Inventory Management

UNIT 17 INVENTORY MANAGEMENT

Objectives
Upon completion of this unit, you should be able to:
• understand the meaning of inventory and identify inventory related cost
parameters
• learn about various types of inventory policies
• appreciate the role of selective inventory management
• know the exchange curve concept for aggregate inventory planning
• get a feel of some mathematical models of inventory analysis
• perform sensitivity analysis on a type of model
• compute safety stocks
• understand the problems of slow moving items
• appreciate the role of computers in inventory control
• have a brief idea about recent developments in inventory management.

Structures

17.1 Introduction to Inventory Systems

17.2 Functions of Inventory
17.3 Classification of Inventory Systems
17.4 Selective Inventory Management
17.5 Exchange Curve and Aggregate Inventory Planning
17.6 Deterministic Inventory Models
17.7 Probabilistic Inventory Models
17.8 Inventory Control of Slow Moving Items
17.9 Recent Developments in Inventory Management
17.10 Concluding Remarks
17.11 Summary
17.12 Key Words
17.13 Self-assessment Exercises
17.14 Further Readings

17.1 INTRODUCTION TO INVENTORY SYSTEMS

Concept of Inventory .

Inventory' may be defined as usable but idle resource'. If resource is some physical
and tangible object such as materials, then it is generally termed as stock. Thus stock
or inventory are synonymous terms though inventory has wider implications.

Broadly speaking, the problem of inventory management is one of maintaining, for a

given financial investment, an adequate supply of something to meet an expected
demand pattern. This could be raw materials work in progress finished products or
the spares and other indirect materials.

Inventory can be one of the indicators of the management effectiveness on the

materials management front. Inventory turnover ratio (annual demand/average
inventory) is an index of business performance. A soundly managed organisation will
have higher inventory turnover ratio and vice-versa.

Inventory management deals with the determination of optimal policies and

procedures for procurement of commodities. Since it is quite difficult to imagine a
real work situation in which the required material will be made available at the point
of use instantaneously, hence maintaining, inventories becomes almost necessary.
Thus inventories could be visualised as `necessary evil'. 27
Materials Management
Inventory Related Cost
An inventory system may be defined as one in which the following costs are
significant:
a) cost of carrying inventories (holding cost)
b) cost of incurring shortages (stockout cost)
c) cost of replenishing inventories (ordering cost)
a) Cost of carrying inventory :This is expressed in Rs./item held in stock/unit
time. This is the opportunity cost of blocking material in the non-productive form as
inventories. Some of the cost elements that comprise carrying cost are-cost of
blocking, capital (interest rate); cost of insurances; storage cost; cost due to
obsolescence, pilferage, deterioration etc. It is generally expressed as a fraction of
value of the goods stocked per year. For example, if the fraction of carrying charge is
20% per year and a material worth Rs. 1,000 is kept in inventory for one year, the
unit carrying cost will be Rs. 200/item/year. It is obvious that for items that are
perishable in nature, the attributed carrying cost will be higher.
b) Cost of incurring shortages: It is the opportunity cost of not having an item in
stock when one is demanded. It may be due to lost sales or backlogging. In the
backlogging (or back ordering) case the order is not lost but is backlogged, to be
cleared as soon as the item is available on stock. In lost sales case the order is lost. In
both cases there are tangible and intangible costs of not meeting the demand on time.
It may include lost demand; penalty cost; emergency replenishment; loss of good-will
etc. This is generally expressed as Rs./item short/unit time.
c) Cost of replenishing inventory: This is the amount of money and efforts
expended in procurement or acquisition of stock. It is generally called ordering cost.
This cost is usually assumed to be independent of the quantity ordered, because the
fixed cost component is generally more significant than the variable component.
Thus it is expressed as Rs. /order.
These three types of costs are the most commonly incorporated in inventory analysis,
though there may be other costs parameters relevant in such an analysis such as
inflation, price discounts etc.
Importance of Inventory Management
Scientific inventory management is an extremely important problem area in the
materials management function. Materials account for more than half the total cost of
any business and organisations maintain huge amount of stocks much of this could be
reduced by following scientific principles. Inventory management is highly amenable
to control. In the Indian industries there is a substantial potential for cost reduction
due to inventory control. Inventory being a symptom of poor performance we could
reduce inventories by proper design of procurement policies by reduction in the
uncertainty of lead times by variety reduction and in many other ways.

