4 Major Problems Faced during

Inventory Control (With

Examples)
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The following points highlight the four major problems faced during
inventory control. The problems are: 1. The Classification Problem
2. The Order Quantity Problem 3. The Order Point Problem  4.
Safety Stock.

Inventory Control: Problem # 1.

The Classification Problem:
ABC Analysis:
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This widely-used classification technique recognises different items

of inventory for the purpose of inventory control which is based on
the assumption that a firm should not exercise equal attention on all
items of inventory since a firm has to maintain various types of
inventories. It, therefore, should pay maximum attention to those
items that are (i) most costly, and /or (ii) slow moving.

On the contrary, inventories which are less expensive should be

given less control effort. Thus, the firm should be selective in its
approach towards the inventory control management. This
analytical approach is known as ABC Analysis Approach. It tends to
measure the relative cost significance of each component of
inventories.

According to this system, various items are grouped into

three distinct categories:
1. ‘A’ Items — which involve the highest/largest investment and, as
such, would be under the tightest control, i.e. the most sophisticated
inventory control techniques should be applied.

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2. ‘C’ Items — which involves relatively least value and, as a result,

need not require any special attention and control.

3. ‘B’ Items — which stands in between items ‘A’ and ‘C’. It desires
less attention than A but more attention than C, or, it requires
reasonable attention of the management.

Since the above items are classified according to importance of their

relative value, it is also known as Proportional Value Analysis
(PVA).

The following table printed on the basis of physical

quantities and value will make the principle clear:

The above statement can also be presented graphically as:

The above graphic presentation indicates that Item ‘A’ forms a
minimum proportion but represents the highest value, viz., 70% of
the cost. On the contrary, Item ‘C’ represents 65% of the total units
but 10% of the cost. And Item ‘B’ occupies the middle place.

Thus, Item ‘A’ and Item ‘B’ jointly represent 35% of the total units
but 90% of the total investment whereas Item ‘C’ forms more than
half of the total units against 10% of total investment.

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So, the highest control should be exercised on Item ‘A’ for

maximising profitability.

Illustration 1:
Firm X has 7 different items in its inventory. The average
number of units in inventory together with their average
cost per unit is presented below:
Suggest a break-down of the items into ABC classification
assuming that the firm wants to introduce ABC inventory
system:
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The ABC Analysis is presented with the help of the

following table:

No doubt the ABC analysis is a very useful technique. But it should

be used with care; for example, an item of inventory may be very
inexpensive but, at the same time, may be very critical to the
production process and may not be easily available.

As such, as per ABC analysis, it would be classified into Item ‘C’

which requires least attention. But because of its special importance
to the production process, it deserves special attention of the
management.

Inventory Control: Problem # 2.

The Order Quantity Problem:
Economic Order Quantity (EOQ):
How much inventory should be added when inventory is
replenished is a major problem in inventory management, i.e., how
much to buy or produce at a time is really a problem to the
management. If bulk quantities are purchased, the cost of carrying
will be high and, on the contrary, if small quantities are purchased
at frequent intervals, ordering cost will be high.

Therefore, the quantity to be ordered at a given time should be

economic, taking mainly two factors into account, viz., ordering
costs, and carrying costs. In short, it represents the most favourable
quantity to be ordered at the reorder level.

EOQ is a problem of balancing the two conflicting kinds of costs —

costs of carrying (arising out of balance purchases) and cost of not
carrying (arising out of frequent purchases in small lots). To sum
up, EOQ is determined at the point where the carrying costs are
approximately equal to the cost of not carrying (the ordering costs),
where the total cost is minimum.

The natures of the above costs are discussed:

Cost of Carrying:
1. Handling and transportation.

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2. Clerical.

3. Rent, Insurance and other Costs of storage.

4. Interest on capital blocked.

5. Pilferage and normal loss of holding.

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6. Risk of obsolescence.

Cost of not Carrying:

1. Extra cost of purchasing, handling and transportation.

2. Frequent stock-outs resulting in disruption of production

schedules and, consequently, extra costs of overtime setups hiring
and training.

3. Foregone quantity discounts and contribution margins on lost

sales.
4. Additional cost of uneconomic production runs.

