Techniques of inventory control

THE NEED FOR INVENTORY

The ordinary dictionary meaning of inventory is 'a list of goods an estate
contains'. In industry, inventory means 'stock of goods'. It may mean raw
materials, 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, required
for future use, mainly in the production process as in the case of finished
goods for re-sale. In any case, it is an idle resource having an economic value
awaiting conversion, consumption or re-sale. Thus inventories are held
primarily for some transaction. 'Today's inventory is tomorrow's production'. In
case of production inventory, generally there is a time-lag between the
recognition of the need and fulfillment of that need. This time-lag; which is
technically 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 is
that inventories are held as a precautionary measure for increases in both
leadtime and consumption rate. Also, there are reasons for holding inventory
as a matter of speculation, because prices may subsequently go up or the
material may become scarce in the future. This is however, not 'of so much
importance for our purpose. Finally, inventories also serve to decouple
materials from consumption at successive stages of production operations.

1

THE NEED FOR CONTROL
We have already seen how important it is to improve upon the return on
capital, that is, profit margin. But there are obvious limitations such as
competition in the business world. One way of improving the profit margin is
to turn inventories into saleable products with less investment and as quickly
as possible so that higher sales targets can be achieved and more profits made
with less investment. In other words, a high inventory to sales turn over ratio is
necessary to achieve an improvement over return on capital.
The inventory-turnover ratio can be defined as the gross sales revenue to
average inventory held during a year. This ratio is too low in India. While it is
roughly about 3:1 in India, it is about 12 to 18 in the USA on an average. The
same 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 investment
structure:
Raw Materials and Inventories …. Rs. 600 crores
Plant and Machineries …. Rs. 540 crores

The above figures show higher capital outlay in raw materials and inventories
than in plant and machinery. A constant attempt should be made to reduce
investment in inventories. If a modest
5 per cent reduction is possible, that would mean release of 1m extra amount
of investable funds for other productive purpose. The overall picture is
gloomier. It has been variously estimated that in India about Rs. 15,000 crores
is blocked in immovable inventory of which about Rs.2,500 crores is blocked in
dead inventories. One wonders whether a developing economy can afford to
block so much money in an idle resource.

2

FINANCE FOR INVENTORIES
Like their counterparts all over the world, Indian industries also performance
their inventories primarily through bank credit. Banks extend credit by way of
advance against inventories. It is generally made available under pledge or
hypothecation. As a matter of fact, full value of inventories is not advanced. A
margin is retained by the bank and the borrower is required to meet the
financial requirements of inventory through internal resources. Margins,
however, vary widely depending upon many factors which are taken into
account by the bankers while they extend credit. Large portions of working
capital of many companies are sunk in inventories and banks generally provide
the working capital requirements. Traditionally, organized industrial sector of
the 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. As
such, inventory financing has becoming a very important part of credit
planning for the banking system in India.
The Reserve Bank of India, in order to regulate and control bank credit, from
time to time issues policy directives to commercial banks. As for example,
banks are required to maintain a statutory reserve in the form of cash. The
liquidity ratio of cash to demand and time liabilities are periodically reviewed
and varied in order to control credit. The Variable Reserve Ratio (VRR), as it is
called, is a powerful tool in the hands of RBI for controlling credit and money
supply in the country. The RBI also lowers or increases lending rates to
commercial banks for such purposes. Over and above, it also exercises selective
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credit control for a large number of commodities and recommends a minimum
margin to banks for advances and loans. For others, banks are left free to
advance loans and credits at their discretions. In July .1974, RBI appointed a
study group to frame some guide lines for hank credit to industries. The
committee headed by the then Chairman of the Punjab National Bank, Sri
Prakash Tandon, recommended three methods of financing inventories.

(a) Firstly, the borrowing organisation is expected to finance 25 per cent of the
working capital requirements from its own internal resources.

(b) Secondly, the borrowing organisation is required to finance to the extent of
at least 25 per cent of its current assets from its own internal resources.

(c) Thirdly, the borrowing organisation is expected to finance its 'core current
assets'.

