In management of inventories, the firm’s objective should be in consonance with the wealth maximization principle. To achieve this, the firm should determine the optimum level of investment in inventory. To deal with the problems of inventory management effectively, it becomes necessary to be conversant with the different techniques of inventory control.
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Although the concepts involved in inventory management are production oriented and not strictly financial, it is important that financial manager understands them, since they have certain built-in financial costs. The different tools of inventory control are:
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1. A.B.C Analysis
2. EOQ (Economic Order Quantity)
3. VED Analysis
4. GOLF Classification
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5. XYZ Analysis
6. SDE Classification
7. HML Classification
8. S-OS Classification
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9. FNSD Classification
1. The Selective Inventory Control (A-B-C Analysis):
The materials are divided into a number of categories for adopting a selective approach for materials control. It is generally seen that in manufacturing concerns, a small percentage of items contribute large percentage of value of consumption and large percentage of items of material contribute a small percentage of value.
In between these two limits there are some items which have almost equal percentage of value of materials. Under A-B-C analysis, the materials are divided into three categories viz. A’, ‘B’ and ‘C’. Past experience has shown that almost 10% of the items contribute to 70% of value of consumption and this category is called A’ category.
About 20% of items contribute about 20% of value of consumption and this is known as ‘B’ category materials. Category ‘C’ covers about 70% of items of materials which contribute only 10% of value of consumption. There may be some variations in different organisations and an adjustment can be made in these percentages.
A-B-C analysis helps to concentrate more efforts on category ‘A’ since greatest monetary advantage will come by controlling these items. An attention should be paid in estimating requirements, purchasing, maintaining safety stocks and properly storing of ‘A’ category materials.
These items are kept under a constant review so that a substantial material cost may be controlled. The control of ‘C’ items may be relaxed and their stock may be purchased for the year. A little more attention should be given towards ‘B’ category items and their purchase should be undertaken at quarterly or half yearly intervals.
Advantages of ABC Analysis:
This approach helps the materials manager to exercise selective control and focus his attention only on a few items when he is confronted with lakhs of stores’ items. By concentrating of ‘A’ class items, the materials manager is able to control inventories and show visible results in a short span of time.
By controlling the ‘A’ items, and doing a proper inventory analysis, obsolete stocks are automatically pinpointed. Many organisations have claimed that ABC analysis has helped in reducing the clerical posts and resulted 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. Concentrating on all the items is likely to have a diffused effect on all the items, irrespective of the priorities.
Limitations of ABC Analysis:
ABC analysis, in order to be fully effective, should be carried out with standardization and codification. ABC analysis is based on grading the items according to the importance of performance of an item that is by V.E.D -Vital, essential and Desirable— analysis discussed later.
Some items, though negligible in monetary value, may be vital for running the plant, and constant attention is needed. If the inventory position is analyzed according to the value, commonly known as XYZ analysis, then results of ABC and XYZ analysis will be different, depending upon the nature of obsolete items.
The results of ABC analysis have to be reviewed periodically and updated. It is a common experience that a ‘C’ item, like diesel oil in a firm, will become the most high value item during power crisis. However, ABC analysis is a powerful approach in the direction of cost reduction as it helps to control items with a selective approach.
2. Economic Order Quantity (EOQ):
A decision about now much to order has great significance in inventory management, the quantity to be purchased should neither be small nor big because of buying and carrying cost of materials are very high.
EOQ is the size of the lot to be purchased which is economically viable. This is the quantity of material which can be purchased at minimum cost. Generally, EOQ is the point at which inventory carrying costs are equal to order costs. In determining EOQ, it is assumed that cost of managing inventory is made up solely of two parts, i.e., ordering cost and carrying costs.
(i) Ordering Coats:
These are the costs which are associated with the purchasing or ordering of materials. These costs include:
(a) Costs of staff posted for ordering of goods. A purchase order is processed and then placed with suppliers. The labour spent on this process is included in ordering costs.
(b) Expenses incurred on transportation of goods purchased.
(c) Inspection costs of incoming materials.
(d) Cost of stationery, typing, postage, telephone charges, etc.
These costs are also known as buying costs and will arise only when some purchases are made.
When materials are manufactured in the same concern then these costs will be known as set-up costs. These costs will include costs of setting up machinery for manufacturing material, time taken up in setting cost of tools, etc.
The ordering costs are totaled up for the year and then divided by the number of orders placed each year.