5. Loss of customer goodwill.

The EOQ model is illustrated below with the help of the

following diagram:

In the above diagram, the ordering costs, inventory carrying cost

and the total costs are plotted. The diagram shows that the carrying
costs vary directly with the size of the order whereas ordering costs
vary inversely with the size of the order. The total cost (i.e., the sum
of the two costs) curve at first goes downwards due to the fact that,
at this stage, the fixed costs of ordering are spread over many units.

But, at the next stage, this curve goes upward because of the fact
that, at this stage, decrease in average ordering costs is more than
what is offset by the additional inventory carrying costs. The point P
denotes the optimum order where the total cost is the minimum.
Therefore, OP units are considered as the EOQ.
It should be remembered that the EOQ is not a stock level. It lies
between the Maximum Stock Level and the Minimum Stock Level.
However, the EOQ will be determined in such a way as would help
in earning the advantages of bulk purchases on one side and, on the
other, would keep the other costs (such as interest on capital) as
minimum as possible.

The above principle can be illustrated with the help of the

following formula:

where A = the annual consumption, i.e., annual quantity, used in

units. P = the ordering cost/cost per purchase order.

S = the annual cost of carrying one unit in stock for one year, i.e.,
carrying cost percentage x cost of one unit.

The above model is based on the following assumptions:

1. The supply position of the materials will be in such a way as will
enable a firm to place as many order as it desires;

2. Cost of materials or finished goods remains constant during the

year;

3. Quantity-discount is not allowed;

4. Production and/or sales are evenly distributed over the period

under consideration; and
5. Variable inventory carrying cost per unit and ordering cost per
order remain constant throughout the year.

Illustration 2:
Calculate the EOQ from the following particulars under:
(i) Equation Method, and

(ii) Tabular Method

Annual Demand — 300 units

Buying cost per order — Rs. 25

Carrying cost of inventory @ 15% on Cost

Cost per unit — Rs. 10.

Hence, it is evident from the above table that 100 units per order is
the most favourable one. Thus, the EOQ level is 100 units.

Illustration 3:
From the following particulars with respect to a particular
item of material of a manufacturing company, calculate
the best quantity to order:

The annual consumption for the materials is 4,00 tonnes. Stock

holding costs are 20% of material cost per annum. The ordering cost
per order is Rs. 6,00.

Solution:
1. Annual Demand 4,000 tonnes

2. Holding Cost = 20% of materials cost

3. Ordering Cost = Rs. 6 per order

Therefore, it is quite clear from the above table that, at 800 order
quantity, the total cost is the lowest one. Hence, EOQ is 800 tonnes.

Alternatively, the same conclusion can be drawn up if

discount forgone is taken into consideration in lieu of cost
of annual consumption of the components at different
price. The same is shown:

Hence, the EOQ is 800 units.

Inventory Control: Problem # 3.
The Order Point Problem:
Reorder Point:
It indicates that level of stock at which the store-keeper initiates
purchase requisition for fresh supplies of the materials for
replenishing the stock, i.e., when to place order for replenishment of
inventories. This level is fixed somewhere between the maximum
and the minimum levels.

In short, this level is fixed in such a manner that sufficient quantity

will remain in the stores in order to meet the normal and abnormal
situations up to a certain period till the fresh supplies are received.
In other words, the size of the order should be equivalent to the
EOQ.

However, this fixation depends on:

(i) The maximum delivery period, and,

(ii) The maximum rate of consumption and,

(iii) The minimum or safety stock level.

Reorder point may be calculated under conditions of

certainty in the following manner:
a. With Safety Stock:
Reorder Point = (Average Usage of Inventory x Lead Time) + Safety
Stock.

b. No Safety Stock:
Reorder Point = Average Usage of Inventory x Lead Time

The following illustration will make the principle clear

with the help of a diagram:
EOQ = 800 units
Lead Time = 3 weeks.

Average Usage = 80 units per week.

Therefore, the EOQ 800 units is quite sufficient for 10 weeks (800 ÷
80). As such, if there is no lead time or the delivery of inventory is
instantaneous, the new order will be placed at the end of the 10th
week —immediately when the EOQ is exhausted or reaches zero
level.

But, since there is a lead time for 3 weeks, the order should be
placed at the end of the 7th week. Because, at that moment, only
240 units will remain for the next three weeks, i.e., during the lead
time. So, when the lead time ends, level of inventory will reach zero
and the first inventory for 800 units will arrive. Thus, the reorder
point is 240 units (80 x 3).

