Techniques of inventory control


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Inventory Control details with techniques with case study on Jindal Steel Works- Vasind Plant, Avon Cycles- Punjab, Bhushan Steel Works- Punjab.

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Techniques of inventory control

  1. 1. THE NEED FOR INVENTORYThe ordinary dictionary meaning of inventory is a list of goods an estatecontains. In industry, inventory means stock of goods. It may mean rawmaterials, work-in-progress, maintenance materials, processed and semi-processed materials, oils, fuels and lubricants as well as finished and semi-finished goods. They may be either in solid, liquid or gaseous form, requiredfor future use, mainly in the production process as in the case of finishedgoods for re-sale. In any case, it is an idle resource having an economic valueawaiting conversion, consumption or re-sale. Thus inventories are heldprimarily for some transaction. Todays inventory is tomorrows production. Incase of production inventory, generally there is a time-lag between therecognition of the need and fulfillment of that need. This time-lag; which istechnically called leadtime, is due to the time required for ordering,processing and time needed by the vendor for actual delivery of the materials.Consequently, leadtime greatly influences holding of the volume of inventory.Had it been so that materials were readily available right on placing orders,there would have been no need for holding inventory. The second element isthat inventories are held as a precautionary measure for increases in bothleadtime and consumption rate. Also, there are reasons for holding inventoryas a matter of speculation, because prices may subsequently go up or thematerial may become scarce in the future. This is however, not of so muchimportance for our purpose. Finally, inventories also serve to decouplematerials from consumption at successive stages of production operations. 1
  2. 2. THE NEED FOR CONTROLWe have already seen how important it is to improve upon the return oncapital, that is, profit margin. But there are obvious limitations such ascompetition in the business world. One way of improving the profit margin isto turn inventories into saleable products with less investment and as quicklyas possible so that higher sales targets can be achieved and more profits madewith less investment. In other words, a high inventory to sales turn over ratio isnecessary to achieve an improvement over return on capital.The inventory-turnover ratio can be defined as the gross sales revenue toaverage inventory held during a year. This ratio is too low in India. While it isroughly about 3:1 in India, it is about 12 to 18 in the USA on an average. Thesame is about 7 in West Germany and about 6 to 8 in the UK.An RBI study on 700 Joint Stock Companies shows the following investmentstructure:Raw Materials and Inventories …. Rs. 600 croresPlant and Machineries …. Rs. 540 croresThe above figures show higher capital outlay in raw materials and inventoriesthan in plant and machinery. A constant attempt should be made to reduceinvestment in inventories. If a modest5 per cent reduction is possible, that would mean release of 1m extra amountof investable funds for other productive purpose. The overall picture isgloomier. It has been variously estimated that in India about Rs. 15,000 croresis blocked in immovable inventory of which about Rs.2,500 crores is blocked indead inventories. One wonders whether a developing economy can afford toblock so much money in an idle resource. 2
  3. 3. FINANCE FOR INVENTORIESLike their counterparts all over the world, Indian industries also performancetheir inventories primarily through bank credit. Banks extend credit by way ofadvance against inventories. It is generally made available under pledge orhypothecation. As a matter of fact, full value of inventories is not advanced. Amargin is retained by the bank and the borrower is required to meet thefinancial requirements of inventory through internal resources. Margins,however, vary widely depending upon many factors which are taken intoaccount by the bankers while they extend credit. Large portions of workingcapital of many companies are sunk in inventories and banks generally providethe working capital requirements. Traditionally, organized industrial sector ofthe economy accounts for more than 50 to 60 per cent of the total bank credit.The quantum of bank credit for industries has always been on the increase. Assuch, inventory financing has becoming a very important part of creditplanning for the banking system in India.The Reserve Bank of India, in order to regulate and control bank credit, fromtime to time issues policy directives to commercial banks. As for example,banks are required to maintain a statutory reserve in the form of cash. Theliquidity ratio of cash to demand and time liabilities are periodically reviewedand varied in order to control credit. The Variable Reserve Ratio (VRR), as it iscalled, is a powerful tool in the hands of RBI for controlling credit and moneysupply in the country. The RBI also lowers or increases lending rates tocommercial banks for such purposes. Over and above, it also exercises selective 3
