selective control helps in maintaining high stock turnover rate.
Technique # 2. Determination of Stock Levels:
In order to guard against under-stocking and over-stocking, most of the large companies adopt a scientific approach of fixing stock levels.
ADVERTISEMENTS:
These levels are:
(i) Maximum level
(ii) Minimum level
(iii) Re-order/ ordering level
ADVERTISEMENTS:
(iv) Danger level, etc.
These levels are not permanent and must be changed to suit changing circumstances. Thus, change will take place if consumption of materials is increased or decreased or if in the light of a review of capital available, it is decided that the overall inventory must be increased or decreased.
The Modern Inventory Management makes use of research and statistical techniques in fixing stock-levels. However, given below is the description of various levels along with formula that are commonly used in their computations –
Factors Affecting Stock Levels:
Some of the factors which influence the stock levels are:
1. Anticipated rate of consumption
ADVERTISEMENTS:
2. Amount of capital available
3. Availability of storage space
4. Cost of storing
5. Procurement costs
6. Reliability of suppliers
7. Minimum order quantities imposed by suppliers
8. Risk of loss due to (a) obsolescence (b) Deterioration (c) Evaporation and (d) Fall in market prices, etc.
This is that level above which stocks should not normally be allowed to rise. The maximum level may however, be exceeded in certain cases, e.g., when usually favourable purchasing condition arise.
It is computed by the following formula:
Maximum Stock Level = Re-order level + Re-order Quantity – (Mini. Consumption × Mini Re-order Period)
The following factors are taken into account in setting this level:
1. Rate of consumption of material
2. Risk of obsolescence and deterioration
3. Storage space available
4. Cost of storage and insurance
5. Availability of funds needed
6. Seasonal considerations, e.g. bulk purchases during seasons at low prices
7. Reorder Quantity
8. Restrictions imposed by Government or local authority in respect of certain materials in which there are inherent risk of fire, explosion, etc.
The idea of setting maximum stock level is to ensure that capital is not unnecessarily blocked in stores and also to avoid loss due to obsolescence and deterioration.
It is that level below which stock should not normally be allowed to fall. This is essentially a safety stock and is not normally touched. In case of stock falling below this level, there is a risk of stoppage in production and thus top priority should be given to the acquisition of fresh supplies.
It is computed by the following formula:
Minimum Stock Level = Reorder level – (Normal Consumption x Normal reorder period)
In fixing this level, the following factors are considered:
1. Rate of consumption
2. The time required to acquire fresh supplies under top priority conditions so that stoppage in production can be avoided.
Re-Order Level or Ordering Level:
This is that level of material at which purchase requisition is initiated for fresh supplies. This level is fixed somewhere above minimum level. This is fixed in such a way that by re- ordering when materials fall to this level, then in the normal course of events, new supplies will be received just before the minimum level is reached.
It is calculated with the help of following formula:
Re-order level = (Max. Consumption × Max. Re-order Period)
In fixing this level the following factors are taken into consideration:
1. Rate of consumption of the material
2. Minimum level
3. Delivery time
4. Variation in delivery time.
This is a level at which normal issues of materials are stopped and materials are issued for important jobs only. This level is generally fixed somewhat below the minimum level. When stock reaches danger level, urgent action is needed for the replenishment of stock so that stoppage in production can be avoided. Purchasing materials on an urgent basis results in higher purchasing cost.
It is calculated with the help of following formula:
Danger Level = (Normal Consumption x Maximum re-order period under emergency condition)
Average Stock Level:
It is calculated with the help of following formula:
Average Stock Level = 1/2 (Mini. Stock level + Max. Stock level).
Technique # 3. Economic Order Quantity (E.O.Q.) Analysis:
Economic order Quantity is also termed as Re-order Quantity. Economic Order Quantity is that size of the order which gives maximum economy in purchasing any material and ultimately contributes towards maintaining the material at the optimum level and at minimum cost.
