Unit-3
Inventory Management
EOQ Model
The economic order quantity (EOQ) refers to the ideal order quantity a company should purchase in order to minimize its inventory costs, such as holding costs, shortage costs, and order costs. EOQ is necessarily used in inventory management, which is the oversight of the ordering, storing, and use of a company's inventory. Inventory management is tasked with calculating the number of units a company should add to its inventory with each batch order to reduce the total costs of its inventory.
Formula for EOQ
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2. Fixing Levels of Material.
(a) Minimum Level
This represents the quantity which must be maintained in hand at all times. If stocks are less than the minimum level, then the work will stop due to shortage of materials. Following factors are taken into account while deciding minimum stock level:
(i) Lead Time:
A purchasing firm requires some time to process the order and time is also required by the supplier/vendor to execute the order. The time taken in processing the order and then executing it is known as lead time. It is essential to maintain some inventory during this period to meet production requirements.
(ii) Rate of Consumption:
It is the average consumption of materials items in the industry. The rate of consumption will be decided on the basis of past experience and production plans.
(iii) Nature of Material:
The nature of material also affects the minimum level. If a material is required only against special orders of the customer then minimum stock will not be required for such materials. Wheldon has given the following formula for calculating minimum stock level:
Minimum stock Level = Re-ordering Level – (Normal Consumption x Normal Reorder Period)
(iv) Re-ordering Level: When the quantity of materials reaches a certain level then fresh order is sent to procure materials again. The order is sent before the materials reach minimum stock level.
(b) Maximum Level
It is the quantity of materials beyond which a firm should not exceed its stocks. If the quantity exceeds maximum level limit then it will be termed as overstocking. A firm avoids overstocking because it will result in high material costs. Overstocking will lead to the requirement of more capital, more space for storing the materials, and more charges of losses from obsolescence. Maximum stock level will depend upon the following factors:
1. The availability of capital for the purchase of materials in the firm.
2. The maximum requirements of materials at any point of time.
3. The availability of space for storing the materials as inventory.
4. The rate of consumption of materials during lead time.
5. The cost of maintaining the stores.
6. The possibility of fluctuations in prices of various materials.
7. The nature of materials. If the materials are perishable in nature, then they cannot be stored for long periods.
8. Availability of materials. If the materials are available only during seasons then they will have to be stored for the future period.
9. Restrictions imposed by the government. Sometimes, government fixes the maximum quantity of materials which a concern can store. The limit fixed by the government will become the deciding factor and maximum level cannot be fixed more than that limit.
10. The possibility of changes in fashions will also affect the maximum level.
It is calculated as-
Maximum Stock Level = Reordering Level + Reordering Quantity – (Minimum Consumption x Minimum Reordering period)
(c) Danger Level
It is the level below which stocks should not fall in any case. If danger level approaches, then immediate steps should take to replenish the stocks even if more cost is incurred in arranging the materials. Danger level can be determined with the following formula:
Danger Level = Average Consumption x Maximum reorder period for emergency purchases.
ABC Analysis
Certain products need more attention than others. Using an ABC analysis lets you prioritize your inventory management by separating out products that require a lot of attention from those that don’t. Do this by going through your product list and adding each product to one of three categories:
1.High-value products with a low frequency of sales
2.Moderate value products with a moderate frequency of sales
3.Low-value products with a high frequency of sales
Items in category A require regular attention because their financial impact is significant but sales are unpredictable. Items in category C require less oversight because they have a smaller financial impact and they're constantly turning over. Items in category B fall somewhere in-between.
ABC method of inventory control involves a system that controls inventory and is used for materials and throughout the distribution management. It is also known as selective inventory control or SIC. ABC analysis is a method in which inventory is divided into three categories, i.e. A, B, and C in descending value. The items in the A category have the highest value, B category items are of lower value than A, and C category items have the lowest value.
Need for Prioritizing Inventory
Item A:
In the ABC model of inventory control, items categorized under A are goods that register the highest value in terms of annual consumption. It is interesting to note that the top 70 to 80 per cent of the yearly consumption value of the company comes from only about 10 to 20 per cent of the total inventory items. Hence, it is crucial to prioritize these items.
