Management must make decisions about the control of stock levels with a view to minimizing the cost of the company while achieving more efficiency in the availability of material to fulfill planned usage requirements. Consideration should be given to the following control levels:
a) Minimum stock level
b) Maximum stock level
c) Re-order level
d) Re order-quantity (Note the re-order quantity is not necessary the Economic Order Quantity (EOQ)
Minimum stock level
This is the level below which stocks should not be allowed fall. It is essentially a base (buffer) stock level. If stock falls below this point, there is a danger of stock-out and firms will incur shortage costs. This may also be referred to as safety stock. It can be expressed as:
Minimum Stock Level = Reorder level – (Normal consumption x normal reorder period)
Stock out may be caused by various factors such as delay on the part of the supplier, an increase in material usage due to a change in the pattern of production and increase in scrap levels in the production process and delays in placing orders due to scarcity of suppliers.
Maximum stock level
This is the upper limit above which stock should not be allowed to exceed. Each material to be kept in store must have a maximum level and stock should not be allowed to go beyond this level. If stock level goes beyond this point, then the firm will be overstocking hence incur high holding costs. It is computed as follows.
Maximum Stock level = Reorder level + Reorder Quantity – (Minimum Consumption x
Minimum reorder period)
In setting the maximum stock level, the cost accountant must take into account various other factors that may act as a constraint. This may include the nature of the materials being stocked, rate of consumption of materials, lead time or re-order period, availability of adequate storage space and the cost of storing versus the benefits derived from advantageous purchasing.
It is a point that lies between minimum and maximum stock levels at which purchase orders must be placed to ensure that goods ordered are received before the minimum stock level is reached. It is the level of stocks if and when approached; orders for stock replenishment must be made to cater for the unused stocks. This level is normally higher than the minimum stock level to cover for emergencies such as abnormal usage or unexpected delay in the delivery of new supplies. It can be expressed as follows:
Reorder Level – Maximum Consumption X Maximum Re-order Period
This is the quantity of stock ordered once the re-order point is reached. The quantity is such as to minimize stock costs taking into consideration the cost of holding stocks and making an order.
The EOQ is an example of a re-order quantity. However, reorder quantity must not be the EOQ. Given the maximum stock level, the reorder level, minimum usage and the minimum reorder level, it may be computed as follows:
Re-order quantity = Maximum Stock – Re-order level + (Minimum Usage X Minimum
Costs associated with materials
This is the price charged by the supplier on an item of inventory. Purchase price will remain irrelevant, where prices are fixed and no discounts are offered or no advantageous purchasing exists. However, if there exists discounts associated with quantity purchased, they remain relevant for decision making.
Purchase cost = Acquisition price per unit x Number of units
Holding or carrying cost
These are costs incurred because firms own or maintain inventories. They are associated with high stock levels and include opportunity cost of funds tied up in stock, incremental in insurance costs, incremental warehousing and storage costs, incremental material handling costs and cost of obsolescence and theft of stock. The relevant holding cost should include those items which vary with the level of stock. Costs unaffected by changes in the inventory levels are irrelevant in decision making and thus not included in carrying costs, for instance, rent, depreciation of equipment and salaries for storekeepers. Costs such as insurance costs should be included only when premiums are charged on the fluctuating value of stocks. Therefore, fixed annual insurance cost is irrelevant and thus should not be included in the ordering cost.
Carrying costs = Holding cost per unit per annum x Average stock
Ordering and procurement costs
This is the cost of getting an item into the firm’s inventory. It usually consists of clerical costs of preparing a purchase order, receiving deliveries and paying invoices. Ordering costs that are common to all stock decisions are irrelevant, and only incremental ordering costs are used. Note that ordering costs are incurred each time an order is made and are associated with low stock levels.
Stock out costs; they are costs incurred as a result of an item not being in stock. They include loss of future sales due to disappointed customers, loss of goodwill, lost contribution or profit from lost sales, extra costs of speeding up orders, etc.