  4. 4. credit control for a large number of commodities and recommends a minimummargin to banks for advances and loans. For others, banks are left free toadvance loans and credits at their discretions. In July .1974, RBI appointed astudy group to frame some guide lines for hank credit to industries. Thecommittee headed by the then Chairman of the Punjab National Bank, SriPrakash Tandon, recommended three methods of financing inventories.(a) Firstly, the borrowing organisation is expected to finance 25 per cent of theworking capital requirements from its own internal resources.(b) Secondly, the borrowing organisation is required to finance to the extent ofat least 25 per cent of its current assets from its own internal resources.(c) Thirdly, the borrowing organisation is expected to finance its core currentassets.The implication is that individual borrowing organisations will need to takecare to minimize their current assets. They must reduce inventory and will tryto increase the inventory-turnover ratio .in order to maintain a steady flow offunds and liquidity. They will have to streamline procedures to cutadministrative and internal leadtimes. This in turn requires an analyticalapproach to inventory control, flow of information, documentation,organisational restructuring and delegation of financial powers for smoothflow of materials, to, through and out of an organisation. Thus, inventorycontrol has assumed great importance to industries. 4
  5. 5. WHAT IS INVENTORY CONTROL The simplest language, inventory control may be said to be a planned methodwhereby investment in inventories held in stock is maintained in such amanner that it ensures proper and smooth flow of materials needed forproduction operations as well sales, while at the same time, the total costs ofinvestment in inventories is kept at a minimum. From the above definition itfollows that a comprehensive inventory control system must be closelycoordinated with other planning and control activities, such as, (planning,capital budgeting, sales forecasting, including production planning, productionscheduling and control. This impinges on a wide range of operations, operatingdecisions and policies for production, sales and finance. The finance controllerof a company regards inventory as a necessary evil, since it drains off cashwhich could he used elsewhere to earn some profits. The marketing manageralways wants enough of ready stock of finished goods inventories in order togive better customer service to ensure the companys goodwill and would notlike to see a sales opportunity lost for want of saleable ready stock. Theproduction manager does not want an out-of. Stock condition for whichproduction might be held up. It will, therefore, he seen that everyone- has someobjectives which arc connecting in nature. The basic problem is, therefore, tostrike a balance between operating efficiency and the costs of investment andother associated costs with large inventories, with the object to keep the basicconflicts at the minimum while optimizing the inventory holding. 5
  6. 6. THE TECHNIQUESSome of the techniques which will follow include methods of fixing purchasequantities, setting of order points and safety stocks. The decisions as to whichitem to make when and to keep inventories in balance requires application of awide range of techniques from simple graphical methods to more sophisticatedand complex quantitative techniques. Many of these techniques employconcepts and tools of mathematical and statistical methods and make use ofvarious control theories from engineering and other fields. They arc primarilyaimed at helping to make better decisions and getting people involved andfollow a wise policy. As such, they are far from academic exercises only.However, making decisions more intelligently and making actions follow thesedecisions is not easy. Thus while these quantitative techniques have takenmuch out of the decision-making managers what was being done throughbunch or intuitive judgment, real business acumen demands that these must beblended with practical business sense. It is an axiomatic truth that thesetechniques alone cannot turn bad judgement into good ones simply becausethey are exact. However, before focusing our attention on such techniques, letus first attempt to analyze different types of inventories 6
