Quick Notes on Inventory Control | Cost Accounting

After reading this article you will learn about: 1. Meaning of Inventory Control 2. Classification of Inventory Control 3. Commonly used Inventory Control Items 4. Stock levels 5. Levels of Materials.

Meaning of Inventory Control:

Inventory control can be defined as the system used in a manufacturing concern to control the firms investment in Stock. The system involves the recording and monitoring of various stock levels, forecasting future demands and deciding when and how much quantity or order. The overall objective of inventory control is to minimise the costs associated with stock.

Classification of Inventory Control:

(i) Carrying Costs—Carrying Costs include:

(a) Rent, rates, lighting, heating, refrigeration and air-conditioning costs of stores.

(b) Material handling costs.

(c) Insurance and security costs.

(d) Stores staffing, equipment, maintenance and running costs.

(e) Deterioration and obsolescence.

(f) Pilferage, evaporation and damage.

(g) Interest on Capital invested in stocks.

(ii) Costs of obtaining stock or Ordering Costs include:

(a) Clerical and administrative costs of Purchasing, Accounting and Reception of Goods.

(b) Transport Costs.

(c) Set up and tooling costs where goods are manufactured internally and planning, production control costs associated with the internal order.

(iii) Costs of being without Stock or Stock-out Costs:

(a) Cost of production stoppages caused by want of raw materials.

(b) Extra costs associated with urgent and small quantity, replenishment orders.

(c) Loss of future sales because customers may find out other sources.

Having considered the costs involved in stock we find that one of the major objectives of a stores control system is to ensure that ‘Stock outs’ do not occur and surplus stocks do not exist. Stocks out hampers production while surplus stocks lock up working capital. Both are equally harmful.

Under stock leads to loss of customers’ goodwill and reduced profits. On the other hand, surplus stocks result in increased storage costs which also leads to reduced profits. So, it is very essential to maintain ideal stock levels to obviate the demerits of both overstocks and under stocks. Every factory maintains different stock levels to achieve the objectives of efficient inventory control.

Commonly used Inventory Control Items:

(A) Inventory Control Terminology:

(i) Lead time:

This is a period of time between ordering and replenishment.

(ii) Economic Order Quantity [EOQ]:

This is a calculated recorder quantity which minimizes the balance of cost between carrying costs and ordering costs.

(iii) Buffer Stock or Minimum Stock or Safety Stock:

This is a stock allowance to cover the demand of materials during the lead time. This is the level below which stock is not allowed to fall.

(iv) Maximum level:

This is a stock level calculated as the maximum desirable stock to be maintained and is an indicator to the management to show when stocks have risen too high.

(v) Reorder level:

This is the level of stock at which a further replenishment order should be placed. This stock level is dependent on the lead time and the rate of consumption during the lead time.

(vi) Reorder Quantity:

The quantity of the replenishment order.

(B) Economic Order Quantity [EOQ]:

Objectives:

(i) How much to be bought and

(ii) When should they be bought.

So, any inventory planning model focuses on the twin problems of size and timing.

Definition:

Economic Order Quantity may be defined as the most favourable quantity or the optimum quantity of materials which can ideally be purchased each time most economically. The EOQ is the size that will result in minimum total annual costs of the item of material in question.

Factors to be Considered in Deciding EOQ:

 (a) The cost of materials.

(b) The inventory carrying charges.

(c) The ordering cost.

So, the total costs of an inventory policy consist of: Total acquisition cost + Total ordering cost + Total carrying cost.

Carrying Costs:

Carrying costs usually consist of:

(i) Loss of interest on investments in inventory.

(ii) Cost of storage space.

(iii) Loss that may arise out of breakage, obsolescence, deterioration, pilferage etc.

(iv) Cost of insurance.

(v) Taxes on inventories.

Ordering Costs:

Ordering costs consist of:

(i) Clerical costs of preparing a purchase order.

(ii) Postage, telegram charges and telephone bills for placing an order.

(iii) The costs of stationery and other consumables required by the purchasing department relating to the number of orders.

(iv) Processing and receiving costs relating to the number of orders processed.

Determination of EOQ:

The EOQ can be determined by the application of the following formula:

Stock levels (How much to Purchase) for Inventory Control:

Maintenance of various stock levels is very important from costing point of view. For efficient control of both stocks and purchases certain stock levels are fixed up for every item of stores. Adequate stocks of raw materials, components and parts are needed for various reasons.

Advantages:

(i) Ideal stock levels guarantee a constant flow of raw materials to production depart­ments.