While fixing economic order quantity, two types of costs should be taken into consideration:
1. Ordering Cost:
This is the cost of placing on order with the supplier. It includes the following expenses:
(a) Cost of staff posted in the purchasing department, inspection section and payment department.
(b) Cost of stationery, postage and telephone charges, etc. Thus, this type of cost includes cost of floating tenders, cost of comparative evaluation of quotations, cost of paper work and postage involved in placing the order, cost of inspection and cost of accounting and making payments. In other words the cost varies with the number of orders.
2. Carrying Cost:
It is the cost of holding the materials in the store and includes:
(a) Cost of storage space which could have been used for some other purpose.
(b) Cost of maintaining the materials to avoid deterioration.
(c) Cost of bins and racks that has to be provided for the storage of materials.
(d) Transportation cost in relation to stock.
(e) Cost of spoilage in stores and handling.
(f) Cost of obsolescence on account of some of the materials becoming obsolete after some time of storage either due to change in the process or product.
(g) Amount of interest payable on the money locked-up in the materials.
(h) Clerical costs.
(i) Insurance cost, etc.
To sum up, economic order quantity is determined keeping in view the ordering cost and carrying cost.
With the interaction of these two costs, the economic ordering costs during a particular period are equal to carrying costs during that period and total cost to order and carry is the lowest as is made clear in the diagram given below:
From the above diagram it is clear that inventory carrying cost and ordering costs are of opposing nature. For example – if an attempt is made to reduce the inventory carrying cost by keeping stock as low as possible, the cost of ordering will go up because the number of replenishment orders will automatically rise on the other hand, if order is placed for a large quantity at one time, the stock will remain longer in stores and inventory carrying cost will go up. The problem is, therefore, to balance these two types of costs and the economic order quantity is fixed at a point where the aggregate cost is the minimum.
This is shown in the above diagram in which the line of cost of ordering has been shown sloping downward indicating lower cost when large quantity is purchased and the line representing inventory carrying cost going upward indicating higher costs for holding larger stocks. Thus, the economic order quantity, which is the ideal order size is at a point where total cost curve is at its lowest point.
Assumption of Economic Order Quantity (EOQ):
EOQ is based on the following assumptions:
1. Prices of the item remain constant which keep carrying cost stable.
2. The quantity of the item to be consumed during a particular period is well known, i.e., quantity to be consumed is certain.
3. There are dynamic conditions of the supply which enable a firm to place as many orders as it needs.
4. Purchase price of material per unit is constant.
5. Ordering cost per unit is constant.
6. As soon as the previous stock is finished, ordered material is received.
EOQ can be computed with the help of following formula:
Where,
EOQ = Economic Order Quantity
2 = It is a constant figure
A = Annual consumption of materials in units or rupees
S = Cost of placing an order
I = Annual carrying cost of storing one unit.
Technique # 4. Perpetual Inventory System:
This is a system of stock control in which continuous record of receipt and issue of materials is maintained by the stores department. It shows the physical movement of stocks and their current balance.
A perpetual inventory system is usually supported by a programme of continuous stock-taking. In other words, perpetual inventory system means the system of records, whereas continuous stock-taking means the physical checking of actual stock with the records.
Strictly speaking the perpetual inventory system means maintenance of such records (stock control cards, bin cards and the stores ledger) that will show the receipts, issue and balance of all items in stock at all times.
But to ensure accuracy, the system must be supplemented by a system of continuous stock checking which ensures that physical stock agrees with the book figures. The system is essential for planning production and to see that production is not interrupted due to want of materials and stores.
The Chartered Institute of Management Accountants London defines the perpetual inventory system as, “a system of records maintained by the controlling department, which reflects the physical movements of stocks and their current balance.”
The Success of perpetual inventory system depends upon the following:
1. Maintenance and up-to-date writing up of the following records –
(a) the store ledger or bin cards.