  7. 7. TYPES OF INVENTORIESInventories may be classified as under:-(1) Raw materials and production inventories:These are raw - materials, parts and components which enter into the productDirect during the production process and generally form part of the product.(2) In-process inventories:Semi-finished parts, work-in-process and partly finished products formed atvarious stages of production.(3) M.R.O. Inventories:Maintenance, repairs and operating supplies which are consumed during theproduction process and generally do not form part of the prod.uct itself (e.g.POL, Petroleum products like petrol, kerosene, diesels, various oils andlubricants, machinery and plant spares, tools, jibs and fixtures, etc.)(4) Finished goods inventories:Complete finished products ready for sale.Inventories may also be classified according to the function they serve, such as,(a) Movement and transit inventories:This arises because of the time necessary to move stocks from one place toanother. The average amount can be determined mathematically thus- I=S x TWhere, S represents the average rate of sales (say, weekly or monthly average)andT the transit time required to move from one place to another, and I themovement inventory needed.As for example, if it takes three weeks to move materials to aware house fromthe plant and if the warehouse sells 110 per week, then the average inventoryneeded will be 110 units x 3 weeks = 330 units. In fact, when a unit of finishedproduct is manufactured and ready for sale, it must remain idle for three weeksfor movement to warehouse. Therefore, the plant stock on an average must beequal to three weeks sale in transit.(b) Lot-size inventories: In order to keep costs of buying, receipt, inspection and transport and handingcharge slow, larger quantities are bought than are necessary for immediate use.It is common practice to buy some raw materials in large quantities in order toavail of quantity discounts. 7
  8. 8. (c) Fluctuation inventories: In order to cushion against unpredictable demands these are maintained, butthey are not absolutely essential in the sense that such stocks are alwaysuneconomical. Rather than taking what they can get, general practice of servingthe customer better is the reason for holding such type of inventories.(d) Anticipation inventories: Such inventories are carried out to meet predictable changes in, demand. Incase of seasonal variations in the availability of some raw materials, it is ofinventory and also to some extent economical to build up stocks whereconsumption pattern may be reasonably uniform and predictable. of the typesof inventories discussed above, the Lot-size, Fluctuation and AnticipationInventories may be said to he Organization Inventories. As more of these,basic types of inventories are carried into stock, less coordination and planningare required. Also less clerical and administrative efforts are needed andgreater economies can be obtained in handling, manufacturing and dispatching.But the difficulty is that gains are not directly proportional to the size ofinventories maintained.As the size increases, even if they are efficiently maintained, handled andproperly located, gains from additional stock become less and less prominentThe cost of warehousing, obsolescence and capital costs associated withmaintenance of large quantities grow at a faster rate than the inventoriesthemselves. As such, the basic problem is to strike a balance between theincrease in costs and the decline in return from holding additional inventories.Striking a balance in a complex business situation through intuition alone isnot easy. Costs, and to be sure, the balancing of opposite costs, lie at the heartof all inventory control problems, for which cost analyses are necessary towhich we shall turn in this chapter now.As has already been said that even a typically medium-size industrialorganization may use 10,000 to 15,000 different items which are carried ininventory. Initial planning and subsequent control of such inventories can onlybe accomplished on the basis at knowledge about them. Consequently, thestarting point in inventory management and control is the development of astores catalogue, which is more or less comprehensive and complete in allrespects. All inventories should be fully and carefully described and a codenumber should be allotted. Similar items should be grouped together andstandard codification should be adopted. 8
  9. 9. ABC ANALYSIS OR SELECTIVE INVENTORY CONTROL (SIC)80 per cent of the income and wealth were concentrated in the hands of about20 per cent of the population. This 80-20 relationship also holds good in mostcases of inventories where it may be found that about 20 per cent of the totalnumber of items are responsible for about 80 per cent of the value. The idea ofstudying such, inventory value is to find out where the money lies. AS this 20per cent of items, 80 per cent of value rule holds good in many inventorysituations, high value items need more stringent control, which may be termedA class items, and the remaining ones can be classified as B and c classitems according to descending order of value. Thus, the principle of graduatedcontrol may be affected and the degree of control may be equated with thefrequency of reviews. Controlling tightly means reviewing frequently, andfrequency in turn tends to determine the order quantity, A items would bereviewed frequently, and because of their high value they will be ordered insmall quantities in order to keep the inventory investment minimum. B itemswill be renewed less frequently and C items still less, The following graphicalillustration will make the meaning of ABC Analysis more clear, which is basedon selective control technique.CLASS NO. OF ITEMS IN USE (%) VALUE (%)A 20 80B 30 15C 50 5TOTAL 100 100 9