(ii) Adequate stocks ensure that production does not come to a standstill.

(iii) Overstocking leads to increased cost. Stock levels avoid overstock.

(iv) Maintenance of ideal stock levels guarantees that working capital is not unnecessarily locked up.

(v) Various stock levels serve as indices for initiating action on time.

(vi) Risk of loss due to depreciation in quantity, deterioration in quality and obsolescence of the materials during storage can be avoided if proper stock levels can be maintained.

Levels of Materials for Inventory Control:

The various levels fixed for effective stock control to achieve the above advantages are:

(i) Maximum level;

(ii) Re-ordering level;

(iii) Minimum level and; and

(iv) Danger level.

Maximum Level:

Maximum level is the level above which stocks are not allowed to rise. It is advisable to keep the level as low as possible.

In fixing the maximum level of stock the following factors are to be carefully considered:

(i) Maximum requirement of the store for production at any point of time.

(ii) The rate of consumption of the material.

(iii) The time necessary to obtain delivery of the materials.

(iv) Nature and features of the store.

(v) Storage facilities.

(vi) Cost of storage and insurance.

(vii) Availability of funds and the price of the store,

(viii) Economy in prices.

Maximum, Minimum and re-order levels are not static. They must be varied to suit changing circumstances. Thus, alterations will take place if the usage of certain materials is increased or decreased, if the re-order period changes, or if, in the light of a review of Capital available, it is decided that the overall inventory must be increased or decreased.

Determination of Maximum Level:

Re-order level + Re-order quantity Minus (Minimum consumption x Minimum time required for delivery).

Illustration:

From the following information calculate Maximum level:

Re-order quantity — 6,000 units

Time required—2 to 4 months

Re-order level—6,000 units

Minimum consumption—500 units

Maximum Level = Reorder level + Reorder quantity less (Minimum consumption x minimum time for delivery) = 6,000 + 6,000 – (500 x 2) = 12,000 – 1,000 = 11,000 units.

(ii) Reorder Level:

Reorder-level is the point at which purchase requisition for fresh supplies is initiated by the store. This point is lower than the maximum level and fixed to avoid excess stock. It is higher than minimum stock level so as to cover emergencies like delay in supply or abnormal usage of the material.

How to Determine?

Reorder level is determined by the application of the following formula:

Maximum reorder period x maximum usage.

Illustration:

From the following information find out reorder level:

Maximum consumption 2,000 units per month. Time required for delivery 2-4 months.

The Reorder level = Maximum usage x Maximum reorder period

= 2,000 x 4 = 8,000 units.

(iii) Minimum Stock Level:

This is the level below which stocks are not allowed to fall. If stocks go below this level, store will fail to supply materials to production department which will lead to stoppage of production. This level of stock is a ‘buffer stock’ which is maintained to make the materials available in emergencies arising out of delay in supply.

The following factors are to be taken into consideration in fixing the minimum level:

(i) Nature of the item of materials

For special items of materials which are purchased against customers’ specific orders, no minimum level is required.

(ii) The maximum time required for delivery.

This is known as lead time. This indicates the time lag between the date of placing order with the supplier and receiving date of materials.

(iii) Rate of consumption of the material.

Here, the normal rate of consumption is to be considered.

How to Find out Minimum Level?

Minimum level = Reorder level – (normal usage x average reorder period.)

Problem 2:

From the following particulars find out:

(i) Re-order stock level,

(ii) Minimum stock level,

(iii) Maximum stock level, and

(iv) Average stock level.

Re-order quantity – 10,000 units

Time required for delivery 2-4 months

Maximum consumption 2,500 units p.m.

Normal consumption 2,000 units p.m.

Minimum consumption 1,500 units p.m.

Solution:

(a) Reorder Stock level:

Maximum consumption x Maximum Reorder period = 2,500 x 4 = 10,000 units

(b) Minimum Stock level:

Reorder level – (Normal consumption x Normal reorder period) = 10,000 – (2,000 x 3) = 10,000 – 6,000 = 4,000 units

(Normal reorder period = 4 + 2/2 = 6/2 = 3 months.)

(c) Maximum Stock level:

Reorder quantity + Reorder level – (Minimum consumption x Minimum reorder period)

= 10,000 + 10,000 – (1,500 x 2) = 20,000 – 3,000 = 17,000 units

(d) Average Stock level:

Maximum level + Minimum level = 17,000 + 4,000/2 = 21,000/2 = 10,500 units