This principle is illustrated with the help of the following

diagram:
The above diagram shows that the order should be placed at the end
of the 7th week where there are 240 units for the lead time. At the
end of the 10th week, when there is no stock, the first supply of 800
units will arrive.

As such, if there is no lead time, the reorder point will be zero level
of inventory,

Inventory Control: Problem # 4.

Safety Stock:
The EOQ and the Reorder Point have been explained so far on the
assumption of certainty conditions, i.e., on the assumption that
there is constant or fixed usage/requirement of inventory and
instantaneous replenishment of inventory. But, in reality, the same
is not always possible since there is uncertainty.

For example, the demand for inventory is likely to fluctuate from

time to time, particularly, the demand may exceed the anticipated
level at certain point. In short, a discrepancy may arise between the
expected usage and the actual usage of inventory. Besides, the
receipt of fresh inventory from the supplies may be delayed due to
some abnormal situations, e.g., strikes, flood, transportation and so
on, which is beyond the expected lead time.

Therefore, there will be a shortage of inventory either due to

increased usage or due to slower delivery, i.e., the firm will have to
face a stock-out situation which may disrupt the production
schedule. As a result, it is advantageous on the part of the firm to
maintain a sufficient safety margin by having surplus additional
inventory against such stock-out position.

These stocks are known as Safety Stocks which will act as a buffer
against the possible shortage of inventory. The Safety Stocks may be
defined as the minimum additional inventory to serve as a safety
margin or buffer or cushion to meet an unanticipated increase in
usage resulting from an unusually high demand and/or an
uncontrollable late receipt of incoming inventory.

Now, the question arises how do we determine the Safety Stock? It

should be remembered that Safety Stock requires two types of cost,
viz., stock-out costs, and carrying costs.

Therefore, appropriate level of Safety Stocks depends on

the basis of trade-off between these two costs:
Stock-out Costs:
These relate to the costs which are associated with the shortage of
inventory. It may be considered as an opportunity cost since the
firm would be deprived of certain benefits due to the shortage of
inventory viz., the loss of profits which the firm could have earned if
there was no shortage of inventory and damage the relationship
with the customers.

Carrying Costs:
These costs are associated with the maintenance of inventory.
Additional carrying costs are involved since the firm is to maintain
additional inventory in excess of normal usage.
Practically, the above two costs are counterbalancing. That is, the
larger the Safety Stock, the larger will be the carrying costs, or
smaller will be the stock-out costs. In short, if carrying costs are
minimised, there will be an increase in stock-out costs, and vice
versa.

Therefore, the duty of the financial manager will be to have the

lowest total costs (i.e., Carrying Costs + Stock-out Costs). In other
words, the appropriate level of Safety Stock is determined by the
trade-off between the Stock-out and the Carrying Costs.

The principle of Safety Stock can be illustrated with the help of Fig.
10.3.

Assume, in the previous example, the reasonable expected stock-out

is 40 units per week. The firm should maintain a Safety Stock of (40
x 3) 120 units. So, the Reorder Point will be 240 + 120 = 360 units.
As such, the maximum inventory will be equal to EOQ plus the
Safety Stock, i.e., 800 units + 120 = 920 units.

Illustration 4:
Calculate the reorder point from the following particulars:
Annual Demand — 1, 04,000 units.

Lead Time — 5 weeks.

Safety Stock may be assumed to be 1,000 units.

(Sales will be made evenly throughout the period).

Solution:
Weekly Usage/Sales =1,04,000/52 = 2,000 units

Lead Time — 5 weeks.

Reorder Level:
(i) When there is no Safety Stock:

2,000 units x 5 =10,000 units.

(ii) When there is Safety Stock of 1,000 units

= 10,000 + 1,000

= 11,000 units

Illustration 5:
Calculate:
(a) EOQ

(b) Number of order per year; and

(c) Time Lag between two consecutive orders

The following particulars are presented by Arjun Ltd.:

Consumption ― 100 units per month

Cost per unit ― Rs. 20

Ordering Cost ― Rs. 30

Obsolescense 10% p.a., Storage and Insurance 5% and Intrest on

Capital @ 10%.

