CH # 05 MATERIAL INVENTORY CONTROL

Contents:
 Cost Associated with Inventory
 Purchase Quantity / Order Size & EOQ Computation
 Computation of Total Annual Cost (TAC) of Inventory CC
 Evaluation of EOQ with Discount Quantity
 Inventory Control Levels & Concept of Probability
 Safety Stock

Cost associated with Inventory :

The Costs associated with inventory are
 Purchase costs,
 Holding costs
 Ordering costs
 Stock-out costs.

Purchase cost:
The cost of buying the material.
➢ This is the largest cost faced by an organization and once purchased, stock has to be carefully
controlled and checked.
➢ It can be reduced through availability of bulk purchase discounts.

Holding/Carrying Costs:
The costs incurred in keeping and storing stock.It can be divided into three categories

 Cost of Capital (Interest charges/Cost of Capital tied-up/Opportunity Cost,etc)

 Costs of Storage & Store operation (Rent,electricity ,storekeeper's wages,heating & cooling
system.etc.)
 Risks cost (Insurance cost, obsolescence cost,Pilferage/Theft cost & deterioration cost.etc)

Ordering cost:
The cost associated with placing an order to supplier is known as ordering cost.It can be divided into three
categories;

 Costs to place an order( Order processing cost - searching supplier,placing order,telephone,

filing papers.etc)
 Costs to transport the goods ( Delivery charges if pay buyers)
 Costs to receive the order ( Receiving goods, checking quantities and paying invoices )
Stock-out /Shortage Cost:
Stock-out costs are costs associated with running out of stock, for example
 Cost due to production stoppage (production-run cost)
 Loss of customer goodwill,
 Loss of current & future sales
 Labour idle time cost
 Extra cost for urgent re-orders.

Reorder Quantity / Order Size & EOQ Computation:

Re-order Quantity/Order Size;
- Reorder quantity is the number of units of stock ordered each time when re-order level is reached.
- If it is set so as to minimize the total costs associated with holding and ordering stock, then it is
known as EOQ.

Problem with Order Size;

- Ordering and Holding costs varies with the Order Size and are quite opposite to each other.
- There is a trade-off among Ordering & Holding cost which results in increase in TAC of inventory.

Objective of Inventory Management;

- To minimize the total inventory costs and EOQ model helps us just do that.

EOQ Model:

Def: “The economic order quantity is the optimum quantity of goods to be purchased at one
time in order to minimize the total annual costs of ordering and carrying or holding items in
inventory”

Assumptions:

1. Demand is known & constant throughout the year.

2. Lead time is constant or zero
3. Purchase price per unit is constant
4. No Bulk Discount
5. Holding cost per unit per annum will be constant.
6. Ordering cost per order will be constant
7. No safety stock
8. Average stock is equal to half of the re-order quantity (Q/2)

EOQ Computation:

Where,
Co = Cost of placing one order
D = Expected Annual Demand (sale)
Ch: = Cost of holding one item of stock for one year
Computation of Total Annual Cost (TAC) of Inventory

Total Annual costs (TAC) = TAPC + TAOC+ TAHC

Where
Total annual purchase cost (APC) = D x Purchase price per unit
Total annual ordering cost (AOC) = *No. of Orders x Co
Total annual holding cost (AHC) = *Average Stock x Ch

*No. of Orders = D/Q

*Average Stock = Q/2 + Safety stock (if any)
*Frequency of Orders = Q/D x 365 ( in days if required) or 365/ No. of Orders

Example:

1. A company uses the Economic Order Quantity (EOQ) model to determine the purchase order
quantities for materials.The demand for material item M234 is 12,000 units every three
months. The item costs Rs. 80 per unit, and the annual holding cost is 6% of the purchase
cost per year. The cost of placing an order for the item is Rs. 250.
What is the economic order quantity for material item M234 (to the nearest unit)?
2. A company uses the Economic Order Quantity (EOQ) model to determine the purchase order
quantities for materials.The demand for material item M456 is 135,000 units per year. The
item costs Rs. 100 per unit, and the annual holding cost is 5% of the purchase cost per
year.The cost of placing an order for the item is Rs. 240.
What are the annual holding costs for material item M456?
3. A company uses a chemical compound, XYZ in its production processes.XYZ costs Rs. 1,120 per
kg. Each month, the company uses 5,000 kg of XYZ and holding costs per kg. per annum are Rs.
20.Every time the company places an order for XYZ it incurs administrative costs of Rs. 180.
What is the economic order quantity for material item XYZ (to the nearest unit)?
4. ABC Ltd. is engaged in sale of footballs. Its cost per order is Rs.400 and its carrying cost is
Rs.100 per unit per annum. The company has a demand for 20,000 units per year.Purchase price
per unit is Rs.200.
Calculate the Economic order quantity, total annual carrying cost and total annual
ordering cost and toal annual cost (TAC) for the year.
 Evaluation of EOQ with Discount Quantity:
Optimum order quantity with price discounts for large orders:
- When the EOQ formula is used to calculate the purchase quantity, it is assumed that the purchase
cost per unit of material is a constant amount, regardless of the order quantity(O.S).