Item B:
These are items that have a medium consumption value. These amounts to about 30 percent of the total inventory in a company which accounts for about 15 to 20 percent of annual consumption value.
Item C:
The items placed in this category have the lowest consumption value and account for less than 5 percent of the annual consumption value that comes from about 50 percent of the total inventory items.
Pros of ABC inventory management
•Aids demand forecasting by analyzing a product’s popularity over time
•Allows for better time management and resource allocation
•Helps determine a tiered customer service approach
•Enables inventory accuracy
•Fosters strategic pricing
Cons of ABC inventory management
•Could ignore products that are just starting to trend upwards
•Often conflicts with other inventory strategies
•Requires time and human resources
Stock Levels
To avoid stock-outs firms maintain safety stocks of inventory. The safety stock is the minimum level of inventory desired for an item given the expected usage rate and the expected time to receive an order. If an order is placed when the inventory reaches 12,000 units instead of 10,000 units, the additional 2,000 units constitute a safety stock.
The manager expects to have 2,000 units in stock when the new order arrives at the scheduled time. The safety stock protects as a safe-guard against stock-outs ‘position due to unanticipated increase in usage resulting from an unusually high demand and/or an uncontrollable late delivery of inventories.
The increase in the amount of inventory held as safety stock reduces the chances of stock-out and therefore, reduces stock-out costs over the long-run. The level of inventory investment is, however increased by the amount of safety stock. The optimum level of safety stock is determined by the trade-off between the stock-out and the carrying costs.
Thus, the best level of safety stock for a given item depends on stock-out costs, variability of usage rates and delivery times. The safety stock level is the multiplication of the average demand during a period of the maximum delay and the probability of its occurrence.
If the usage rate and delivery time or lead time can be forecasted with a high degree of accuracy and if the cost of stock-out is estimated to be small, then little or no safety stock will need. If the circumstances are not so favorable, then the significant investment in safety stock will be desirable.
VED Analysis
Meaning of VED Analysis
VED analysis is an inventory management technique that classifies inventory based on its functional importance. It categorizes stock under three heads based on its importance and necessity for an organization for production or any of its other activities. VED analysis stands for Vital, Essential, and Desirable
V-Vital category
As the name suggests, the category “Vital” includes inventory, which is necessary for production or any other process in an organization. The shortage of items under this category can severely hamper or disrupt the proper functioning of operations. Hence, continuous checking, evaluation, and replenishment happen for such stocks. If any of such inventories are unavailable, the entire production chain may stop. Also, a missing essential component may be of need at the time of a breakdown. Therefore, order for such inventory should be before-hand. Proper checks should be put in place by the management to ensure the continuous availability of items under the “vital” category.
E- Essential category
The essential category includes inventory, which is next to being vital. These, too, are very important for any organization because they may lead to a stoppage of production or hamper some other process. But the loss due to their unavailability may be temporary, or it might be possible to repair the stock item or part.
The management should ensure optimum availability and maintenance of inventory under the “Essential” category too. The unavailability of inventory under this category should not cause any stoppage or delays.
D- Desirable category
The desirable category of inventory is the least important among the three, and their unavailability may result in minor stoppages in production or other processes. Moreover, the easy replenishment of such shortages is possible in a short duration of time.
Importance of VED Analysis
It is of utmost importance to any organization to maintain an optimum level of inventory. Maintaining inventory has its costs, and hence, this analysis bifurcates inventory in three parts to help in managerial decisions on inventory maintenance. There are four types of costs to maintain stock which are:
Item cost
This is the cost or price of the inventory items. It is the actual purchase value of holding stock. Therefore, it will be high with more inventory and vice-versa.
Ordering / Set-up Cost
The purchase of inventory involves certain costs. These may include transportation charges, packing charges, etc.
Holding Costs
After the purchase of inventory items, there are a few costs too. These may be related to storage, insurance charges of stock or inventory, labor costs associated with the handling of stock, etc. Moreover, it includes any damage, leakage, or pilferage of the stock in hand.
Stock Out Cost
These costs are the result of an inventory item running out of stock. It includes loss of production due to a spare part getting out of stock. Moreover, this may delay the product sale. Also, the product itself may get out of stock. Such losses are a part of the stockout cost.