17.2 FUNCTIONS OF INVENTORY

As mentioned earlier, inventory is a necessary evil. Necessary, because it aims at
absorbing the uncertainties of demand and supply by `decoupling' the demand and
supply sub-systems. Thus an organisation maybe carrying inventory for the following
reasons:
a) Demand and lead time uncertainties necessitate building of safety stock (buffer
stocks) so as to enable various sub-systems to operate somewhat in a decoupled
manner. It is obvious that the larger the uncertainty of demand and supply; the larger
will have to be the amount of buffer stock to be carried for a prescribed service level.
b) Time lag in deliveries also vcessitates building of inventories. If the
replenishment lead times are positive then stocks are needed for system operation.
c) Cycle stocks may be maintained to get the economics of scale so that total system
cost due to ordering, carrying inventory and backlogging are minimised.
Technological requirements of batch processing also build up cycle stocks.
d) Stocks may build up as pipeline inventory or work-in-process inventory due to
28 finiteness of production and transportation rates. This includes materials actually
 Inventory Management
being worked on or moving between work centres or being in transit to distribution
centres and customers.
e) When the demand is seasonal, it may become economical to build inventory
during periods of low demand to ease the strain of peak period demand.
f) Inventory may also be built up for other reasons such as: quantity discounts being
offered by suppliers, discount sales, anticipated increase in material price, possibility
of future non-availability etc.
Different functional managers of an organisation may view the inventory from
different viewpoints leading to conflicting objectives. This calls for an integrated
systems approach to planning of inventories so that these conflicting objectives can
be scrutinised to enable the system to operate at minimum total inventory related
costs-both explicit such as purchase price, as well as implicit such as carrying,
shortage, transportation and inspection costs. Concepts and techniques useful in
analysis these problems to arrive at sound policy decisions are the focal point of
presentation in this unit.

17.3 CLASSIFICATION OF INVENTORY SYSTEMS

Lot Size Reorder Point Policy
Under this operating policy the inventory status is continuously reviewed and as soon
as the inventory level falls to a prescribed value called `Reorder Point'. A fresh
replenishment order of fixed quantity called Economic Order Quantity (EOQ) is
initiated. Thus the order size is constant and is economically determined. This is one
of the very classical type of inventory policies and a lot of mathematical analysis has
appeared on this type of policy. Figure I shows the typical stock balance under this
type of inventory policy. The solid line in this figure represents the actual inventory
held in practical situation with a finite lead time, the lead time being defined as the
time delay between the placing of a replenishmentorder and its subsequent receipt.
The broken line indicates the inventory that would be held in the ideal situation if no
lead time existed. Lot size and reorder. point are the two decision variables involved
in the design of the policy.

Fixed Order Interval Scheduling Policy

Under this policy the time between the consecutive replenishment orders is constant.
There is a maximum stock level(s) prescribed and the inventory status is reviewed
periodically with a fixed interval (T). At each review an order of size Q is placed
which takes the stock on hand plus an order equal to the maximum stock level. Thus
order quantity could vary from period to period. This policy ensures that when the 29
Materials Management
level of stock on hand is high at review, a smaller size replenishment order is placed.
Figure II shows the typical stock balances under this fixed reorder cycle policy. S, the
maximum stock level and T the review period are the decision variables under this
policy.

Optional Replenishment Policy

This is very popularly known as the (s, S) policy. Figure III shows the typical stock
balance under this policy. The status of stock is periodically reviewed and maximum
stock level (S) and minimum stock level (s) are prescribed.