The implication is that individual borrowing organisations will need to take
care to minimize their current assets. They must reduce inventory and will try
to increase the inventory-turnover ratio .in order to maintain a steady flow of
funds and liquidity. They will have to streamline procedures to cut
administrative and internal leadtimes. This in turn requires an analytical
approach to inventory control, flow of information, documentation,
organisational restructuring and delegation of financial powers for smooth
flow of materials, to, through and out of an organisation. Thus, inventory
control has assumed great importance to industries.

4

WHAT IS INVENTORY CONTROL
The simplest language, inventory control may be said to be a planned method
whereby investment in inventories held in stock is maintained in such a
manner that it ensures proper and smooth flow of materials needed for
production operations as 'well sales, while at the same time, the total costs of
investment in inventories is kept at a minimum. From the above definition it
follows that a comprehensive inventory control system must be closely
coordinated with other planning and control activities, such as, (planning,
capital budgeting, sales forecasting, including production planning, production
scheduling and control. This impinges on a wide range of operations, operating
decisions and policies for production, sales and finance. The finance controller
of a company regards inventory as a necessary evil, since it drains off cash
which could he used elsewhere to earn some profits. The marketing manager
always wants enough of ready stock of finished goods inventories in order to
give better customer service to ensure the company's goodwill and would not
like to see a sales opportunity lost for want of saleable ready stock. The
production manager does not want an out-of. Stock condition for which
production might be held up. It will, therefore, he seen that everyone- has some
objectives which arc connecting in nature. The basic problem is, therefore, to
strike a balance between operating efficiency and the costs of investment and
other associated costs with large inventories, with the object to keep the basic
conflicts at the minimum while optimizing the inventory holding.

5

THE TECHNIQUES
Some of the techniques which will follow include methods of fixing purchase
quantities, setting of order points and safety stocks. The decisions as to which
item to make when and to keep inventories in balance requires application of a
wide range of techniques from simple graphical methods to more sophisticated
and complex quantitative techniques. Many of these techniques employ
concepts and tools of mathematical and statistical methods and make use of
various control theories from engineering and other fields. They arc primarily
aimed at helping to make better decisions and getting people involved and
follow a wise policy. As such, they are far from academic exercises only.
However, making decisions more intelligently and making actions follow these
decisions is not easy. Thus while these quantitative techniques have taken
much out of the decision-making managers what was being done through
bunch or intuitive judgment, real business acumen demands that these must be
blended with practical business sense. It is an axiomatic truth that these
techniques alone cannot turn bad judgement into good ones simply because
they are exact. However, before focusing our attention on such techniques, let
us first attempt to analyze different types of inventories

6

TYPES OF INVENTORIES
Inventories may be classified as under:-

(1) Raw materials and production inventories:
These are raw - materials, parts and components which enter into the product
Direct 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 at
various stages of production.

(3) M.R.O. Inventories:
Maintenance, repairs and operating supplies which are consumed during the
production process and generally do not form part of the prod.uct itself (e.g.
POL, Petroleum products like petrol, kerosene, diesels, various oils and
lubricants, 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 to
another. The average amount can be determined mathematically thus-
I=S x T
Where, S represents the average rate of sales (say, weekly or monthly average)
and
T the transit time required to move from one place to another, and I the
movement inventory needed.

As for example, if it takes three weeks to move materials to aware house from
the plant and if the warehouse sells 110 per week, then the average inventory
needed will be 110 units x 3 weeks = 330 units. In fact, when a unit of finished
product is manufactured and ready for sale, it must remain idle for three weeks
for movement to warehouse. Therefore, the plant stock on an average must be
equal to three weeks' sale in transit.

(b) Lot-size inventories:
In order to keep costs of buying, receipt, inspection and transport and handing
charge 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 to
avail of quantity discounts.

7

(c) Fluctuation inventories:
In order to cushion against unpredictable demands these are maintained, but
they are not absolutely essential in the sense that such stocks are always
uneconomical. Rather than taking what they can get, general practice of serving
the 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. In
case of seasonal variations in the availability of some raw materials, it is of
inventory and also to some extent economical to build up stocks where
consumption pattern may be reasonably uniform and predictable. of the types
of inventories discussed above, the Lot-size, Fluctuation and Anticipation
Inventories may be said to he 'Organization Inventories'. As more of these,
basic types of inventories are carried into stock, less coordination and planning
are required. Also less clerical and administrative efforts are needed and
greater economies can be obtained in handling, manufacturing and dispatching.
But the difficulty is that gains are not directly proportional to the size of
inventories maintained.