(ii) Carrying Costs:
These are the costs for holding the inventories. These costs will not be incurred if inventories are not carried. These costs include:
(a) The cost of capital invested in inventories. An interest will be paid on the amount of capital locked up in inventories.
(b) Costs of storage which could have been used for other purposes.
(c) The loss of materials
(d) Insurance cost
(e) Cost of spoilage in handling of materials.
Ordering cost increases as the number of orders increases. Carrying cost decreases as the number of orders increases. EOQ is that quantity where the total cost is minimum.
Assumptions of EOQ Analysis:
While calculating EOQ, the following assumptions are made:
1. Supply of goods is satisfactory. The goods can be purchased whenever these are needed.
2. The quantity to be purchased by the concern is certain.
3. The prices of goods are stable. It results to established carrying cost.
When the above mentioned conditions are satisfied, economic order quantity can be calculated with the help of following formula:
EOQ = √2AS/I
Where,
A = Annual consumption in rupees.
S = Cost of placing an order.
I = Inventory carrying costs of one unit.
Limitations of EOQ Model:
1. The demand for inventory is seldom constant. When demand fluctuates, the EOQ model will give misleading results. In a period of rising demand, EOQ model based on historic demand levels will suggest smaller inventory levels that are economical.
2. The lead time for any supplier is generally unpredictable. Therefore, buffer stocks are required to ensure against changes in lead time. It is difficult to determine buffer stock as it depends upon uncertainty in the lead time.
3. It is very difficult to determine carrying cost. Only a rough estimate can be made of obsolescence and deterioration costs.
4. The EOQ formula is based on the assumption that no stock-outs will take place. In some cases, an occasional stock-out position may be less costly than carrying excessively large stocks. But it is not easy to determine the cost of stock-out.
3. VED Analysis:
In this analysis, the items are classified on the basis of their criticality to the production process or other services. In the VED classification of materials:
V = Vital items
E = Essential items
D = Desirable items
Vital items are stocked in adequate number to ensure smooth and risk free operation of plant. In other words, without such items the production process would come to a standstill.
Essential items are those whose stock-out would adversely affect the efficiency of the production system. Although the production system would not stop for want to these items, yet their non-availability might cause temporary losses in, or dislocation of production.
The D or desirable class of items are those which are required but do not immediately cause a loss of production.
The VED analysis is done in respect of spare parts. However, this VED classification can also be done in the case of critical raw materials, which are difficult to obtain.
4. GOLF Classification:
The GOLF classification of inventory items is done considering the nature of suppliers. As the source of supply of different items are different, with a view to determining the lead time, order quantities, safety stock and terms of purchase and payment. Here, under this classification:
G = Government controlled supplies
O = Open market supplies
L = Local supplies
F = Foreign market supplies.
5. XYZ Analysis:
It is based on the closing inventory value of different items. Such classification is done every year at the time of annual stock taking and items having highest inventory- valuation are classified as ‘X’, while those with low investment in them are termed as ‘Z’ items.
Other items are ‘Y items whose inventory value is neither too high nor too low. This type of analysis is particularly useful in identifying the items requiring maximum care and attention during storage.
6. SDE Classification:
Under this analysis, ‘S’ stands for scarce items which are in short supply, ‘D’ refers to the difficult items meaning the items that might be available in the indigenous market but cannot procured easily while ‘E’ represents easily available items, may be from the local market.
7. HML Classification:
The HML classification is similar to the ABC classification, except for the fact that instead of consumption values of items, their unit values are considered. Items are classified on the basis of their unit values into:
H = High value items.
M = Medium value items.
L = Low value items.
This type of analysis is useful for keeping control over materials consumption at the departmental level. For example, gold, which is a high value item, will be classified as H and coal, which is a low value item, will be classified as L.
8. S-OS Classification:
This analysis is based on the nature of suppliers and period of their availability. This is useful for deciding the time of purchase or procurement, so that the cost of materials and the holding cost may be balanced. Here, the two classes are:
S = Seasonal items
OS = off seasonal items i.e., items available throughout the year.
9. FNSD Classification:
Based on the consumption pattern of the items, the FNSD classification calls for classification of items as
F = Fast moving items
N = Normal moving items
S = Slow moving items
D = Dead items or non-moving items.
Cut off points of these classes are usually in terms of number of items issued during the last few years. This helps in preventing obsolescence and ensures disposal of dead stock. Some authors classify the items as FSN where ‘F stands for fast, ‘S’ stand for slow moving, ‘N’ stand for non-moving materials & parts. This will automatically reduce inventory costs.