If at the time of review, the stock on hand, is less than or equal to s, an order of size
Q is placed so that stock on hand plus on order equals the maximum stock level S. If
stock on hand at review is higher than s, no order is placed and the situation is
reviewed at the time of next review period. S, s and T (review period) are the
decision variables in the design of such inventory policy.
Other Types of Inventory Systems
There may be other policies which may be special cases of the policies mentioned
above or may be a combination of these policies. As a special case of (s, S) policy we
may have (S-1, S) policy or one-for-one order policy when the maximum stock level
may be upto S and whenever there is demand for one unit, a replenishment of one
unit is ordered. Such a policy may be quite useful for slow moving expensive items.
We may use a combination of lot-size reorder point policy and fixed interval order
scheduling policy. Yet another variation of inventory policy could be multiple
reorder point policy where more than one reorder point may be established.
Other types of inventory systems may be static inventory systems when a single
purchase decision is to be made which should be adequate during the entire project
duration. Such decisions are not repetitive in nature. Other initial provisioning
decisions may be with respect to repairable assemblies such as engines, gearboxes
etc. in a bus which may have to be overhauled and for which we have to find
30 adequate number of spare engines to be provided initially.
 Inventory Management
The right choice of an inventory policy depends upon the nature of the problem;
usage value of an item and other situational parameters. We must first select an
operating policy before determining optimal values of its parameters.
17.4 SELECTIVE INVENTORY MANAGEMENT
Role of Selective Inventory Control
One of the major operating difficulty in the scientific inventory control is an
extremely large variety of items stocked by various organisations. These may vary
from 10,000 to 100,000 different types of stocked items and it is neither feasible nor
desirable to apply rigorous scientific principles of inventory control in all these items.
Such an indiscriminate approach may make cost of inventory control more than its
benefits and therefore may prove to be counter-productive. Therefore, inventory
control has to be exercised selectively. Depending upon the value, criticality and
usage frequency of an item we may have to decide on an appropriate type of
inventory policy. The selective inventory management thus plays a crucial role so
that we can put our limited control efforts more judiciously to the more significant
group of items. In selective management we group items in few discrete categories
depending upon value; criticality and usage frequency. Such analyses are popularly
known as ABC, VED and FSN Analysis respectively. This type of grouping may
well form the starting point in introducing scientific inventory management in an
organisation.
ABC Analysis
This is based on a very universal Pareto's Law that in any large number we have
`
significant few' and `insignificant many'. For example, only 20% of the items may be
accounting for the 80% of the total material cost annually. These are the significant
few which require utmost attention.

Figure IV shows a typical ABC analysis showing percentage of number of inventory

items and percentage of average inventory investment (annual usage value). Annual
usage value is the demand multiplied by unit price thus giving monetary worth of
annual consumption. It can be seen from this figure that 10% items are claiming 75%
of the annual usage value and thus constitute the `significant few'. These are called
A-class items. Another 15% items account for another 15% annual usage value and
are called B-class items. A vast majority of 75% items account for only 10%
expenditure on material consumption and constitute `insignificant many' and are 31
Materials Management
called C-class items. To prepare an ABC type curve we may follow the following
simple procedure:
i) Arrange items in the descending order of the annual usage value. Annual usage
value = Annual demand x Unit price.
ii) Identify cut off points on the curve when there is a perceptible sudden change o1
slope or alternatively find cut off points at top 10% next 20% or so but do not
interpret these too literally- rather as a general indicator.
A very simple empirical way to classify items may be adopted as follows:
Total material cost per year
Average annual usage value X=
Total number of items
A-Class items ≤ 6X
C-Class items ≥ 0.5X
In between we have B-class items.
Once the items are grouped into A, B and C category, we can adopt different degree '
of seriousness in our inventory control efforts. A class items require almost
continuous and rigorous control. Whereas B-class items may have relaxed control
and C-class items may be procured using simple rules of thumb, as usual.
VED Analysis
This analysis attempts to classify items into three categories depending upon the
consequences of material stockout when demanded. As stated earlier, the cost of
shortage may vary depending upon the seriousness of such a situation. Accordingly
the items are classified into V(Vital), E(Essential) and D(Desirable) categories. Vital
items are the most critical having extremely high opportunity cost of shortage and
must be available in stock when demanded. Essential items are quite critical with
substantial cost associated with shortage and should be available in stock by and
large. Desirable group of items do not have very serious consequences if not
available when demanded but can be stocked items.
Obviously the % risk of shortage with the `vital' group of items has to be quite small-
thus calling for a high level of service. With `Essential' category we can take a
relatively higher risk of shortage and for `Desirable' category even higher. Since even
a C-class item may be vital or an A-class item may be `Desirable' we should carry out
a two-way classification of items grouping them in 9 distinct groups as A-V, A-E, A-
D, B-V, B-E, B-D, C-V, C-E and C.D. Then we are able to argue on the aimed at
service-level for each of these nine categories and plan for inventories accordingly.
FSN Analysis
.Not all items are required with the same frequency. Some materials are quite
regularly required, yet some others are required very occasionally and some materials
may have become obsolete and might not have been demanded for years together.
FSN analysis groups them into three categories as Fast-moving, Slow-moving and
Non-moving (dead stock) respectively. Inventory policies and models for the three
categories have to be different. Most inventory models in literature are valid for the
fast-moving items exhibiting a regular movement (consumption) pattern. Many spare
parts come under the slow moving category which have to be managed on a different
basis. For non-moving dead stock, we have to determine optimal stock disposal rules
rather than inventory provisioning rules. Categorisation of materials into these three
types on value, criticality and usage enables us to adopt the right type of inventory
policy to suit a particular situation. In this unit, we shall mainly be developing some
decision models more appropriate for A-class and fast-moving items. Later on a brief
discussion on the inventory management of slow-moving items will be given.
Activity A
i) Collect consumption data for 100 different items for an organisation and classify
these into an ABC framework following the procedure described.
ii) List these items in a two-way classification ABC and VED and identify the
number of items belonging to each of these 9 distinct group.
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32 .........................................................................................................................................
 Structure
Objectives
Introduction
Meaning and Objectives of Inventory Control
4.2.1 Meaning
4.2.2 Objectives
Techniques of Inventory Control
4.3.1 ABC Analysis
4.3.2 Stock Levels
4.3.3 Re-Order Quantity
4.3.4 Stores Records
4.3.5 Perpetual Inventory System
4.3.6 Inventory Turnover Ratio
Let Us Sum Up
Key Words
Answers To Check Your Progress b
Terminal Questions/Exercises