As the size increases, even if they are efficiently maintained, handled and
properly located, gains from additional stock become less and less prominent
The cost of warehousing, obsolescence and capital costs associated with
maintenance of large quantities grow at a faster rate than the inventories
themselves. As such, the basic problem is to strike a balance between the
increase in costs and the decline in return from holding additional inventories.
Striking a balance in a complex business situation through intuition alone is
not easy. Costs, and to be sure, the balancing of opposite costs, lie at the heart
of all inventory control problems, for which cost analyses are necessary to
which we shall turn in this chapter now.

As has already been said that even a typically medium-size industrial
organization may use 10,000 to 15,000 different items which are carried in
inventory. Initial planning and subsequent control of such inventories can only
be accomplished on the basis at knowledge about them. Consequently, the
starting point in inventory management and control is the development of a
stores catalogue, which is more or less comprehensive and complete in all
respects. All inventories should be fully and carefully described and a code
number should be allotted. Similar items should be grouped together and
standard codification should be adopted.

8

ABC ANALYSIS OR SELECTIVE
INVENTORY CONTROL (SIC)

80 per cent of the income and wealth were concentrated in the hands of about
20 per cent of the population. This 80-20 relationship also holds good in most
cases of inventories where it may be found that about 20 per cent of the total
number of items are responsible for about 80 per cent of the value. The idea of
studying such, inventory value is to find out 'where the money lies'. AS this '20
per cent of items, 80 per cent of value' rule holds good in many inventory
situations, high value items need more stringent control, which may be termed
'A' class items, and the remaining ones can be classified as 'B' and 'c' class
items according to descending order of value. Thus, the principle of graduated
control may be affected and the degree of control may be equated with the
frequency of reviews. Controlling tightly means reviewing frequently, and
frequency in turn tends to determine the order quantity, A items would be
reviewed frequently, and because of their high value they will be ordered in
small quantities in order to keep the inventory investment minimum. B items
will be renewed less frequently and C items still less, The following graphical
illustration will make the meaning of ABC Analysis more clear, which is based
on selective control technique.

CLASS NO. OF ITEMS IN USE (%) VALUE (%)
A 20 80
B 30 15
C 50 5
TOTAL 100 100

9

THE TWO-BIN SYSTEM
One of the earliest systems of stock control is two-bin system, which is a
simple method of control exercised by two simple rules. One is when the order
should be placed, and the other is what quantity should be covered. The
following diagram shows this simple method. The bins contain, say, mild-steel
bolts and nuts. The bolts and nuts are issued from the first bin as and when
required, and as soon as the first bin is empty, more bolts and nuts are
ordered.
The replenishment arrives just when the second bin is empty. While delivery is
awaited, the nuts and bolts from the second bin are issued. When the delivery
arrives, 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 empty

Such a method is appropriate only when consumption rate is constant, that is
to say, it is a deterministic system. We know from our experience what quantity
of bolts and nuts are necessary for a given period as well as we know their rate
of consumption.

10

MAX MINI SYSTEM
Under this method, maximum level and minimum level are fixed. Re-ordering is
done after a period of review and order or re-order is placed when the quantity
touches a certain level.
Suppose you have an item in inventory for which maximum is fixed at 1,000
and minimum quantity to be held in stock is 250units. Previous experience
shows that a safety stock of 250 units is quite sufficient. If during the past two
months consumption rate has been 300 units per month on an average, and if
the leadtime is taken to be two months time, then you will run out soon, if
either delivery is not received just after two months or if during the
subsequent months consumption rate increases. The weakness of this system
is:

(a) Stock levels are actually fixed at lower levels since managers have no time to
study inventory levels of individual items.

(b) Re-order points and safety levels once fixed are not frequently changed after
study.

