Determining Various Inventory Levels
Inventory Control Techniques
In order that the inventory costs are reduced to the minimum and yet the process of production and sales goes on uninterrupted, it is necessary to determine the following inventory levels:
(1) Re-order Point or Ordering Level
(2) Maximum Level
(3) Minimum Level
(4) Safety Level.
(A) Re-order Point represents the quantity level at which an order for fresh supplies must be placed with the supplier to replenish the present stock. When the balance of a particular material on hand falls to this level, a fresh order must be placed. Suppose, a company wants to maintain a minimum stock of 100 kg of a material X. Every time, this company places an order for 1,000 kgs of X, which is the economic order quantity. Now the question is at what level of stock, this order should be placed. The answer depends upon two factors (1) the time interval between the date of placing an order and date of receipt of goods (2) the rate of consumption of material during this period of time. Suppose the delivery of raw material takes a period of one month and during this period the consumption of material amounts to 300 kg. Since, the company does not wish to see the stock of material X going down below 100 kgs at any time, it must place an order when the stock is at the level of400 kgs. Because when at the end of the months 300 kgs of material would have been consumed, the balance would come down to 100 kgs, the fresh delivery would be received.
Generally, the following formula is used:
Ordering level=Maximum Consumption x Maximum Delivery Time
But most of the writers on Financial Management use the following formula for determining re-order point or ordering level.
Re-order Point=Average Usage x Lead time in days (or delivery time)
Here “lead time’ means the time normally taken in receiving delivery of inventory after placing the order. It is also called Delivery Time or Procurement Time.
Suppose the average daily consumption of material Y is 50 units and the economic order quantity is 3,000 units. Then this quantity will be exhausted within 60 days. Suppose the lead time is 20 days, then order must be placed when the stock level reaches 1,000 units, so that when fresh delivery of goods arrives, the stock reaches zero level and it is replenished by 3,000 units.
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