After studying this unit, you should be able to:

define the term inventory control and List its objectives
e enumerate the various techniques of inventory control
e explain the various stock levels, and the methods of their calculation
9 define the term ordering quantity and list the factors on which it depends
r explain the record maintained by the store keeper and the costing department
e define perpetual inventory system and explain its advantages
e determine the stock turnover ratio to determine the fast and slow moving stocks.

4.1 INTRODUCTION

You have learnt that inventories constitute a significant part of the total production
cost of a product. An inadequate stock of inventory leads to holding up of
production thereby leading to customer dissatisfaction, loss of revenue etc. Excessive
investment in inventory, on the other hand,leads to locking up of capilal results in
losses due to deterioration and obsolescence of products. Thus, control of inventory
will go a long way in reducing the cost of production and improving the profitability
of a concern. In this unit you will study the various methods by which a firm exercises
proper control over inventories and avoids losses arising from understocking and
overstocking of materials.

4.2 NIEANING AND OBJECTIVES OF INVENTORY

CONTROL.
4..2.1 Meaning
Inventory control includes control over raw materials, stores supplies, space parts, .
* partly finished goods and finished goods. It is a system which ensures the required
quantity of inventories of the required quality, at the required time and with the
minimum amount of capital. The function of inventory turnover is to obtain
maximum iaventory turnover with sufficient stock to meet all requirements. The
quantum of inventory to be kept is decided after taking into consideration the
availability of finance, the quantum of discount allowed, the cost of storage and
storage space available etc. 1

- .
 4.2.2 Objectives Inventory Control
-1e main objectives of inventory control are as follows:

i) To provide continuous flow of inventory for efficient and uninterrupted flow of

production ,
ii) T o avoid excessive investment in inventory and consequently reducing carrying
costs
@) To keep ,surplus and obsolete items to the minimum
iv) To relieve. the management in taking inventory decisions for various items of
inventory from time to time.

The following are the common techniques of inventory control:

1) ABC analysis
2) Setting of various stock levels
3) Economic order quantity
4) Use of perpetual inventory records and continuous stock verification
1 5) Use 6f control ratios and review of slow and non-moving items.