(c) Delay in postings makes the records useless for control as often even a
critical item can be held up for want of posting which otherwise would have
been shown that the re-order point has been touched. Thus, we may conclude
that in any inventory management and control system, control is exercised
through various levels, and the order point and the order quantity:

i. Maximum level
ii. Minimum level
iii. Order level or re-order level or the order point
iv. Order quantity

There 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.

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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 consider
the following:
(a) What to order.
(b) When and how much.

The first involves planning with due regard to production and marketing
requirements. The second has two aspects:
(i) Order point
(ii) Order or re-order quantity

Order quantity will be discussed along with safety stock or buffer stock since
subtle influence of time in transit on .total inventory is closely related to the
safety stock provisioning to create an impact on inventory control. At this
point, it would be better to draw a distinction between
Accounting costs and operational costs. The former is based on historical cost
concept used for financial reporting and the latter is, by and large, used for
day-to-day decision-making and insensitive to small variations. Accounting
system typically distinguishes three types of costs, viz., direct cost, indirect
cost and overheads. As against the principles and consistency of accounting
costs, the definition of costs in an inventory system may vary from time to
time, depending upon the length of time being planned and other
circumstances. However, the objective underlying inventory control is to
minimize the total cost of procurement, storage,
handling, distribution and other charges. Economic ordering starts with an
analysis of these various components of costs.
12

ECONOMIC ORDER QUANTITY OR EOQ
FORMULA

The 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 its
policy.)

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 inspection

B.
(i) Interest on capital
(ii) Expected return on capital (imputed cost)
(Hi) Warehousing (this includes insurance, lighting and other maintenance
costs).

A point of minimum cost is reached at which the ordering cost will be just
equal to the carrying cost so that the tota1 cost is minimum at that point. In
other words, neither excess quantity of material is ordered, nor too fr6quently
too many orders are placed for the same material during a period of time. We
assume, 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 are
price-breaks, this will not hold true. In such cases, linear relationship of the
unit price with purchase quantity breaks down and distorts the formula given
below as we shall presently see, When unit price is same regardless of the
quantity purchased, we can use the following formula when we find that the
order quantity varies in proportion to the square root of the demand. These are
indices given on scientific basis to order quantity, keeping in view position
states of inventories, viz., the set of costs, ordering cost and carrying cost. This
is known as Economic Order Quantity

13

(EOQ) or Square Root Formula developed by R.H Wilson.

EOQ or D2 = (2Qa)
C
Where 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 costs
of 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 be
altogether ruled out.

Ordering cost:
This is the additional cost of placing an order or re-order. Its characteristic is
that it is independent of the order size. It increases with the number of orders
and is not influenced by the size of the order.

Carrying cost:
On the other hand, the characteristic of the carrying cost is that it increases
with the volume of inventory irrespective of the number of orders. It is linearly
related with the quantum of inventory. The cost of inventory carrying is
generally expressed as an annual percentage of the unit purchase cost. From
the above graph, it will thus be noticed that the above two costs are opposite in
nature. The former varies with the number of orders and the latter varies
directly with the volume of inventory. Thus, if purchases are made frequently
and in small lots, carrying cost can be kept low, but the order or re-order cost
will be higher. It will, therefore, be appreciated that when the slope of the order
cost curve meets the rising carrying cost curve, that is to say, where the
marginal ordering cost is equal to the marginal carrying cost, the total
minimum cost point is reached. In other words, this is the point where we hold
the optimum inventory meet this point the order cost curve begins to rise
again.

14

Limitations of the EOQ formula

However, the very restrictive nature of the assumptions made in the EOQ
formula restrains the use of the formula in many cases of practical inventory
situations. The cost-analyses on the basis
Of which the formula has been developed are merely notional rather .than
actual in some cases. In practice, unit cost of purchase of an item varies, lead
times are uncertain and also requirements or demands of inventory items are
not perfectly predictable in advance. Rate of consumption varies greatly in
many cases. As such, the Application of the formula often becomes difficult
and complicated.

Price Breaks or Quantity Discounts

In many cases, quantity discounts are allowed by firms in order to boost their
sales and it becomes preferable to purchase in some bulk quantities to avail of
the discounts. In such cases, it is only worthwhile to calculate the EOQ for an
item in order to see that if it is really profitable to order in EOQ quantity. This
will also mean that the usage rate must be steady. Again, if the, unit cost of
purchase fluctuates greatly from time to time, then the EOQ for that particular
item will also not hold good.