2. Reconciling the quantity balances shown by store ledger and bin card.
3. Checking the physical balance of a number of items every day sympathetically and by rotation.
4. Explaining promptly the causes of discrepancies between physical balances and book figures.
5. Making corrective entries where called for after noting the discrepancies.
6. Removing the cause of the discrepancies.
Advantages:
The following are the advantages of the perpetual inventory system:
1. It helps in avoiding the long and costly work of physical checking of all the stocks at the end of the year.
2. It also avoids dislocation in production which arises in the case of periodic stock-taking at the end of the year.
3. As stock figures are readily available at all times, the Profit and Loss Account and Balance Sheet can be easily prepared at interim periods.
4. The system acts as moral check on the staff of the stores department to work honestly and to keep-up-to-date records.
5. A system of internal check remains in operation all the time.
6. Discrepancies are readily discovered and rectified. This gives an opportunity for preventing a recurrence in future.
7. The system helps in keeping the stocks within the limits decided upon by the management so that excessive working capital is not sunk in the stock.
8. A detailed and reliable check on stores is obtained.
9. It makes available correct stock figures for claim to be lodged with the Insurance company for loss on account of stock destroyed by fire.
10. As the work of recording and continuous stock-taking is carried out systematically and without undue haste, the figures are more reliable.
11. Planning of production can be done according to the availability of the material in the stores because the management is constantly kept informed of the stores position.
12. It reveals the existence of surplus, dormant, obsolete and slow moving materials and hence remedial action can be taken.
13. It helps in avoiding the under-stocking and over-stocking of materials and the dangers associated with them.
Besides the above advantages of perpetual inventory system, it suffers from the following limitations:
(i) The system is expensive and a small concern cannot afford to implement this system.
(ii) The information about actual stock of a particular item on a particular day may not be available, only book figures above are available.
Technique # 5. Periodic/Annual Inventory Control System:
Under this system, stock-taking is undertaken at the end of the accounting year. As the stock taking involves verifying the physical quantities of stores in hand, some firms temporarily suspend plant operations when this is done. This is because it is rarely feasible to take stocks when production is going on. Thus, the annual stock- taking should be organised well in advance to minimise production holds up.
The following points are to be considered while conducting periodic stock verification:
1. A person should be appointed to control the whole operation.
2. While stock verification is going on, store room should not be opened for issues and receipts.
3. All damaged, deteriorated or used items must be recorded separately.
4. The stock-taking sheets must be under the control of one individual, consecutively numbered as issued to staff on duty as required.
5. Materials received should be listed separately but still under inspection.
6. Make each person responsible for a particular section.
7. Show the method of check i.e. count, weight, measurement on the stock sheet for each item.
8. The method of pricing should be known and if possible, it is desirable to enter all prices in terms of units of issue on the stock sheets in advance.
9. In case of decentralised store systems, the materials in transit at the date of stock-taking must be taken into account.
Following are the main limitations of this system:
1. It takes more time to verify the stock.
2. Under this system the factory has to be closed during the period of stock verification which results in the loss of production time.
3. Sometimes a complete check on materials may not be exercised often those materials which are not used go unnoticed.
Technique # 6. VED Analysis:
VED-vital, essential, desirable, analysis is used primarily for control of spare parts. The spare parts can be divided into three categories-vital, essential and desirable, keeping in view the criticality to production. The spares, the stocks out of which even for a short time will stop production for quite some time and where the cost of stock out is very high, are known as vital spares. The spares, the absence of which cannot be tolerated for more than a few hours or a day and the cost of lost production is high and which are essential for the production to continue, are known as essential spares.
The desirable spares are those spares which are needed but their absence for even a week or so will not lead to stoppage of production. Some spares, through negligible in monetary value, may be vital for the production to continue and require constant attention. Such spares may not receive the attention they deserve, if they are maintained according to ABC analysis because their value of consumption is small. So, in their cases, VED analysis is made to get the effective results.