'
,
4.3.1 ABC Analysis
For the purpose of exercising selective control over matcrials, manufacturing
concerns find it useful to divide materials into three categories. An analysis of the
annual consumption of materials of any organisation would indicate that a handful to
top high value items (less than 10 per cent of the total nufnber) will account for a
substantial portion of about 70 per cent of total consumption value. Similarly, a large
.number bottom items (over 70 per cent of the total number of items) account for
only about 10 per cent of the consumption value. Between these two extremes will
fall those items the percentage number of which is more or legs equal to their
consumption value. Items in the top category are treated as 'A' items, items in the
bottom category are called as 'C' category items and the items that lie between the
top and the bottom are called 'Bycategory items. Such an analysis of materials is
known as 'ABC analysis' or 'Proportional parts value analysis'.

The logic behind this kind of anlaysis is that the management should study each item
of stock in terms of its usage, lead time, technical or other problems and ils relative
money value in the total investmcnt in inventories. Critical kc., high value items
deserve very close attention and low value items need tn be devoted minimum
expense and effort in the task of controlling iventories.

The material manager by concentrating on 'A' class-items is able to control

inventories and show visiblc results in a short span of time. By controlling 'A' items
and do~nga proper inventory analysis, obsolete stocks are automatically pinpointcd.
ABC analysis also helps in reducing the clerical costs and results in better planning
. and improved inventory turnover. ABC analysis has to be resorted to because equal
attention to A, B and C items will not be worthwhile and would be very expensive.

. . The following steps will explain to you the classification of the items into A, R and C
categories.

1I I) Calculate the unit cost and the usage of each material over a given period.

11 2) Multiply the unit cost by the estimated usage to obtain the net value.

1 3) List out all the items by rupee annual issues and arrange them in the descending
value.
a 4) Accumulate value and add up number of items and calculate percentage on total
1 inventory in value and in number.
i
4
Materials and Labour
5) Draw a curve of percentage items and percentage value.
-
6) Mark off from the curve the rational limits of A,B and C categories.

The graphical representation of ABC analysis is shown in Figure 4.1.

0 lllrX, 30%
Percenl:~gtul t o t i l l Q u l l n t ~ t y

Figure 4.1: ABC Analysis

Check Your Progress A

1) Indicate whether the following statements are True c r ~ a l s e :
i) In ABC analysis 'A' group of items consist of those inaterials
the vlaue of which is not high but which are used in large quantities .............
ii) ABC analysis is based on the principle of management by
exception. ................
2) Define Inventory Control.

3) List the main objects of inventory control.

..........................................................................................................................

4.3.2.Stock Levels
You know that the maintenance of proper stock of each item of stores is one of the
main functions of stores department. If large quantity of stores is maintained it would
lead to huge investment, large space coverage, dangers of deterioration in quality,
etc. On the other hand, less stock will result in frequent purchases, higher costs, loss
of production etc. It implies that there is always a limit to the minimum and
maximum quantity of materials in stores.
 In order to ensure that the optimum quantity of material is purchased and stored, Inventory Control
neither more nor less, the storekee+r applies scientific technique of material
management. Fixation of certain levels for each item of materials is one of such
techniques. The following levels are generally fixed:
1) Minimum stock level
2) Maximum stock level
3) Re-ordering level
4) Danger level

Re-ordering level
You should know the level at which the storekeeper will initiate the requisition for
the purchase of materials for fresh supplies. This level is referred to as 're-order level'
or 'ordering level'. This level normally lies between the maximum and minimum
stock level. This level will usually be higher than the minimum stock level to cover
for emergencies as abnormal usage of material or unexpected delay in delivery of
fresh supplies. The fixation of this level normally takes into consideration the lead
'time (period of supply or re-order period), rate of consumption and the economic
ordering quantity.

Re-ordering level can be calculated according to any one of the following formulas:
Re-order level = Maximum consumption X Maximum
re-order period
OR '

Re-order level = Minimum level + consumption during

the time required to get fresh deliveries

The following illustrations 1 and 2 will explain to you the calculation of the re-order
' level.