Leadtime variation
The formula was' also developed on the basis of invariant leadtime, that is, the
time interval between placement of an order and actual replenishment will not
vary for all practical purposes.
Often this supposition is invalid, because schedule of deliveries varies for many
reasons. Moreover, some items have longer leadtimes than others and even for
the same items, it will differ from one lot purchase to another. For this reason
also, it is difficult to use
EOQ for many times

Order or re-order Point
Thus, while EOQ tells us something about how much to order, it tells us almost
nothing about when to order or re-order, for, this depends upon the level of
inventory in question. The order or reorder point should be set at such a level
that the stock on hand plus on orders should last till fresh supplies are
received. This will require ascertaining the usage rate of that particular item. If
the rate of consumption greatly varies and there is an upward surge in the
consumption pattern suddenly, this will lead ultimately to stock-out condition.

15

For this reason only, for many items additional stocks have to be maintained in
order to meet unanticipated demand due to variation in usage rate due to
normal consumption and during lead times.

SAFETY OR BUFFER STOCK
Some additional stocks are always provided in order to meet contingencies of
unanticipated, demand due to both (a) leadtime variations usage pattern during
leadtime. 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 risk
of stock-out, on the other. If the rate of consumption remains fairly constant,
the suppliers' delivery times do not vary, there are no rejections during
inspection, it would have been a simple matter to place a new order whenever
stock on hand reaches the quantity equal to the lead time usage. A hundred per
cent service level can be easily .attained in such circumstances when there will
be no occasion for stock-outs as fresh supplies would always be arriving before
the existing stock out.

The EOQ was developed on the presumption that such an ideal situation holds
true and the average inventory holding during the twelve-month period is 1/2
during the year. So, the inventory level is equal to Q or EOQ intermediately
upon receipt of the order quantity and is reduced at a constant rate of
depletion until it reaches a zero-level again. But such an ideal situation is hard
to come across. In practice, demands vary greatly, supplies are uncertain,
prices do not remain constant and a host of other variables and seen
circumstances and difficulties are experienced, which may lead to occasional
stock -out conditions. On the other hand, unnecessary apprehension about
stock shortages leads to holding of a building up of huge stock piles. So, an
inventory control system should be provided that can absorb the shocks or
bumps up and down, the system itself not being too costly at the same time. In
designing such a system, we have already stressed the importance of service
level desired by management. Some additional stocks are kept on hand always
in reserve to avoid temporary shortages or stock-out conditions. As more and
more safety or buffer stocks are provided, this eliminates the changes of
shortages and means holding of unnecessary additional inventories. But when
less are provided, this means there are chances of occasional stock-outs and
management has to run the risk or production hold ups. Thus the provisioning
of safety stock assumes great importance in the face of uncertainties. The
following illustration depicts the situation. The problem of determining safety
stock of buffer stock is a comparatively simple matter, where the rate of
consumption fairly constant or can be accurately forecast. At this point mill be

16

appreciated that variations in future consumption are not only cause of stock-
outs. The variations in leadtime use ages and related uncertainties of delivery
time must also be taken into account, which make the calculation of safety
stock a complicated affair. It involves numerous repeated trials or tests of the
combined effect of variations in demand and in leadtime useages to arrive at an
ideal safety stock level.

FSN/VED analysis
A-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 given
inventory record.
Controlling tightly means reviewing frequently, which tends to determine order
quantity.
A-items would be reviewed frequently and order in small quantities to keep
inventory investment low.
B-items less, C-items still less. But this approach does not take into account
the fact that sometimes a low-valued small item of critical nature needs as
much attention as high-valued A-class item, so that inventories also need to be
classified according to Vital, Essential and Desirable (V -E-D), which in essence
means 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 to
weed out the unnecessary ones. This is aimed at keeping the total inventory
size down and reduces investment.
Thus, selective control may be exerted under different types of classification
according to necessity. A single-type approach may not prove fruitful under all
circumstances.

17

Techniques of inventory control

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