Illustration 6:
Sachin Ltd. Furnished the following information:
(i) Consumption 300 units per quarter;
(ii) Cost per unit Rs. 40;

(iii) Cost of processing an order Rs. 600;

(iv) Obsolescense 15%;

(v) Insurance on inventory 25%

Compute:
(a) Economic Order Quantity;

(b) No. of order per year;

(c) Time between two consecutive orders.

A supplier offers a discount of 2% on a purchase of 600 units.

Should it be accepted?
Illustration 7:
The following particulars are presented by X Ltd:
Annual consumption 12,000 units (in 360 days).

Ordering Cost Rs. 12 per order.

Cost per units Re. 1.

Inventory carrying cost 20% ( including storage cost 5% and interest

on capital 5%)

Normal Lead Time 15 days

Safety Stock ― 30 days consumption.

Compute:
(a) EOQ

(b) Reordering level (when should the order be placed);

(c) Ideal inventory level; and

(d) Number of Time order for EOQ to be placed in a year.

Ascertainment of Reorder Level, Minimum Level and

Average Stock Level
Formula:
(a) Reorder Stock Level = Maximum Consumption x Maximum
Reorder Period.
(b) Minimum Stock Level = Reorder Level – (Normal Consumption
x Normal/ Average Reorder Period).

(c) Maximum Stock Level = Reorder Level + Reorder Quantity –

(Minimum Consumption x Minimum Reorder period).

(d) Average Stock Level = Maximum Level + Minimum Level/ 2

Or, Minimum Stock Level + (1/2) or Reorder Quantity

(e) Danger Stock Level = Average Consumption or Minimum

Consumption x Lead Time for emergency purchase

Illustration 8:
The following particulars are given for Component A in a
factory:
Normal usage ― 50 units per week each

Minimum usage ― 25 units per week each

Maximum usage ― 75 units per week each

Reorder/Ordering Quantity ― 300 units

Reorder/Delivery period ― 4 to 6 weeks

Calculate:
(a) Reorder Level;

(b) Minimum Level;

(c) Maximum Level;

(d) Average Stock Level.

Solution:
(a) Reorder Level = Maximum Consumption x Maximum Reorder
period

= 75 units x 6 = 450 units

(b) Minimum Level = Reorder Level – (Normal Consumption x

Normal Reorder Period)

= 450 units – (50 units x 5) = 200 units

(c) Maximum Level = Reorder Level + Reorder Quantity –

(Minimum consumption x Minimum Reorder period)

= 450 units + 300 units – (25 units x 4) = 750 units – 100 units

= 650 units

(d) Average Stock Level = Minimum Level + Reorder Quantity/2

= 200 units + 350/2 = 350 units

Or, = Maximum Level + Minimum Level/ 2

= 650 units + 200 units / 2 = 425 units

Although answers differ, both of them arc correct.

Illustration 9:
From the details given below, calculate:
(i) Reordering level,

(ii) Maximum level,

(iii) Minimum level,

(iv) Danger level.

Reordering quantity is to be calculated on the basis of

following information:
Cost of placing a purchase order is Rs. 20.

Number of units to be purchased during the year is 5,000.

Purchase price per unit inclusive of transportation cost is Rs. 50.

Annual cost of storage per unit is Rs. 5.

Details of lead time: Average 10 days, Maximum 15 days, Minimum

6 days, for emergency purchase 4 days.

Rate of consumption: Average 15 units per day, Maximum 20 units

per day.
Minimum Consumption:
Average Consumption per day = Maximum Consumption +
Minimum Consumption/ 2

Or, 15 = 20 + Minimum Consumption/ 2

Or, 10 units per day.

(i) Reorder Level = Maximum Consumption x Maximum Reorder

period

= 20 units per day x 15 days

= 300 units.

(ii) Minimum Level = Reorder Level – (Normal Consumption x

Normal Reorder period)

= 300 units – (15 units x 10 days)

= 300 units – 150 units = 150 units.

(iii) Maximum Level = Reorder Level + Reorder Quantity ―

(Minimum Consumption x Minimum Reorder period)

= 300 units + 200 units – (10 units per day x 6 days)

= 300 units + 200 units – 60 units = 440 units.

(iv) Danger Level = Average Consumption x Lead Time for

emergency purchase

= 15 units per day x 4 days = 60 units

Or, = Minimum Consumption x Lead Time fo9r emergency

purchase

= 10 units x 4 days = 40 units.