, Illustration~l
Calculate the re-order level from the following information:
; --
Maximum consumption
Minimum consumption - 400 units per week
250 units per week
-
,I

Re-order period 4 to 6 weeks

Solution
Re-order level = Maximum consumption X Maximum
= -
re-order period
400 X 6 2,400 units

Illustration 2

Maximum stock -
Find out the order level from the following information:
2,500 units
Minimum stock - 1,000 units
Time required for receiving the material a 10 days
I Daily consumption, of material .- 50 units

Solution
' Re-order level -- +
Minimum stock level consumption
during the period required for fresh
delivery
- 1,000 + 50 X 10
= 1,000 + 500 - 1,500 units

Minimum Stock level

Minimum stock level points to the level of an .item of material below which the stock
in hand is not normally allowed to fall. In other words, it refers to the minimum
quantity of a particular item of materials which must be kept in stores at all times. 21
b
 Materials and Labour' This limit is fixed so as to avoid the possibility of suspension of production due to .
shortage of material. In fixing this level the following important factors, among others
are taken into consideration:
i) . Lead tirne i.e., time lag between indenting and receiving of material
.ii) Rate of consumption of material during the lead tirne
iii) Re-order level

Minimum stock level can be determined by applying the following formula:

Minimum'stock level = Re-order level-(Normal
consumption X Normal re-order
period)

Illustraion 3 will explain to you the calculation of the minimum stock level.

Illustration 3
Calculate the minimum stock level from the fallowing ddta:
Net normal consumption = 400 units ,per week
Normal re-order period = 5 weeks
Re-order level = 3,500 units
Minimum stock level = Re-order level-(Normal~consumption x
Normal re-order period) "
'
y 3,500 - (400x5)
= 3,500 - 2.000 = 1,500 units a

Maximum stock level

It is that quantity of material above which the stock of any item should not be
allowed to exceed. The main object of fixing the maximum stock level is to avoid
undue investment in stock and to use the working capital in a proper way.

Maximum stock level is fixed by taking into consideration the following factors:
I ) Amount of working capital available
2) Normal rate of consumption of materials during the lead time
3) Time necessary to obtain deliveries
4) Availability of storage space
5 ) Economic ordering quantity
6) Cost of carrying the inventory I a

7) Possibility of loss due to evaporation, deterioration etc.

8) Extent to which price fluctuations may b,e important.
9) Possibility of change in fashion, habit etc., which may necessitate the change in
the specification of materials
10) Incidence of insurance costs which may be important for some materials.

The following formula is generally used for the calculation of mximum stock level.
Maximum stock level = +
Re-order level Re-order
, . quantity-(Minimum consumption X
I
Minimum re-order period)

Danger level
' This is generally a level below the minimum level. When stock reaches this level,
urgent action is needed for replcnishrnent of stock. If no emergency steps are taken
to restock the materials, the stores will be complet'ely exhausted and normal
production stopped. A t this level no further issues are made by the storekeeper
except on special requisition approved by the works manager. The level is generally
calculated by taking into account the time required to get the materials by the
 quickest possible means of transport i.e., minimum time required for obtaining Inventory Control
supplies from any possible source. It is calculated as follows:
= Average consumption X Maximum
re-order period for emergency
purchases

Average stock level

Average stock level is usually calculated with the help of the following formula:
1(~inimumstock level
2
+~ - u m stock level)

Depending upon the availability ;f information average stock level cah also be
calculated as follows:
1 1

Average stock-level = Minimum stock level + 2 Re-order

quantity

Illustration 4 will explain to you the calculation of the various stock levels.

1 Illustration 4
1 From the foUowing information, calculate:

/ b) Minimum stock level

I c) Maximum stock level
I
Re-order quantity , - 30,OO'Ounits
I Time required for delivery = 2-4 months
1 Maximum consumption = 8,000 units per month
Normal consumption 5,000 units per month
Minimum consumption = 3,000 units per month
Solution
a) Re-ordering level
= Maximum consumption X Maximum re-order period
= 8,000 X 4 = 32,900 units

b) Minimum stock level

= Re-order level-(Normal consumption X Normal re-order period)
= 32,000 - (5,000 X 3)
+= 32,000 - 15,000 = 17,000 units
NOTE: Normal re-order period = = 3 months
c) Maximum stock level
= Re-order level -I-Re-order quantity-(Minimum consumption X Minimum

re-order period)
= 32,000 +
30,000 - (3,000 X 2)
+
= 32,000
-
30,000 - 6,000
= 62,000 - 6,000 56,000 units

4.3.3 Re-Order Quantity .

It is helpful to determine in advance to how much should the storekeeper buy when
.the stock reaches the re-order level. This quantity is known as 're-order quantity'
(ROQ). The quantity ordered must be such that when the same is received the stock
level will not exceed the maximum stock to be carried at any point of time.