VED analysis is a crucial tool to understand and categorize inventory according to its importance. Because of it, the management can optimize costs by investing more in the vital and essential categories of stock and lesser in the desirable category of inventory.
Usage of VED Analysis
Small and big organizations both widely use VED analysis. The most important application of this analysis is in maintaining medical inventory in hospitals and their drug stores. Drugs and related supplies comprise a significant portion of a hospital’s budget. Moreover, maintaining the right quantity of the right drugs is an extremely challenging task for management. While a shortage of critical medicine can lead to crises and even loss of lives, an abundance of non-important medications can lead to blockage of money and space, both.
VED analysis helps in dividing medicines into the three categories as per their usage and importance. Therefore, medication in the vital group is to be kept in stock compulsorily, as they would be critical for patients. Medicines which are a bit less risky, or which can be obtained from other sources too at short notice, become part of an essential category. Those that are least critical and their shortage will not pose any danger to a patient’s health, and lives get its place in the desired class. As a result, the hospital’s management can wisely allocate resources on medical inventory as per their respective VED categories.
FSN Analysis
Meaning of FSN Analysis
FSN Analysis is an inventory management technique which is based on the rate of consumption of spares and goods in an organization. This analysis divides the inventory into three categories based on their speed or rate of utilization, their consumption rate, and average stay. FSN stands for Fast-moving, Slow-moving, and Non-moving.
Fast-moving inventory
Fast-moving inventory comprises of inventory, which moves in and out of stock fastest and most often. Therefore, these goods have the highest replenishment rate. Items in this category generally comprise less than 20% of the total inventory.
Slow-moving inventory
Items in this category move slower, and hence, their replenishment is also slower. This category comprises of around 35% of the total inventory in an organization.
Non- moving inventory
The last category of this analysis is the least moving portion of the inventory and also includes the dead stock. Replenishment of such inventory may or may not take place at all after utilization. This category can go as high as 55%-60% of the total inventory in organizations.
FSN Analysis and calculation
FSN analysis makes use of a few parameters to arrive at the three categories of goods in the inventory. Since it is a scientific analysis and not based on the judgment of a few individuals, formulas are used to arrive at figures which tell us if a good belongs to a fast-moving or slow-moving or non-moving category.
Average Stay: Number of cumulative days inventory is held/ (Opening Balance of the good + Number of goods received during the period)
Consumption Rate: Total number of goods issued/ Total period
The next step is to calculate the Cumulative average stay and Cumulative consumption rate.
Cumulative average stay: Average stay of the item + Average stay of all goods having an average stay more than itself
Cumulative consumption rate: Consumption rate of the item + Consumption rate of all goods that are consumed faster
Percentage average stay: (Cumulative average stay of the item/ Cumulative average stay of all goods) x 100
Percentage consumption rate: (Cumulative consumption rate of the item/ Cumulative consumption rate of all goods) x 100
Interpretation
As per Cumulative average stay, FSN analysis goods have three categories as:
• Fast-moving goods comprise of 10% or lesser of the average cumulative stay calculated.
• Slow-moving goods comprise of 20% or lesser of the average cumulative stay calculated.
• Non-moving goods comprise of 70% or lesser of the average cumulative stay calculated.
Therefore, as per the classification, fast-moving goods stay only 10% or lesser of the cumulative average stay of the total inventory. In other words, they have the quickest movement time of all the inventory.
As per Cumulative consumption rate, the three categories will be:
• Goods with 70% or less of consumption rate are fast-moving.
• Goods with 20% of the cumulative consumption rate are slow-moving.
• Items with 10% or lesser of the cumulative consumption rate are non-moving.
Therefore, again we see that as per the classification, goods that are consumed the quickest are the fast-moving goods. Those with the lowest consumption rates are non-moving goods.
Both the parameters, i.e., the average stay of goods in the inventory and consumption rate of that product, should be simultaneously calculated and used. It helps to arrive at accurate FSN analysis results, and inventory management decisions can be effectively taken based on it.
Importance and Usage of FSN Analysis
FSN analysis helps the management to make informed and accurate inventory decisions. It helps in the optimum utilization of scarce resources and guides the management to make the best use of money, time, and space available.