  10. 10. THE TWO-BIN SYSTEMOne of the earliest systems of stock control is two-bin system, which is asimple method of control exercised by two simple rules. One is when the ordershould be placed, and the other is what quantity should be covered. Thefollowing diagram shows this simple method. The bins contain, say, mild-steelbolts and nuts. The bolts and nuts are issued from the first bin as and whenrequired, and as soon as the first bin is empty, more bolts and nuts areordered.The replenishment arrives just when the second bin is empty. While delivery isawaited, the nuts and bolts from the second bin are issued. When the deliveryarrives, then both the bins are again filled in. BIN NO 1 BIN NO 2 Use till Bin no 1 is empty Use Bin No 2 when Bin no 1 is emptySuch a method is appropriate only when consumption rate is constant, that isto say, it is a deterministic system. We know from our experience what quantityof bolts and nuts are necessary for a given period as well as we know their rateof consumption. 10
  11. 11. MAX MINI SYSTEMUnder this method, maximum level and minimum level are fixed. Re-ordering isdone after a period of review and order or re-order is placed when the quantitytouches a certain level.Suppose you have an item in inventory for which maximum is fixed at 1,000and minimum quantity to be held in stock is 250units. Previous experienceshows that a safety stock of 250 units is quite sufficient. If during the past twomonths consumption rate has been 300 units per month on an average, and ifthe leadtime is taken to be two months time, then you will run out soon, ifeither delivery is not received just after two months or if during thesubsequent months consumption rate increases. The weakness of this systemis:(a) Stock levels are actually fixed at lower levels since managers have no time tostudy inventory levels of individual items.(b) Re-order points and safety levels once fixed are not frequently changed afterstudy.(c) Delay in postings makes the records useless for control as often even acritical item can be held up for want of posting which otherwise would havebeen shown that the re-order point has been touched. Thus, we may concludethat in any inventory management and control system, control is exercisedthrough various levels, and the order point and the order quantity: i. Maximum level ii. Minimum leveliii. Order level or re-order level or the order pointiv. Order quantityThere are two basic control systems:1. Periodic review system.2. Fixed order quantity system. 1. Periodic review system: This is a time-bound system which requires periodic reviews of the stock- levels of all items. Here, period of review is fixed either at three months, six months or once in a year, when requirements of all items are worked out ,a fresh, and the quantity varies. This system works well for production raw materials and components for which long leadtimes are necessary. 11
  12. 12. 2. Fixed order quantity system: Under this system, order quantity is fixed but the time varies. This system recognizes the fact that each item in inventory possesses its own characteristics and optimum order quantity requirements. Designing of this system requires consideration of many factors, such as, price, usage rate and other pertinent factors. Maximum and minimum levels are determined for each inventory item and an order or re-order point is established in between the two levels. The order point is computed in such a manner that by the time new supplies is received, the stock balance will fall to the minimum and it will be replenished again to the maximum.The major advantages are: (i) Each item can be procured at the most economical price and quantity, (ii) Purchasing and inventory control people automatically pay attention to the items when they need it.Thus, in order to devise a good inventory control system, we have to considerthe following:(a) What to order.(b) When and how much.The first involves planning with due regard to production and marketingrequirements. The second has two aspects:(i) Order point(ii) Order or re-order quantityOrder quantity will be discussed along with safety stock or buffer stock sincesubtle influence of time in transit on .total inventory is closely related to thesafety stock provisioning to create an impact on inventory control. At thispoint, it would be better to draw a distinction betweenAccounting costs and operational costs. The former is based on historical costconcept used for financial reporting and the latter is, by and large, used forday-to-day decision-making and insensitive to small variations. Accountingsystem typically distinguishes three types of costs, viz., direct cost, indirectcost and overheads. As against the principles and consistency of accountingcosts, the definition of costs in an inventory system may vary from time totime, depending upon the length of time being planned and othercircumstances. However, the objective underlying inventory control is tominimize the total cost of procurement, storage,handling, distribution and other charges. Economic ordering starts with ananalysis of these various components of costs. 12