The re-order quantity is also referred to as the economic order quantity. It is called
'economic order qugntity' (EOQ) because the purchase of this size of materials is
most economical. Purchase of material larger than the economic order quantity of
- material will result in increase in' the carrying cost. If on the other hand small
quantities of materials are purchased at frequent intervals the ordering cost will
increase and will lead. to disruption in the production dbe t o inadequate inventory.
The economic order quantity is fixed at such a level as to minimise the cost of
--
Materials and Labour ordering and carrying the stock. It is the size of the order which produces the lowest
cost of material ordered.

Carrying cost includes the interest on investment,obsolescencelosses, space costs,

storage charges such as warehouse rent, insurance, heating and lighting expenses on .-,
stores staff, pilferage, breakage etc. The cost of ordering is independent of the size of '
the order and includes-rnsptsdue to extra purchasing, handling and transportation \
costs, higher price due to small'o~derquantities, frequent stock outs, resulting in
disruption of production schedules, overtime and extra set up time, loss of sales and i
customer goodwill etc.

The economic order quantity can be calculated by making use of the following
formula:
2UO
EOQ = J-T-"
where EOQ = Economic order quantity
U = Annual usage in units
0= Cost of placing one order including the cost of receiving the
goods
I = Cost of carrying one unit of inventory for one year

Diagram representing the konomic Order Quantity is shown in Figure 4.2

+Units -+
Figure 4.2: Economic Order Quantity

Assumptions in the calculation of economic order quantity

The calculation of economic order quantity is subject to the following conditions:
1) The quantity of the item to be consunled during a particular period is known.
2) Cost per unit is known and is constant. Further quantity discounts are not
involved
3) Ordering cost and carrying cost are known. They are fixed per unit and will
remain the same throughout
4) Quantity ordered is delivered immediately. The following illustration will explain
- to you the calculation of economic order quantity.

Illustration 5
From the following particulars calculate the economic order quantity
' Annual usage = 6,000 units
-
,

Cost of the material per unit Rs. 2.50

Cost of placing and receiving one order = Rs. 15.00 -.

Annual carrying cost of one unit = 20% of inventory value

 Solution Inventory Control
Economic order quantity
U = 6,000 units
0 -. Rs. 15.00 per unit
I = 20% of Rs. 2.50 to Rs. 0.50

Substituting the values in the above formula

EOQ = -1
0.50
= 600 units
Check Your Progress B
1) Indicate whether the following statements are True or False: .
i) When maximum stock level is fixed, the
stock in hand should never exceed this level. .................
ii) Re-ordering level is always fixed some where
between maximum and minimum stock levels. .................
iii) Minimum stock'level is the level of materials
at which a new order for material is to be placed.
iv) Economic order quantity is the reorder quantity. .................
.-.
2) How do you compute average stock level?
.............................................................................................................................................

.............................................................................................................................................
,
; >
I

' 3) ~ i s t ' t h assumptions

e made while fixing the re-order iuantity.

4.3.4 Stores Records

. In order to exercise 1;roper control over materials, it is necessary to record the
physical movement of every item of materials. One of the main functions of the
storekeeper is to maintain records for receipts, issues and balances of various items of
materials. Bin card and stores ledger are the two~importantstores records that are
generally kept for making a record of the various items of stores.

Bin Card
A bin card provide? a quantitative record of the receipts issues and balance of
material. A bin is a place where the goods are stored. A bin may be a shelf, an
almirah, open space etc. depending upon the nature of .the commodity. These cards
are usuallyattached to or place near the bin so that receipts and the issues may be
entered therein as soon as they take place. Separate bin cards are prepared for each
item of stores and if two different materials are kept in one almirah,.two bin cards
one for each item are prepared, treating the almirah as two bins.

