Important Techniques of Inventory Control System

Some of the most important techniques of inventory control system are: 

1. Setting up of various stock levels. 

2. Preparations of inventory budgets. 

3. Maintaining perpetual inventory system. 

4. Establishing proper purchase procedures. 

5. Inventory turnover ratios. and 

6. ABC analysis.

1. Setting up of various stock levels:

To avoid over-stocking and under stocking of materials, the management has to decide about the maximum level, minimum level, re-order level, danger level and average level of materials to be kept in the store. 

These terms are explained below:

(a) Re-ordering level:

It is also known as ‘ordering level’ or ‘ordering point’ or ‘ordering limit’. It is a point at which order for supply of material should be made.

This level is fixed somewhere between the maximum level and the minimum level in such a way that the quantity of materials represented by the difference between the re-ordering level and the minimum level will be sufficient to meet the demands of production till such time as the materials are replenished. Reorder level depends mainly on the maximum rate of consumption and order lead time. When this level is reached, the store keeper will initiate the purchase requisition.

Reordering level is calculated with the following formula:

Re-order level =Maximum Rate of consumption x maximum lead time

(b) Maximum Level:

Maximum level is the level above which stock should never reach. It is also known as ‘maximum limit’ or ‘maximum stock’. The function of maximum level is essential to avoid unnecessary blocking up of capital in inventories, losses on account of deterioration and obsolescence of materials, extra overheads and temptation to thefts etc. This level can be determined with the following formula. Maximum Stock level = Reordering level + Reordering quantity —(Minimum Consumption x Minimum re-ordering period)

(c) Minimum Level:

It represents the lowest quantity of a particular material below which stock should not be allowed to fall. This level must be maintained at every time so that production is not held up due to shortage of any material.

It is that level of inventories of which a fresh order must be placed to replenish the stock. This level is usually determined through the following formula:

Minimum Level = Re-ordering level — (Normal rate of consumption x Normal delivery period)

(d) Average Stock Level:

Average stock level is determined by averaging the minimum and maximum level of stock.

The formula for determination of the level is as follows:

Average level =1/2 (Minimum stock level + Maximum stock level)

This may also be expressed by minimum level + 1/2 of Re-ordering Quantity.

(e) Danger Level:

Danger level is that level below which the stock should under no circumstances be allowed to fall. Danger level is slightly below the minimum level and therefore the purchases manager should make special efforts to acquire required materials and stores.

This level can be calculated with the help of following formula:

Danger Level =Average rate of consumption x Emergency supply time.

(f) Economic Order Quantity (E.O.Q.):

One of the most important problems faced by the purchasing department is how much to order at a time. Purchasing in large quantities involve lesser purchasing cost. But cost of carrying them tends to be higher. Likewise if purchases are made in smaller quantities, holding costs are lower while purchasing costs tend to be higher.

Hence, the most economic buying quantity or the optimum quantity should be determined by the purchase department by considering the factors such as cost of ordering, holding or carrying.

This can be calculated by the following formula:

Q = √2AS/I

where Q stands for quantity per order ;

A stands for annual requirements of an item in terms of rupees;

S stands for cost of placement of an order in rupees; and

I stand for inventory carrying cost per unit per year in rupees.

2. Preparation of Inventory Budgets:

Organizations having huge material requirement normally prepare purchase budgets. The purchase budget should be prepared well in advance. The budget for production and consumable material and for capital and maintenance material should be separately prepared.

Sales budget generally provide the basis for preparation of production plans. Therefore, the first step in the preparation of a purchase budget is the establishment of sales budget.

As per the production plan, material schedule is prepared depending upon the amount and return contained in the plan. To determine the net quantities to be procured, necessary adjustments for the stock already held is to be made.

They are valued as standard rate or current market. In this way, material procurement budget is prepared. The budget so prepared should be communicated to all departments concerned so that the actual purchase commitments can be regulated as per budgets.