  13. 13. ECONOMIC ORDER QUANTITY OR EOQ FORMULAThe inventory costs may be broadly divided components:A PROCUREMENT COST (this includes administrative and provisioning costs.)B. STORAGE. COST (this includes carrying, handling, etc.)C. STOCK-OUT COST (this may be laid down by management according to itspolicy.)The first two may be broken down into a number of components.Typically they are:A. (i) Requisitioning(ii) Order-placing(iii) Processing and progress-chasing(iv) Receiving, checking and inspectionB.(i) Interest on capital(ii) Expected return on capital (imputed cost)(Hi) Warehousing (this includes insurance, lighting and other maintenancecosts).A point of minimum cost is reached at which the ordering cost will be justequal to the carrying cost so that the tota1 cost is minimum at that point. Inother words, neither excess quantity of material is ordered, nor too fr6quentlytoo many orders are placed for the same material during a period of time. Weassume, however, that no stock-out or idle-time cost has to be accounted for.Also, where quantity discounts are allowed on lot-purchases or where there areprice-breaks, this will not hold true. In such cases, linear relationship of theunit price with purchase quantity breaks down and distorts the formula givenbelow as we shall presently see, When unit price is same regardless of thequantity purchased, we can use the following formula when we find that theorder quantity varies in proportion to the square root of the demand. These areindices given on scientific basis to order quantity, keeping in view positionstates of inventories, viz., the set of costs, ordering cost and carrying cost. Thisis known as Economic Order Quantity 13
  14. 14. (EOQ) or Square Root Formula developed by R.H Wilson.EOQ or D2 = (2Qa) CWhere Q= Annual requirements in units (estimated demands) a = Unit cost of placing an order (in Rupees) c = Annual carrying cost (this is generally expressed in percent)In determining the EOQ, this mathematical model has assumed that the costsof managing. an inventory item consist solely of two parts: (1) Ordering cost and(2) Carrying cost, ignoring the idle time or stock-out cost, which cannot bealtogether ruled out.Ordering cost:This is the additional cost of placing an order or re-order. Its characteristic isthat it is independent of the order size. It increases with the number of ordersand is not influenced by the size of the order.Carrying cost:On the other hand, the characteristic of the carrying cost is that it increaseswith the volume of inventory irrespective of the number of orders. It is linearlyrelated with the quantum of inventory. The cost of inventory carrying isgenerally expressed as an annual percentage of the unit purchase cost. Fromthe above graph, it will thus be noticed that the above two costs are opposite innature. The former varies with the number of orders and the latter variesdirectly with the volume of inventory. Thus, if purchases are made frequentlyand in small lots, carrying cost can be kept low, but the order or re-order costwill be higher. It will, therefore, be appreciated that when the slope of the ordercost curve meets the rising carrying cost curve, that is to say, where themarginal ordering cost is equal to the marginal carrying cost, the totalminimum cost point is reached. In other words, this is the point where we holdthe optimum inventory meet this point the order cost curve begins to riseagain. 14
  15. 15. Limitations of the EOQ formulaHowever, the very restrictive nature of the assumptions made in the EOQformula restrains the use of the formula in many cases of practical inventorysituations. The cost-analyses on the basisOf which the formula has been developed are merely notional rather .thanactual in some cases. In practice, unit cost of purchase of an item varies, leadtimes are uncertain and also requirements or demands of inventory items arenot perfectly predictable in advance. Rate of consumption varies greatly inmany cases. As such, the Application of the formula often becomes difficultand complicated.Price Breaks or Quantity DiscountsIn many cases, quantity discounts are allowed by firms in order to boost theirsales and it becomes preferable to purchase in some bulk quantities to avail ofthe discounts. In such cases, it is only worthwhile to calculate the EOQ for anitem in order to see that if it is really profitable to order in EOQ quantity. Thiswill also mean that the usage rate must be steady. Again, if the, unit cost ofpurchase fluctuates greatly from time to time, then the EOQ for that particularitem will also not hold good.Leadtime variationThe formula was also developed on the basis of invariant leadtime, that is, thetime interval between placement of an order and actual replenishment will notvary for all practical purposes.Often this supposition is invalid, because schedule of deliveries varies for manyreasons. Moreover, some items have longer leadtimes than others and even forthe same items, it will differ from one lot purchase to another. For this reasonalso, it is difficult to useEOQ for many timesOrder or re-order PointThus, while EOQ tells us something about how much to order, it tells us almostnothing about when to order or re-order, for, this depends upon the level ofinventory in question. The order or reorder point should be set at such a levelthat the stock on hand plus on orders should last till fresh supplies arereceived. This will require ascertaining the usage rate of that particular item. Ifthe rate of consumption greatly varies and there is an upward surge in theconsumption pattern suddenly, this will lead ultimately to stock-out condition. 15
