eoq technique of inventory management
The organization should not go beyond the maximum stock level because it would unnecessarily increase the cost of holding inventory. The overall goal of EOQ is to minimize related costs. As a result, the spindle time of a lathe or milling machine increases significantly. Therefore, limitations of the EOQ model are as follows: (a) The EOQ model assumes that demand for a product is spread equally over a period, but in practice there may be seasonal fluctuations in demand for a product. Then there are some materials that may have become obsolete and might not have been demanded for year’s altogether. The high value and low volume items are included in category A, items with intermediate value are included in category B and the remaining items are included in category C. The categorisation of items has been explained below: Items having high value and low volume are placed in this category. If more than optimal size quantity of inventory is ordered the carrying cost will be high. Given the above assumptions, the EOQ model may be presented as follows: Since it is assumed that the inventory falls to zero before it is replenished, the average inventory becomes EOQ/2. Otherwise, both production and sales are adversely affected through the uninterrupted supply of these items. After that, an indication is sent to concerned department to deliver the precise quantum of parts and materials required for further assembly of products. Economic Order Quantity (EOQ) 3. The Economic Order quantity model is designed to help in deciding how much to order. EOQ can be explained with the help of following diagram: ABC analysis is a technique of controlling different items of inventory. Based on any one of these, the ratio differs from industry to industry and is given by the following formula: A comparison of the current year’s inventory ratio with those of previous years will unfold the following points relating to inventories: This is indicated by a high inventory ratio. Huge Collection of Essays, Research Papers and Articles on Business Management shared by visitors and users like you. Effective management of inventory plays a decisive role in deciding a firm’s ability to operate with good profit margins. This refers to the size of the order to be placed at a given point of time. Thus, a considerable amount of supply chain management is needed to make Just-In-Time inventory control work properly. The EOQ model is used in a firm to find the optimal size of inventory. The EOQ equation in particular helps in identifying the level of inventory which allows for uninterrupted operations while minimizing reordering costs and hence enhances cash flow. This can be referred to as residuary category. Even when some of the assumptions are violated, EOQ model may still be used as a starting point for analyzing an optimum level. In addition, over-stocking would block working capital that results in wastages of material. EOQ is necessarily used in inventory management, which is the oversight of the ordering, storing, and use of a company's inventory. Although all the assumptions do not hold exactly, this is a commonly used model for inventory management by most of the firms. In HML analysis inventories are classified into three categories on the basis of the value of the inventories. It can be calculated using … The firm has a demand for 10,800 units per year. 10,000. But in actual practice, both of these factors are difficult to predict accurately. Aging Schedule of Inventory 6. The VED analysis is done to determine the criticality of an item and its effect on production and other services. Some of the other risks under the JIT approach are: (a) A supplier that does not deliver goods to the firm exactly on time and in the correct amounts may seriously impact the production process. Technique # 1. The EOQ can be mathematically calculated by using the following formula: Inventory management and control refers to a system, which ensures the supply of required quantity and quality of inventory at the required time. Copyright 10. Only then will it result in uninterrupted operations of the business enterprise. 6) FSN Analysis. Their shortage can be tolerated for a short period. Inventory control is a system which ensures supply of required quantity and quality of inventory at the required time without unnecessary investment in inventory. It accounts for about 10—20% of total inventory items, but represents about 70—80% of the annual consumption value of the firm. Whenever the inventory level comes down to the re-order point, a fresh order is placed for procuring additional inventory equal to the economic order quantity. (ii) Dormant Items – These are items having no demand. The turnover ratio may also be used to find out the holding period of inventory. Fewer the number of orders lesser the ordering cost. Economic order quantity can be determined with the help of the following formula: In order to decide when to order an inventory, one has to decide: (i) Order Lead Time – Average time that elapses between placing an order and receiving the goods. Accordingly, inventory items are classified into three categories as under: (i) Category A – These are the costliest items of inventory, (ii) Category B – These are less costly items. Class B items merit a formalized inventory system and periodic purchase and store management. 3. At what level should the order for replenishment be placed? (b) Lead Time – The lead time for an order is the time in days it takes from the placement of an order to when the goods arrive (or produced). Group B items represent about 25% of items with 20% usage value. 