At periodical intervals actuals are compared with the budgeted figures and reported to management which provide a suitable basis for controlling the purchase of materials,

3. Maintaining Perpetual Inventory System:

This is another technique to exercise control over inventory. It is also known as automatic inventory system. The basic objective of this system is to make available details about the quantity and value of stock of each item at all times. Thus, this system provides a rigid control over stock of materials as physical stock can be regularly verified with the stock records kept in the stores and the cost office.

4. Establishing Proper Purchase Procedures:

A proper purchase procedure has to be established and adopted to ensure necessary inventory control. The following steps are involved.

(a) Purchase Requisition:

It is the requisition made by the various departmental heads or storekeeper for their various material requirements. The initiation of purchase begins with the receipts of a purchase requisition by the purchase department.

(b) Inviting Quotations:

The purchase department will invite quotations for supply of goods on the receipt of purchase requisition.

(c) Schedule of Quotations:

The schedule of quotations will be prepared by the purchase department on the basis of quotations received.

(d) Approving the supplier:

The schedule of quotations is put before the purchase committee who selects the supplier by considering factors like price, quality of materials, terms of payment, delivery schedule etc.

(e) Purchase Order:

It is the last step and the purchase order is prepared by the purchase department. It is a written authorization to the supplier to supply a specified quality and quantity of material at the specified time and place mentioned at the stipulated terms.

5. Inventory Turnover Ratio:

These are calculated to minimize the inventory by the use of the following formula:

Inventory Turnover Ratio

= Cost of goods consumed/sold during the period/Average inventory held during the period

The ratio indicates how quickly the inventory is used for production. Higher the ratio, shorter will be the duration of inventory at the factory. It is the index of efficiency of material management.

The comparison of various inventory turnover ratios at different items with those of previous years may reveal the following four types of inventories:

(a) Slow moving Inventories:

These inventories have a very low turnover ratio. Management should take all possible steps to keep such inventories at the lowest levels.

(b) Dormant Inventories:

These inventories have no demand. The finance manager has to take a decision whether such inventories should be retained or scrapped based upon the current market price, conditions etc.

(c) Obsolete Inventories:

These inventories are no longer in demand due to their becoming out of demand. Such inventories should be immediately scrapped.

(d) Fast moving inventories:

These inventories are in hot demand. Proper and special care should be taken in respect of these inventories so that the manufacturing process does not suffer due to shortage of such inventories.

Perpetual inventory control system:

In a large b essential to have information about continuous availability of different types of materials and stores purchased, issued and their balance in hand. The perpetual inventory control system enables the manufacturer to know about the availability of these materials and stores without undergoing the cumbersome process of physical stock taking.

Under this method, proper information relating to receipt, issue and materials in hand is kept. The main objective of this system is to have accurate information about the stock level of every item at any time.

Perpetual inventory control system cannot-be successful unless and until it is accompanied by a system of continuous stock taking i.e., checking the total stock of the concern 3/4 times a year by picking 10/15 items daily (as against physical stock taking which takes place once a year).

The items are taken in rotation. In order to have more effective control, the process of continuous stock taking is usually undertaken by a person other than the storekeeper. This will check the functioning of storekeeper also. The items may be selected at random to have a surprise check. The success of the system of perpetual inventory control depends upon the proper implementation of the system of continuous stock taking.

6. ABC analysis:

In order to exercise effective control over materials, A.B.C. (Always Better Control) method is of immense use. Under this method materials are classified into three categories in accordance with their respective values. Group ‘A’ constitutes costly items which may be only 10 to 20% of the total items but account for about 50% of the total value of the stores.

A greater degree of control is exercised to preserve these items. Group ‘B’ consists of items which constitutes 20 to 30% of the store items and represent about 30% of the total value of stores.

A reasonable degree of care may be taken in order to control these items. In the last category i.e. group ‘Q’ about 70 to 80% of the items is covered costing about 20% of the total value. This can be referred to as residuary category. A routine type of care may be taken in the case of third category.

This method is also known as ‘stock control according to value method’, ‘selective value approach’ and ‘proportional parts value approach’.

If this method is applied with care, it ensures considerable reduction in the storage expenses and it is also greatly helpful in preserving costly items