- If a supplier offers a discount on the purchase price for orders above a certain quantity, the
purchase price becomes a relevant cost. When this situation arises, the order quantity that
minimises total costs will be either:
 The economic order quantity; or
 The minimum order quantity necessary to obtain the price discount.

- The total costs each year including purchases, ordering costs and holding costs must be
calculated for the EOQ and the minimum order quantity to obtain each discount on offer.

Steps for Evaluation:

Step # 01: Compute TAC (Only Relevant) for the EOQ/Existing Order Size(Current Policy OS)

Step # 02: Compute TAC(only Relevant) for Minimum Order Quantity (MOQ) to obtain discount

Step # 03: Compare TAC computed for EOQ/Existing Order Size with TAC computed for MOQ to
determine Whether Business should accept the MOQ to obtain discount or not.
Step # 04:Compute Saving (if required in exam) by comparing TAC at Current Order Quantity/EOQ
with Proposed Order Quantity (Opted as a result of step #3)

Tabular Approach:

Average No. of Annual Purchase Annual Holding Annual Ordering

Order Total Annual
stock Orders Cost (APC) Cost (AHC) Cost (AOC)
Size(Q) Cost (TAC)
(Q/2) (D/Q) = (D x PPPU) = (Q/2 x Ch ) = (D/Q xCo)
Example
Choco-king Limited (CL) produces and markets various brands of chocolates having annual demand
of 80,000 kg. The following information is available in respect of coco powder which is the main
component of the chocolate and represents 90% of the total ingredients.
(i) Cost per kg is Rs. 600.
(ii) Process losses are 4% of the input.
(iii) Purchase and storage costs are as follows:
 Annual variable cost of the procurement office is Rs.6 million. The total number of
orders (of all products) is estimated at 120.
 Storage and handling cost is Rs. 20 per kg per month.
 Other carrying cost is estimated at Rs. 5 per kg per month.

(iv) CL maintains a buffer stock of 2,000 kg.

Required:
(a) Calculate economic order quantity. (07)
(b) A vendor has offered to CL a quantity discount of 2% on all orders of minimum of
7,500 kg. Advise CL, whether the offer of the vendor may be accepted. (06)

Inventory Control Levels :

In an inventory control system, if there is uncertainty about the length of the supply lead time and
demand (usage) during the lead time there might be three warning levels for inventory, to warn
management that:

 The item should now be reordered ( Reorder level )

 The inventory level is too high ( maximum inventory level ) or
 The inventory level is getting dangerously low ( minimum inventory level ).

Re-Order Level:
Def.”Reorder level (or reorder point) is the inventory level at which a company would place a new order or
start a new manufacturing run”.

Computation:

a) In times of Certain lead time and constant demand;

ROL = Average Usage x Average Lead time = xxxx units

b) In times of Uncertain lead time and uncertain demand (to avoid stock-out);
ROL = Maximum usage x Maximum lead time = xxxx units
nd
Note:Use 2 formula to compute ROL in absence of clear information (e.g.either demand/lead time is
constant or not)

Lead time; Lead time is the time (in days or weeks) between placing the order and receiving the goods .
Usage;Consumption/demand of material during supply lead time (per day or per week) .

Average usage = (Max usage + Min usage) /2 = xxxx units

Average Lead time = (Max lead time + Min lead time)/2 = days/weeks

Maximum Inventory Level:

Def. “Maximum inventory level is that level of stock, which is not normally allowed to be exceeded”.

Computation;

Max. Inventory Level = Re-order Quantity + Re-Order Level – (Minimum usage x Minimum lead time)

Example:
Re-order quantity = 1000 units
Re-order Level = 1500 units
Lead time period = 4 to 6 days
Daily consumption = 150 to 250 units
Maximum Level = ?

Minimum Inventory Level:

Def. “The minimum inventory level is that level of stock below which stock should not be allowed to fall”

Computation;

Min. Inventory Level = Re-order Level – (Avg. usage x Avg. lead time)

Example:
Normal usage 100 units per day
Maximum usage 130 units per day
Minimum usage 70 units per day
Re-order period 25 to 30 days

Minimum Level = ?

Safety Stock/Buffer Stock:

Def.”Safety stock is a level of extra stock that is maintained to mitigate risk of stockouts due to
uncertainties in supply and demand”.

Computation;
Safety Stock = Re-order Level – (Avg. usage x Avg. lead time)

Example:
ABC Ltd. is engaged in production of tires. It purchases rims from DEL Ltd. an external supplier. DEL
Ltd. takes 10 days in manufacturing and delivering an order. ABC's requires 10,000 units of rims. Its
ordering cost is Rs.1,000 per order and its carrying costs are Rs.3 per unit per year. The maximum
usage per day could be 50 per day.
Calculate economic order quantity, reorder level and safety stock.