  16. 16. For this reason only, for many items additional stocks have to be maintained inorder to meet unanticipated demand due to variation in usage rate due tonormal consumption and during lead times. SAFETY OR BUFFER STOCKSome additional stocks are always provided in order to meet contingencies ofunanticipated, demand due to both (a) leadtime variations usage pattern duringleadtime. This additional stock, safety or buffer stock as it is called will,however, depend upon the service level desired on the one hand, and, the riskof stock-out, on the other. If the rate of consumption remains fairly constant,the suppliers delivery times do not vary, there are no rejections duringinspection, it would have been a simple matter to place a new order wheneverstock on hand reaches the quantity equal to the lead time usage. A hundred percent service level can be easily .attained in such circumstances when there willbe no occasion for stock-outs as fresh supplies would always be arriving beforethe existing stock out.The EOQ was developed on the presumption that such an ideal situation holdstrue and the average inventory holding during the twelve-month period is 1/2during the year. So, the inventory level is equal to Q or EOQ intermediatelyupon receipt of the order quantity and is reduced at a constant rate ofdepletion until it reaches a zero-level again. But such an ideal situation is hardto come across. In practice, demands vary greatly, supplies are uncertain,prices do not remain constant and a host of other variables and seencircumstances and difficulties are experienced, which may lead to occasionalstock -out conditions. On the other hand, unnecessary apprehension aboutstock shortages leads to holding of a building up of huge stock piles. So, aninventory control system should be provided that can absorb the shocks orbumps up and down, the system itself not being too costly at the same time. Indesigning such a system, we have already stressed the importance of servicelevel desired by management. Some additional stocks are kept on hand alwaysin reserve to avoid temporary shortages or stock-out conditions. As more andmore safety or buffer stocks are provided, this eliminates the changes ofshortages and means holding of unnecessary additional inventories. But whenless are provided, this means there are chances of occasional stock-outs andmanagement has to run the risk or production hold ups. Thus the provisioningof safety stock assumes great importance in the face of uncertainties. Thefollowing illustration depicts the situation. The problem of determining safetystock of buffer stock is a comparatively simple matter, where the rate ofconsumption fairly constant or can be accurately forecast. At this point mill be 16
  17. 17. appreciated that variations in future consumption are not only cause of stock-outs. The variations in leadtime use ages and related uncertainties of deliverytime must also be taken into account, which make the calculation of safetystock a complicated affair. It involves numerous repeated trials or tests of thecombined effect of variations in demand and in leadtime useages to arrive at anideal safety stock level. FSN/VED analysisA-B-C Analysis was evolved on the principle of graduated control stringency.The degree of control was equated with the frequency of reviews of a giveninventory record.Controlling tightly means reviewing frequently, which tends to determine orderquantity.A-items would be reviewed frequently and order in small quantities to keepinventory investment low. B-items less, C-items still less. But this approach does not take into accountthe fact that sometimes a low-valued small item of critical nature needs asmuch attention as high-valued A-class item, so that inventories also need to beclassified according to Vital, Essential and Desirable (V -E-D), which in essencemeans that stress is more on importance rather than on value. Again, inventories may also be classified according to Fast-moving, Slow-moving and Non-moving items in order to see the rapidity of their use and toweed out the unnecessary ones. This is aimed at keeping the total inventorysize down and reduces investment.Thus, selective control may be exerted under different types of classificationaccording to necessity. A single-type approach may not prove fruitful under allcircumstances. 17