• It helps to identify the “deadstock.” The management needs to invest only as per the actual stay and consumption of that product and not make extra purchases. Also, it can identify which item is not moving at all and dispose of it at discounted rates.
• FSN analysis also helps in space management effectively. Slow-moving and non-moving category of goods can be bought only in limited quantities to avoid jamming of storage space. Also, fast-moving goods can be stored at locations near to entry and exit points of godowns or warehouses that have clear access all the time. It would help in saving time and labor.
• This analysis can be an excellent buying guide in the case of seasonal products. The management will have a clear picture of the time of the year when a product turns into a fast-moving one from a slow or non-moving category. As a result, it can time its purchase accordingly.
FSN analysis helps to effectively allocate monetary resources to items that are fast moving and beneficial for the organization. As a result, it helps to avoid blocking money in the slow-moving or non-moving category of goods.
Traditional Techniques
Traditional techniques refer to those techniques which are prevalent before the evolution of the modern techniques. These techniques were derived with the working practice and are based on experience and ease of usage by the workers and the small business enterprises. These techniques are explained as follows:
(a) INVENTORY CONTROL RATIOS
Ratios related to inventory are calculated and further used as a measure of control.
Stock Turnover = Cost of goods sold / Average Stoc
(b) TWO BIN SYSTEM
Under two bin system, all the inventory items are stored in two separate bins. Bin means container of any size. In the first bin, a sufficient amount of inventory is kept to meet the current requirement over a designated period of time. In the second bin, a safety stock is maintained for use during lead time. When the stock of first bin is completely used, an order for further stock is immediately placed. The material in second bin is then consumed to meet stock needs until the new order is received. On receipt of new order, the stock used from the second bin is restored and the balance is put in the first bin. Therefore, depletion of inventory in the first bin provides an automatic signal to re-order. Thus, this technique is traditional yet logical and can be used by illiterate workers also without using any formula.
(c) PERPETUAL INVENTORY SYSTEM
Perpetual inventory system is defined as the method of recording stores balance after each receipt and each issue to facilitate regular checking of inventory. It is also known as continuous stock checking. The application of perpetual inventory control system involves –
- Attaching bin cards with bins.
- Continuous stock taking to compare the actual stock.
Bin cards refers to the cards attached to every bin in which the details regarding the quantity of material received, issued and balance left in that bin is recorded hand to hand. Under this system, statement of material, follow up actions, monitoring etc. can be smoothly carried out.
(d) PERIODIC ORDER SYSTEM
Under this system, the stock levels of all types of inventories held, are reviewed after a fixed time interval. Time interval may be weekly, fortnightly, monthly, quarterly etc. depending upon the criticality of the item. Critical items may require a short review cycle and on the other hand, lower cost and non-moving items may require long review cycle. Therefore, for different items different time intervals should be used. After the review, the items which are less than the required level, order is placed to replenish their exhausted level.
Key takeaways –
- Inventory control is the process of managing and regulating the supply, storage and distribution of stock. Inventory control is a key function of supply chain management that maintains appropriate quantities of stock to meet customer demand Certain products need more attention than others.
- Using an ABC analysis lets you prioritize your inventory management by separating out products that require a lot of attention from those that don’t. Do this by going through your product list and adding each product to one of three categories:
- VED analysis is an inventory management technique that classifies inventory based on its functional importance. It categorizes stock under three heads based on its importance and necessity for an organization for production or any of its other activities. VED analysis stands for Vital, Essential, and Desirable
- FSN Analysis is an inventory management technique which is based on the rate of consumption of spares and goods in an organization. This analysis divides the inventory into three categories based on their speed or rate of utilization, their consumption rate, and average stay. FSN stands for Fast-moving, Slow-moving, and Non-moving.
Sources:
- Pandey, I M, Financial Management. Vikas Publications.
- Chandra, P Financial Management-Theory and Practice (Tata Mc Graw Hill).
- Rustagi, R.P. Fundamentals of Financial Management.Taxmann Publication Pvt.Ltd.
- 5.Singh J.K, Financial Management-Text And Problems.2nd Edition Dhanpat Rai And Company,Dellhi.
