Inventory Quantity Standards
1. Ordering Level or Ordering Point or Re-ordering Level:
This is that level of material at which a new order for supply of material is to be placed. In other words, at this level a purchase requisition is made out. This level is fixed some where between maximum and minimum levels. Order points are based on usage during time necessary to requisition order, and receive materials, plus an allowance for protection against stock out.
The order point is reached when inventory on hand and quantities due in are equal to the lead time usage quantity plus the safety stock quantity.
The following two formulas are used for the calculation of re-ordering level or point:
(i) Ordering Point or Re-order level = Maximum daily or weekly or monthly usage × lead time
(Lead time would mean the time required to get fresh or new supply of material)
The above formula is used when usage and lead time are known with certainty; therefore, no safety stock is provided.
When safety stock is provided then the following formula will be applicable:
(ii) Ordering point or Re-order Level = Normal daily or weekly or monthly usage × lead time + Safety Stock.
2. Minimum Level or Minimum Limit:
The minimum stock or level is the lowest level to which the inventory should be allowed to fall. It is the cushion stock which allows some margin of safety.
In other words, the minimum level is that level of stock below which stock should not normally be allowed to fall. In case of any item falling below this level, there is danger of stoppage of production and, therefore, the management should give top priority to the acquisition of new supplies.
Minimum level or limit may be calculated as follows:
Minimum Limit or Level = Re-order Level or Ordering Point – Average or Normal Usage × Normal reorder period
Or it can be written as follows:
Minimum Level = Reorder Level – Average usage for normal reorder period.
3. Maximum Level or Maximum Limit:
The maximum stock limit is upper level of the inventory and the quantity that must not be exceeded without specific authority from management. In other words, the maximum stock level is that quantity of material above which the stock of any item should not normally be allowed to go. This level is fixed after taking into account such factors as: Capital available, rate of consumption of materials, storage space available, insurance cost, risk of deterioration and obsolescence, and Economic order quantity.
The maximum level or limit may be calculated by the help of following formula:
Maximum Limit or Level = Reorder Level – minimum usage × minimum reorder period + Economic Order Quantity.
4. Danger Level:
Some enterprises also calculate ‘danger level’. When this level of stock is reached, then emergency steps are taken by the management to acquire material supplies. When this level is reached, the try is made to purchase materials from the nearest possible source or place so that the workers and plant and machinery may not remain idle due to shortage of material supplies. It may be calculated as follows:
Danger Level = Average daily requirement × time required to get emergency supply.
5. Economic Order Quantity
economic Order Quantity is that size of the order which gives maximum economy in purchasing any material and ultimately contributes towards maintaining the material at the optimum level and at the minimum cost. In other words, the Economic Order Quantity is the amount of inventory to be ordered at one time for purposes of minimising annual inventory cost.
The quantity to order at a given time must be determined by balancing two factors (1) the cost of possessing (carrying) materials and (2) the cost of acquiring (ordering materials). Purchasing a larger quantities may decrease the unit cost of acquisition, but this saving may not be more than offset by the cost of carrying materials in stock for a longer period of time.
The carrying cost of inventory may include:
Interest on investment of working capital; property tax and Insurance, storage cost, handling cost, deterioration and shrinkage of stocks, obsolescence of stocks.
The different formulas have been developed for the calculation of Economic Order Quantity.
The following formula is usually used for the calculation of Economic Order Quantity (E. O. Q):