20 per unit per year then the Economic Order Quantity is Rs. Ordering cost are constant. These should be disposed of as early as possible to curb further losses caused by them. %���� The class A constitutes 15%, class B includes 35%, and class C contains 50% of the total inventory. FSD Analysis 12. The economic order quantity (EOQ) is the order quantity that minimizes total holding and ordering costs for the year. (ii) Surplus items, stocks of which are higher than their rate of consumption. There should be an organized approach to inventory management to balance out the anticipated costs and benefits of holding inventories. The aim of inventory management is, therefore, to neither hold too much nor too little inventory, and also to obtain a correct balance between these two extremes. On the basis of objectives of inventory management mentioned earlier, the major problems faced by inventory management are to determine: (a) Level of inventory at which new purchase order should be placed, (b) Quantity of material which should be purchased by each purchase order, and. Inventory Management, also known as stock management, is a crucial part of working capital management. What Would Holding and Ordering Costs Look Like for the Years? Material Management, Inventory Control, Techniques of Inventory Management. The costs associated with the inventory, such as ordering cost and carrying cost, can be distinguished. If less than optimal size quantity of inventory is ordered, the ordering cost will be high. At the same time, it prevents unnecessary investment in inventories. JIT inventory management, as its name advocates, means all inventories, including raw materials, work in progress, and finished goods. This study mainly focuses on ABC analysis. 2) ABC analysis . Reordering level or ordering level is fixed between minimum level and maximum level of inventory. It means that an order for replenishing stock of inventory should be placed as soon as the level is reduced to 30,000 units so that new goods enter the stock before the existing stock is consumed and the manufacturing process continues. At the same time, it prevents unnecessary investment in inventories. (ii) Last in First out Method (LIFO) — newer inventory is sold first and older remains in inventory. (iv) Fast Moving Items – These items are very much in demand. At what level should the order be placed? The total inventory cost for the annual level of demand (including holding costs, ordering costs and purchase costs) should be compared with two order sizes: one for the order size determined by EOQ model and the other for the order size that enables the discount. Inventory turnover ratio and FSN analysis can be effectively used to maintain right investment in inventories and prevent over-stocking of slow-moving items. (c) A firm may not be able to immediately meet the requirements of a massive and unexpected order, since it has few or no stocks of finished goods. The determinant of when to order in a continuous inventory system is the reorder point. EOQ helps businesses overcome stock-out problems and reduce inventory holding costs. Carrying Cost include storage costs, handling costs, insurance expenses etc. In this model, the store manager will reorder the inventory when it reaches the minimum level. Re-order Point 2. (e) The effectiveness of the basic EOQ model is limited by the assumption of a one-product business, and the formula does not allow combining different products in the same order. In this way, the smooth flow of parts and materials is maintained with no inventory build-up at any point. A low turnover rate, on the other hand, indicates over-investment and locking up of working capital in undesirable items. Its cost per order is Rs.50 and its carrying cost unit is Rs.3 per unit per annum. (iii) Just-in-time (JIT) — ordering inventory only as they are needed in the production process. vi. As it scrutinizes the items based on their criticality, it can be used for raw materials that are difficult to procure. These lower costs may make the firm’s products more affordable, and help the firm gain a larger market share and stay ahead of its competitors. The purpose is to minimize variable inventory costs. The objective of inventory management is to minimise the cost of inventory. Lead time may also be called procurement time of inventory. The behaviour of carrying costs is contrary to that of ordering costs. The annual consumption of inventory of the firm is known and is constant. As a result, carrying costs continue to incur on such items. This analysis represents the classification of items based on the criticality in terms of their effect on production function. These inefficiencies ultimately have an adverse impact on profits. When you have a dropshipping agreement, you can directly transfer customer orders and shipment details to your manufacturer or wholesaler, who then ships the goods. The consumption of inventory is uniform through the year. However, this may not be realistic. On the other hand, if the inventory level is too high, the situation of over inventory arises. In order to ensure that enough inventory or stock is held by an organization to meet both its internal and external demand commitments economically, the finance manager needs to decide –. Advantages and Disadvantages of JIT Approach: JIT method, when applied, offers the following advantages: Storing excess inventory may cost a lot of money, and reducing the amount of inventory you keep on hand may reduce your carrying costs as well. Firms that implement the Just-In-Time inventory model may be able to reduce the number of warehouses, they maintain, or even allow them to eliminate those warehouses altogether. In JIT inventory control, the inventories are obtained and introduced in production process at the right time. If a part is vital it is given V classification, if it is essential, then it is given E classification and if it is not so essential, the part is given D classification. and purchase establishment expenses. These items should have tight inventory control, secure storage areas and better sales forecasts. All these items are not equally important. The successful operation of JIT inventory system has the following requirements: i. Good inventory management is essential to the successful operation for most organizations because the amount of money invested in inventory represents, and the impact that inventories have on daily operations of an organization. However, it is necessary to have some control on category ‘C’ items also because some items though very inexpensive may be very critical to whole manufacturing process and non-availability of those items on time may halt the production. Therefore, level of safety stock should be determined after a trade-off between these costs. The items of group C require minimum level of control. One of the assumptions of the EOQ model is instantaneous replenishment and the firm places the order only when the existing level of inventory falls to zero. A typical quantity discount has the following three effects on the income of a purchaser: (a) A saving in the form of reduced price. Therefore, inventory control should be made stringent by adopting advanced techniques. <> Holding a high amount of inventory for a long duration is not idea for a business because of inventory consumes storage space and further it is subject to risk obsolescence and spoilage. In other words, raw materials are expected just in time to be used to manufacture finished products; and finished products are manufactured in time to be supplied to the consumers. 