11 Inventory Management
CHAPTER
THEORY
Economic If purchases of material are made in bulk then inventory carrying cost will
Order Quantity be high.
(EOQ) If order size is small each time, then the ordering cost will be high.
The size of the order for which both ordering and carrying cost are minimum
is known as economic order quantity
2× A×O
Economic Order Quantity =
C
A = Annual demand / annual consumption in units
O = Cost of placing and receiving an order
C = Carrying cost per unit per annum
Ordering Cost These are the costs which are associated with the purchasing or ordering of
materials. It includes costs like tender invitation, transportation of goods,
inspection costs etc.
Carrying Cost These are the costs for holding or storing goods in the stores. It includes costs like
storage, rent, insurance, spoilage, deterioration etc.
Assumptions of Annual consumption/usage/requirement of raw material is known in
EOQ advance.
Ordering cost per order is known and constant.
Cost per unit of the material to be purchased is known and it is constant.
Carrying cost is computed on average inventory ordered.
The rate of carrying cost remains constant.
The consumption/usage of material is expected to be even throughout the
year.
ABC Analysis It stands for Always Better control Analysis.
It exercises discriminating Control over various items of inventory by
classifying them into different categories on the basis of value, quantity,
frequency of replacement etc.
Category % in total % in total Extent of control
value quantity
A 70% 10% Strict control through stock levels, EOQ
etc.
B 20% 20% Need based selective control
C 10% 70% Little control – Focus on saving
associated costs
Advantages of Smooth Flow – It ensures that, there should be no danger of interruption
ABC analysis of production.
Cost saving – The cost of placing orders, receiving goods and maintaining
stocks is minimized.
Control by exception – Management time is saved since attention need to
be paid only to some of the items rather than all the items.
Standardization of work – It makes much of the work systematized on a
routine basis.
Limitations of In order to be fully effective it should be carried out with standardization
ABC Analysis and codification.
It is based on gradation of different items, which may include a lot of
subjective elements.
The result of ABC analysis should be reviewed periodically and updated.
Stock Out The demand for materials may fluctuate and delivery of inventory may also
be delayed and in such a situation the firm can face a problem of stock-out.
The sock-out can prove costly by affecting the smooth working of the concern.
In order to protect against the stock out arising out of usage fluctuations
firms usually maintain some margin of safety.
Two costs are involved in the determination of this stock i.e. opportunity
cost of stock-outs and the carrying costs.
PRACTICAL QUESTIONS
1. A company’s requirements for ten days 6,300 units. The ordering cost per order is `10 and the
carrying cost per unit is `0.26. You are required to calculate the economic order quantity.
[Sol. 696 units]
2. SK Ltd. uses a large quantity of salt in its production process. Annual consumption is 60,000 tonnes
over a 50 week working year. It costs `100 to initiate and process an order and delivery follow
two week later. Storage costs for the salt are estimated at `0.10 per tonne per annum. The current
practice is to order twice a year when the stock falls to 10,000 tonnes. Identify an appropriate
ordering policy for SK ltd. and contrast it with the cost of the current policy.
[Sol. Savings = `1,312.30]
Inventory Management 307
3. SK company is a distributor of air filters to retail stores. It buys its filters from several manufacturers.
Filters are ordered in lot sizes of 1,000 and each order costs `40 to place. Demand from retail
stores is 20,000 filters per month, and carrying cost is `0.10 a filter per month.
(a) Compute the optimal order quantity with respect to so many lot sizes
(b) Calculate the optimal order quantity if the carrying cost were `0.05 a filter per month
(c) Compute the optimal order quantity if ordering costs were `10
[Sol. (a) 4; (b) 5.66; (c) 2]
4. A company requires 36,000 units of a product per year at a cost of `100 per unit. Ordering cost
per order is `250 and the carrying cost is 4.5% per year of the inventory cost. Normal lead time
is 25 days and safety stock is NIL.
Assume 360 working days in a year.
(i) Calculate the Reorder Inventory Level
(ii) Calculate the Economic Order Quantity (EOQ)
(iii) If the supplier offers 1% quantity discount for purchase in lots of 9,000 units or more, should
the company accept the proposal
[Sol. (i) 250 units; (ii) 2000 units; (iii) accept the offer]
308 Financial Management PW