Inventory Level Control – Definition, Formula, and Example

Inventory level control is referred to as controlling the threshold of inventory to avoid delay in production. It’s the level of inventory that should be available within the warehouse all the time.

An important concept of inventory level controls is to create a balance between capital tied up in the inventory and the availability of the inventory all the time for production.

Adequate management of the inventory level helps to ensure that excess working capital is not tied in the working capital and inventory is available for production all the time.

The concept of inventory level control starts with the question that how much should be the threshold of inventory to meet expected/unexpected demands of the production/sales. The answer to this question is dependent on the nature of the business, stock management policies, resources of the business, lead time of the inventory, cost of ordering and the cost of holding, etc.

The concept of inventory control applies to all types of inventory that include raw material, finished goods, and spare parts, etc. Normally, the businesses have two sides of stock management which include maintaining little or no inventory and holding higher stock.

Maintaining low/no inventory

Advantages

1. The maintenance of the low inventory requires a lower cost of holding.
2. It’s a flexible approach to stock management and helps you to avoid the hustle of huge inventory management.
3. There is a lower/no risk of inventory obsolescence.
4. The cost of safety and holding of the goods is lower.
5. The working capital tied up in inventory is lower that helps to increase profitability.
6. The approach is the most suitable if the inventory is perishable and lead time short.

Disadvantages

1. The cost of going out of stock can cost not only profit but the goodwill of the business and loss of customers.
2. A little setback in the process can affect the entire chain of the business.
3. If the supplier fails to deliver, it’s the business that suffers.
4. If the cost of ordering is higher, it may impair the profitability of the business.
5. If the lead time is higher, it may further deteriorate the production efficiency.

Holding higher stock

Holding higher stock has the following advantages and disadvantages.

Advantages

1. Holding higher stock gives an inner peace of the mind that sufficient stock is backed for production.
2. It gives economies of the scale as business intends to accumulate higher level of stock. So, they can purchase more.
3. The ordering cost of the inventory is lower as more stock is received in one order.
4. It’s a smart idea to order bulk quantity in times of inflation as the cost of goods in future order is expected to rise.

Disadvantages

1. Holding cost is higher considering the volume of the stock.
2. More money is tied up in the management of the inventory.
3. The cost of security is higher.
4. The risk of obsolete inventory is higher.

Methods for inventory level control

The concept of inventory level decision helps to bring a balance in high/low level of inventory considering advantages and disadvantages discussed above. The well-known methods to control the volume of inventory include minimum stock level, stock review, and JIT.

Minimum stock level

The minimum stock level is when the business identifies the minimum quantity of the goods to be maintained in the warehouse. Once the level of the stock reaches a set threshold, the order is placed to the supplier.

Regular stock review

The business managers make quantity reviews on a regular interval and calculate differential quantity to reach the predetermined level. The differential quantity is ordered to the supplier.

Just in time

The just in time is a system of inventory management that believes in zero inventory. The business does not maintain inventory in the warehouse while an order is made and received on the demand. The business does not need a warehouse as they do not need to maintain the inventory level.

The JIT approach works the best when the premises of the business and suppliers are in the vicinity. There should be no lead time required to transport the inventory from the supplier to the business.

For instance, the clothing manufacturing business gets supplies of the thread from the factory adjacent to production premises and does not need to store the threads in their warehouse. The success of the JIT approach depends on the mutual understanding between the business and supplier.

Economic order quantity – EOQ

If it’s not suitable for the business to follow JIT and they decide to rely on the traditional method of minimum level stock and stock regular review, the business needs to decide what should be the quantity of the order. EOQ is the method of inventory management that uses a certain formula to calculate the threshold where inventory should be ordered.

It takes into account the annual volume of demand/consumption, cost of ordering, and the cost of holding, etc. The formula makes use of the mathematical concepts that keep the cost of ordering and holding minimum while meeting the demands for the product.

Formula

EOQ = Economic Order Quantity

D = Demand

S = Cost per order

H = Holding cost

Example

Consider a demand for products is 20,000 units per annum. The cost of the order is USD 10 and the cost of holding is USD 2. Let’s apply the given data in the formula to calculate the EOQ for the business.

If the business orders 447 units to the supplier in their order, they will be able to manage the minimum cost of holding and the cost of ordering. However, the business needs to consider seasonal variation in the demands of their products and how they manage to meet the expectations of the customers.

Further, the EOQ moded does not consider current stock held by the business on the premises and it might not be possible to calculate the EOQ of each item if there are several items sold by the business.