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Holding cost is expressed as % of average inventory. Formula for calculating Economic Order Quantity (EOQ). Where,. D = Annual Demand of the product. S= ...
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By Yogendra Mani Tripathi – Asst. Professor Faculty of Management and Technology, Harish Chandra PG College
Inventory can be described as an expensive and important current asset of the manufacturing company, representing as much as fifty percent of the total invested capital. It can also be described as any stored resource used to satisfy the current or future needs of the customers.
Examples – Raw Materials, Work-in-progress, Finished Goods
To “decouple” or separate various parts of the production process. To provide a stock of goods that will provide a “selection” for the customers. To take advantage of quantity discount. To hedge against inflation and upward price changes.
Usually there are 4 types of cost associated with any types of Inventory which are given as below:
1. Ordering Cost: - The cost which is incurred in placing and receiving the order for the inventory is called as Ordering Cost. It includes various expense heads such as Ordering Form, Tender Cost, Cost of Stationary, Clerical support etc. 2. Holding Cost: - The cost which is associated with holding or carrying the inventory in proper conditions is called as Holding or Carrying cost. It includes various expense heads such as Cost of Warehousing, Security, Insurance, Interest, Pilferage, Obsolescence etc. 3. Purchase Cost:- It includes the amount which the buyers pays to the supplier for purchasing the inventory item. It takes into consideration any quantity discount being offered by the supplier along with the shipping charges. 4. Setup Cost:- It include the cost which is incurred in preparing a machine or process for manufacturing any order. It includes various expenses such as Clean-up cost, Re-tooling cost etc.
Economic Order Quantity or EOQ : It is one of the oldest and the most popular inventory control technique. The term EOQ can be defined as an order quantity at which the total cost comprising of the ordering and holding cost is at the minimum. It is considered to be an important inventory control technique since it helps the production manager in determining the appropriate order quantity which results in incurring the lower inventory cost in line with estimated market demand.
In the above graph we can notice that when the order quantity (represented on x-axis) increases, the Ordering cost decreases whereas the inventory holding cost (cost of storage, insurance etc.) will increase. Thus in the production process there are two opposite cost; one encourages the increase in the order size while the other discourages. Economic order quantity or EOQ is therefore that order quantity or size at which the total annual cost (represented by y-axis) is minimum and the ordering cost is equal to the holding cost.
Thus, Q = √2540055 / 0.28 * 365 = 76 units per order.
(b) The optimum number of order per year would be D/Q
i.e 5400 / 76 = 71 order per year
(c) Annual Total Inventory Cost (TC) = DC + DS/Q + QHC/
i.e TC = 5400 * 365 + (5400/76) * 55 + (76 * (0.28 * 365) / 2)
=> TC = 1971000 + 3905 + 3876 = 19,78,
Example 2:
For a certain product purchased from a vendor at Rs. 42 per unit, the
ordering cost is Rs. 16 per unit. The inventory carrying cost is 0.
paisa per rupees per order and sales are relatively constant at 1800
units per year.
a. What is the optimal order quantity? b. What is the annual total inventory cost?
Solution:
(a) We know that formula for calculation of EOQ is √2DS/HC
Thus, Q = √2180016 / 0.20 * 42 = 82.8 or 83 units per order.
(b) Annual Total Inventory Cost (TC) = DC + DS/Q + QHC/
i.e TC = 1800 * 42 + (1800/83) * 16 + (83 * (0.20 * 42) / 2)
= 75600 + 347 + 349 = 76296
ABC Analysis of Inventory Control
Also called as Always Better Control, in this analysis it is presumed that all the items stored in the inventory vary in their importance and hence an appropriate level of control should be exercised on each of these items considering the cost associated with exercising proper level of such control.
Thus in this technique all the items available in the inventory are classified into three category A, B and C on the basis of their importance and monetary value. The term importance can be defined from a number of perspective which are as follows:
(a) Unit Purchase Price
(b) Annual Consumption Value
(c) Criticality in manufacturing operation
(d) Consumption Rate
(e) Availability
(f) Inventory level or position
The items which are placed in A category are the ones which are most important and has high consumption value; those placed in B category are relatively less important and has moderate consumption value; while those in C category are not important and has very less consumption value.
The division of items into various categories can be shown with the help of chart given below
Class No. of item in use (%) Consumption Value (%) A 20 80 B 30 15 C 50 5 Total 100 100
Due to its selective approach, this analysis or technique of inventory control is also called as “ Selective technique of Inventory Control”.
However, in cases of uncertainty in Lead time analysis there can be situation when the stock out may occur, if there is delay in replenishing of the order. In such case, the inventory level will go beyond the minimum level of inventory.
In order to handle such situations, the company usually keeps certain contingent or buffer stock to handle such stock out situation, and this buffer is usually called as Safety Stock.