2. Inventory turnover ratio establishes relationship between average inventory and cost of inventory consumed or sold during the particular period. The EOQ is the level of inventory order that minimizes the total cost associated with inventory. Its purpose is to reduce inventory … With the EOQ model, the organization is able to place the right quantity of inventory. iv. Holding costs may include some elements, the costs of which are stepped up with the increase in quantity; for example, if inventory reaches a level where another member of staff is required to control it, there is a stepped increase in costs. On the other hand, if goods are purchased in small quantities, carrying costs decrease but ordering costs increase due to increased number of orders. Basically, the products that were acquired first will also be the first products that you sell. Usually a firm has to maintain several different items as inventory. In determining re-order point, we have assumed that lead time and average usage rate have been correctly estimated. In case of purchases in large quantities, carrying costs increase but ordering costs decrease. Economic Order Quantity . The sum of ordering costs and carrying costs represents the total costs of inventory. (c) It assumes purchase price and ordering costs of inventory units to be constant throughout the year. In this technique, various items of inventory are categorised into three groups of priority. 4 0 obj For example, gaskets for piping connection. One thing that has made possible JIT inventory control is the introduction of the Internet. Inventory holding cost is based on average inventory. However, it should be used with thoughtfulness as the items are categorised on the basis of their value and not on their relative importance. C = the annual usage (or demand) of the item, in units. Account Disable 12. The VED Analysis is very useful in categorizing items of spare parts and components. 50 an order, and the carrying costs are Rs. Danger level is determined by the following formula: Danger level = Average consumption x Maximum reordering point for emergency purchases. Therefore, it is not desirable to keep same degree of control on all these items. The various stock levels maintained by an organization are discussed as follows: Represents the rate of inventory that must be maintained all the times. When a firm uses the traditional method of inventory management and control, it may end up with unsold items. (ii) Carrying Cost – It refers to the cost of keeping items in stock e.g. ABC analysis involves a perusal of a range of items such as finished products, items lying in inventory or with customers that have different levels of significance and thus, should be handled or controlled differently. Just-In-Time Systems Approach 13. However, JIT does suffer from limitations. Stock-out costs are losses due to being out of stock. D stands for dead stock whose usage rate is negligible because the organization does not foresee any additional demand of such products. It assists in reducing certain traditional fixed costs; however, at times, it may reduce variable costs. Various suppliers would then bid for the contract. If the firm is planning a production run, the issue is to decide as to how much production to schedule. FSN analysis groups them into three categories as Fast-moving, Slow-moving and Non-moving (or dead) stock respectively. Firms that use the Just-In-Time model have a greater level of control over the entire manufacturing process, making it easier to respond quickly when the needs of customers change. The ordering costs are inversely related to the inventory carrying costs, i.e. For instance, when the purchasers following EOQ model have the opportunity to avail a quantity discount on order sizes greater than their EOQ, they need to base their decision on the net effect of the decision on their income. (c) Safety Stock – The quantity of inventory on hand by a firm in the event of fluctuating usage or unusual delays in lead time is called safety stock. The consumption is even throughout the year. The FIFO stock control method is when a retailer fulfills an order with the item that has been sitting on the shelf the longest. Record Based Techniques. Rather it should exercise greater control over more costly items and lesser control over less costly items. To provide for these types of events, managers carry a “buffer” or safety stock of items to protect the firm from stock- outs. On the basis of cost, various inventory items are categorized into three classes, such as, A, B, and C. The items included in group A require large amount of investment. Receipt of inventory may be delayed beyond the estimated lead time due to strikes, floods, transportation problems etc. The investment incurred in items of group B is moderate, thus, it deserves less attention than A but more attention than C. The ABC analysis divides the total inventory into three classes using their percentage value. The cost of carrying inventory is used to help companies determine how much profit can be made on current inventory. This length is called … The optimal level of inventory is the one that minimizes the cost and maximizes the benefits of the inventory. For example, Lead time in a business is 15 days and average daily usage of inventory is 2,000 units. 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