Carrying of too much and too little of inventories is detrimental to the firm. If the inventory level is too little, the firm will face frequent stock-outs involving heavy ordering cost and if the inventory level is too high it will be unnecessary tie-up of capital. Therefore, an efficient inventory management requires that a firm should maintain an optimum level of inventory where inventory costs are the minimum and at the same time there is not stock-out which may result in loss of sale or stoppage of production. Various stock levels are discussed as such.
(a) Minimum Level:
This represents the quantity which must be maintained in hand at all times. If stocks are less than the minimum level then the work will stop due to shortage of materials. Following factors are taken into account while fixing minimum stock level:
Lead Time: A purchasing firm requires some time to process the order and time is also required by supplying firm to execute the order. The time taken in processing the order and then executing it is known as lead time.
Rate of Consumption: It is the average consumption of materials in the factory. The rate of consumption will be decided on the basis pas experiences and production plans.
Nature of Material: The nature of material also affects the minimum level. If material is required only against special orders of customer then minimum stock will not be required for such materials.
Minimum stock level = Re-ordering level − (Normal consumption × Normal Reorder period)
(b) Re-ordering Level:
When the quantity of materials reaches at a certain figure then fresh order is sent to get materials again. The order is sent before the materials reach minimum stock level. Reordering level is fixed between minimum and maximum level. The rate of consumption, number of days required to replenish the stock and maximum quantity of material required on any day are taken into account while fixing reordering level.
Re-ordering Level = Maximum Consumption × Maximum Re-order period
(c) Maximum Level:
It is the quantity of materials beyond which a firm should not exceed its stocks. If the quantity exceeds maximum level limit then it will be overstocking. A firm should avoid overstocking because it will result in high material costs.
Maximum Stock Level = Re-ordering Level + Re-ordering Quantity
− (Minimum Consumption × Minimum Re-ordering period)
(d) Danger Level:
It is the level beyond which materials should not fall in any case. If danger level arises then immediate steps should be taken to replenish the stock even if more cost is incurred in arranging the materials. If materials are not arranged immediately there is possibility of stoppage of work.
Danger Level = Average Consumption × Maximum reorder period for
(e) Average Stock Level:
The average stock level is calculated as such:
Average Stock level = Minimum Stock Level + ½ of Re-order quantity