The bin card provides a continuous record of thebsiockin each bin and assist the
storekeeper to control the stock. For each material the m&um stocks to be held ,
are noted on the card. Where the materials are ~f a kind requiring advance ordering,
-
 Materials and Labour an ordering level is also indicated therein so that fresh supplies may be o~dered
before theminimum is reached. These cards also provide-an independent check on
the stores ledger.

In large organisations, the storekeeper also maintains 'store control cards' which are .
similar to bin.cards and are kept by him close at hand. This obviates the difficultyof '
going to bins for obtaining the necessary information as and when required.

A specimen of the bin card is given in Figure 4.3.

Figure 4.3 : Specimen of Bin Card

BIN CARD

..
Name ........................... .......... Maximum level ................................. . .;.......
Description ..............................
.,. Minimum level ................................ ...:.........
Bin No. ...................................... Ordering level ............................................
Location code ............................. Re-order quantity .........................................
Stores ledger folio ......................... Unit ............................................................

Receipts Issues Balance Audit

Date G. R. No. Qty. Date Req. No. Qty. Quantity Date Initials

Stores ledger I

This ledger is kept in the costing department and is identical with the bin card except
that the receipts, issues and balances are shown along with their money values. i
Stores ledger contains an account for each class of material and facilitates
ascertainment of all details relating to the material in minimum time. It provides a
continuous record of stores received and issued and discloses the balance in hand at
any time both in quantity and value. It thus furnishes management with a perpetual
inventory.

Stores ledger is generally maintained in the form of loose leaf cards. These cards
should be serially numbered to obviate the risk of removal or loss.

A specimen of the stores ledger is given in Figure 4.4.

I Figure 4.4: Specimen of Stores Ledger
i STORES LEDGER
ABC CO. Ltd. I

Name ...........................
. ........ Maximum level ....................... .
. .............
Description .................................
8 ,

Minimum level ............................................

Location code'........................... Ordering level ...........................................
.
.
Re-order quantity .............................. .......
I , _

I ,I
, , # . . , . Unit ............;..................................... .:.,....
 Bin Card Stores Ledger
I
1 Bin Card is not a n 1 Stores ledger is the basic
accounting record accounting record.

2 It is a record of quantity only 2 It is a record of both quantity

and value

1 3 It is kept inside the stores 1 3 It is kept outside the stores .

4 It is maintained by the storekeeper 4 It is maintained by the
costing department

5 Each transaction is 5 Transaction may be posted

Individually posted Periodically and in total.

It should be noted that documents like goods received note, materials requisition slip,
materials keturned note, etc. also form part of stores records.

Check Your Progress C

I 1) Fill in the blanks.
j
~ i) Stores ledger is maintained in the .................
~
I

I
ii)
iii)
Bin Card is a record of .................only.
Bin Card is maintained by .................
1
I iv) Quantities of materials on hand as shown by bin cards should agree with
quantities actually on .................
~ '

2) Indicate whether the following statements are True or False:

i) Bin Card shows the quantity and value of
material at any moment of time ..................
1 ii) Bin cards are not a part of accounting~ecords .................
iii) The bin card and stores ledger are written up
with the help of same basic documents .................
iv) Stores control card is used as an alternative
to bin card. .................
v) Documents like materials requisitidn and goods
received note also for& part of stores records

4.3.5 Perpetual Inventory System

In order to facilitate regular checking and to obviate closing down of work for stock
taking, a method of recording stores balances after each receipt and issues, is
adopted. This method is known as perpetual inventory system. Bin cards and the
stores ledger help the management in maintaining this system as they make a record
of the physical movements of the stock on the receipts hnd issues of materials and
also reflect the balance in the stores. To ensure the accuracy uf perpetual inventory
records, physical verification of stores is made by a programme of continuous
stock taking.
\

It is advisable that a number of items should be counted and checked daily or at

frequent intervals and compared with the bin cards or stores ledger.

The actual stock of material should not differ from the recorded stock under normal
' circumstances. However, differences do arise on account of the following reasons
which may be classified as unavoidable and avoidable causes.

The usual unavoidable causes are:

i) Shrinkage and evaporation
ii) Climatic conditions causing deterioration, e.g., absorption of moisture, etc.