In this section, let us gain some idea about various costs and terminology associated with Inventory Management.
associated with Inventory Management
In this section, let us gain some idea about
various costs and terminology associated with Inventory Management.
1. Set up Cost ( or) Ordering
For example, consider a production unit, which is
manufacturing Instant Food mixes, using the same grinding and packing
facilities for both ‘Idli-mix’ and ‘Kesari Mix’. Before they change the production
run it is necessary to clean the grinder with left outs of previous runs. Some
time, they may use some common materials to clear or using cotton waste to
clearing the residues or some special chemicals to clean it. It may consume
material and/or men or there is some amount of cost associated with the
On the other hand, if we have to place an order as
in the case of a Stockist/Dealer, the cost may range from simple clerical plus
stationers plus postage to complex estimates such as placing a quotation. Here
again it consumes labor and/or material, and finally can be bringing down to a
cost element associated with it.
Thus, this is the cost incurred with the placement
of an order or with the initial preparation of production facility such as
resetting the equipment for production. The set up cost is usually independent
of the quantity ordered or size of the production run.
2. Production cost (or) Selling
It is the actual price; an item is produced or
purchased (sold). In case of production it is the cost of producing an item and
it may be a constant or variable one.
3. Holding cost (or) Storage cost
(or) Carrying cost.(C1)
This represents the cost of carrying inventory in
storage. It includes the interest on invested capital, storage space cost,
insurance and handling cost. Holding costs are usually assumed to vary directly
with the level of inventory as well as the length of the time the item is held
Holding cost consists of so many components with it
and the type of storage such as own warehouses to rental warehouses, makes
things much more complicated than expected. Above all, the accounting practices
of many organizations may not support or sound enough to decide the cost
estimates. Even though, the company owns the storage space, electricity
expenses are met, the policies may not be very clear to arrive at the
opportunity cost forgone by owning these facilities.
4. Shortage cost. (C2)
These are the penalty cost incurred as a result of
running out of stock, when the commodity is needed. It generally includes the
costs, due to loss of production, cost of idle equipment, the loss of goodwill
of customers and the penalty of missing the delivery schedule.
In a study on FMCG segments, the stock out percentages
of 85 prime brands, were estimated roughly around 25%, which means, out of
these 85 fast moving brands, on an average, nearly 20 brands will be out of
stock 4. These 85 brands, was in a position to control roughly 20% market share
of the FMCG segment. The amount of revenue loss and loss of good will and
ultimately loss of the customer base are going to be the consequences of
Recent survey reports of NCEAR say that brand
switching is a common phenomenon in most of the FMCG product lines. Above all,
the companies are trying for the same market share through the variety of
consumer promotion tools. During the year 2001, almost 25-30 consumer
promotions were offered in a month against the average of 5-6 5. In the case of
rural consumers, the rate of brand switching is much higher than the urban
Some of the companies while purchasing make it
compulsory to include a class on treatment on missing the scheduled delivery.
Most of the times, very huge penalty such as the loss estimated as the case of
missed scheduled will be entirely borne by the supplier and the missed
scheduled used to estimate the performance of the vendor/seller/suppliers.
Demand is the number of units required per period
and may be known exactly or known in terms of probabilities.
in which demand is known and fixed are called deterministic problems. Problems in which demand is assumed to be a random
variable are called stochastic problems. The demand is invariably probabilistic
in nature for many real time situations. For some of the products, the demand
may be seasonal also, such as soft drinks, cement etc.
When an order is placed it may be
of instantaneous delivery or it may
require some time before delivery is effected. The time between the placement
of order and its receipt is called lead-time. Again the lead-time may also
follow probability distribution. I.e., the lead-time is certain or uncertain.
Consider the example of a FMCG Distribution channel, which faced lot of
problems with high amount of inventory and distribution efficiency.
If the distributor is placing order on, say
February 1, the order may be processed at the Storage point by 4or 5 the month,
he will get the stocks by end of 8 or 9. This will hold well if everything goes
as expected. If there is stock out of one or two of the products, then the lead-time
may vary further. If we refer the picture, the company has suffered with high
amount of inventory, which is almost 50% of the annual sales of the company.
The problem is estimating the demand and lead-time with certain amount of
7. Stock Replenishment Getting stocks again is called replenishment.
Instantaneous replenishment occurs when the stock is purchased from outside.
Uniform replenishment may occur when the procured from local manufacturer.For example, an automobile manufacturer purchasing
Tyres from the local Original Equipment Manufacturer, used to get stocks at
some fixed intervals say everyday one truckload or 1000 Tyres instead of
getting the entire estimated demand of 30,000 Tyres in a month at once. Some of
the parts such as screws and bolts etc can be purchased at bulk and stored.
Here the entire demand for the month is supplied at once.
8. Inventory control with known
control problem in which demand is assumed to be fixed and completely known is
called Economic Order Quantity (EOQ) problems. If it is the context of
production, the batch size to be produced is fixed and completely determined in
advance, and then it is known as Economic Lot Size problems.
9. Buffer Stock or Safety Stock Generally demand is uncertain and cannot be pre
determined completely. Lead-time is not always known exactly. The revenue
forgone by not keeping adequate inventory i.e., cost of under stocking and
sometimes payment of penalty for not meeting the delivery schedule are consequences
of inadequate inventory levels. To overcome the situations of uncertainty in
demand and lead-time, some extra stock is advisable so that shortages may not
occur. This extra stock is known as buffer stock.
Tags : Operations Management - Transportation / Assignment & Inventory Management
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