Planning the Inventory Resources in Logistics

Determining ordering point

In the EOQ model, the leas time for the procurement material is assumed to be zero. Consequently the ordering point for replenishment of stock occurs when the level of inventory drops down to zero. In view of instant replenishment of stock, the level of inventory jumps to the original level from zero level.

However, in real life situations, one never encounters a zero lead-time. There is always a time lag from the date of placing an order for materials and the date on which the materials are received. As a result, the ordering level is always at the level higher than zero. If the firm orders the goods when the inventory level reaches the reorder point, the firm will never run out of goods. The decision on how much stock to hold is generally referred to as “Order point problem” that is how low should the inventory be depleted before it is reordered.

The two factors that determine the appropriate order point are the:

a)           Procurement or delivery time stock (inventory needed during the lead time) and;

b)         The safety stock, which is the minimum level of inventory that is held as a protection against shortages.

Reorder point = Normal consumption + safety stock during lead-time.

In summary, the efficiency of the replenishment system affects how much delivery time is needed.

Determination of level of safety stock involves a basic trade-off between the risk of stock-out, resulting in possible customer dissatisfaction and lost sales, and the increased costs associated with carrying additional inventory.

Reorder level = (Average daily usage rate) x (Lead time in days)

Safety stock

When the wage rate and/or lead-time vary, then the reorder level should naturally be at a level high enough to cater to the production needs during then procurement period and also to provide some measure of safety for at least partially neutralizing the degree of uncertainty.

How much should the magnitude of safe stock be?

It depends on the degree of uncertainty surrounding the usage rate and lead-time. It is possible to a certain extent of to quantify the values that usage rate and lead-time can take along with the corresponding ‘chances of occurrences’ known as ‘probabilities’. These probabilities can be ascertained based on the previous experiences and the judgmental ability of executives. Based on the above values and estimated stock out costs and carrying costs of inventory it is possible to work out the total cost associated with different levels of safety stock. Higher the quantity of safety stock, the lower will be the stock-out cost and the higher will be the incidence of carrying costs. Thus the reorder level will call for a trade-off between stock out costs and carrying cost. The reorder level will be such that the total stock out cost and the carrying cost will be at its minimum.

Cost of carrying inventory

Carrying material in inventory is expensive. A number of studies indicated that the annual cost of carrying a production inventory averaged approximately 25% of the value of the inventory. The escalating and volatile cost of money has escalated the annual inventory carrying cost to a figure between 25% – 35% of the value of the inventory. The following five elements make up this cost:

1)           Opportunity cost (12% -20%)

2)           Insurance cost (2% — 4%)

3)           Property taxes (1% – 3%)

4)           Storage costs (1%- 3%)

5)           Obsolescence and deterioration (4% – 10%)

Total carrying cost (20% – 40%)

Let us briefly look into these costs:

Opportunity cost of invested funds

When a firm uses money to buy production material and keeps it in the inventory, it simply has this much less cash to spend for other purposes. Money invested in external securities or in productive equipment earns a return for the company. Thus it is logical to charge all money invested in inventory an amount equal to that it could earn elsewhere in the company. This is the opportunity cost associated with inventory investment.

Insurance cost

Most firms insure the assets against possible losses from fire and other forms of damage.

Property taxes

This is levied on the assessed value of a firm’s assets, the greater the inventory value, the greater the asset value and consequently the higher the firm’s tax bill.

Storage costs

The warehouse is depreciated every year over the length of its life. This cost can be charged against the inventory occupying the space.

Obsolescence and deterioration

In most inventory operations, a certain percentage of the stock spoils, is damaged, is pilfered, or eventually becomes obsolete. A certain number always takes place even if they are handled with utmost care.

Generally speaking, this group of carrying costs rises and falls nearly proportionately to the rise and fall of the inventory level. Moreover, the inventory level is directly proportional to the quantity in which the ordered material is delivered. Hence costs of carrying inventory vary nearly directly with the size of the delivery quantity. This relationship is illustrated as follows:

(Carrying Cost per year) = (Average inventory value) x (Inventory carrying cost as a % of inventory value)

Origin purchase

Buyer incurs the freight cost and product risk when the product is in transit.

Source: Scribd.com

One thought on “Planning the Inventory Resources in Logistics

  1. Essentially, planning resources in the logistics spectrum is the crux of all SCM activities. To ensure customer satisfaction at less and/or optimised cost(s) all inventories carried throughout the logistics spectrum need to be planned in a balance to ensure that there are no inventory wastes. The essence of effective and efficient SCM stems at effective and efficient inventory management and control.

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