Obtaining actual order, setup, carrying and shortage costs are difficult – sometimes impossible. Even the assumptions are sometimes unrealistic. All inventory systems are plagued by two major problems
- Maintaining adequate control over each inventory item
- Ensuring that accurate records o stock on hand are kept
Three simple inventory systems are often used in practice:
- Optional Replenishment System
- One-Bin System
- Two-Bin system
Apart from the above three systems, ABC Analysis is a popular method used for analysing inventory based on value. Cycle counting is another technique used for improving inventory record accuracy.
Optional Replenishment System
This system forces reviewing the inventory level at a fixed frequency (such as weekly) and ordering replenishment supply if the level has dropped below some amount. For instance, the maximum inventory level can be computed based on demand, ordering costs and shortage costs. Because it takes time and costs money to place an order, a minimum order of size Q can be established. Then, whenever this item is reviewed, the inventory position (I) is subtracted from the replenishment level (M). If that number (say, q) is equal to or greater than Q, order q. Otherwise, forget it until the next review period. Stated formally,
q = M – 1
If q ≥ Q, order q. Otherwise, do not order any.
Two-Bin System
In a two-bin system, items are used from one bin, and the second bin provides an amount large enough to ensure that the stock can be replenished. Ideally, the second bin would contain an amount equal to the reorder point (R) calculated earlier. As soon as the second bin supply is brought to the first bin, an order is placed to replenish the second bin. Actually, these bins can be located together. In fact, there could be just one bin with a divider between. The key to a two-bin operation is to separate the inventory so that part of it is held in reserve until the rest is used first.
One-Bin System
A one-bin inventory system involves periodic replenishment no matter how few are needed. At fixed periods (such as weekly), the inventory is brought up to its predetermined maximum level. The one bin is always replenished, and it therefore differs from the optional replenishment system, which reorders only when the inventory used is greater than some minimum amount.
ABC Inventory Planning
Maintaining inventory through counting, placing orders, receiving stock and so on takes personnel time and costs money. When there are limits on these resources, the logical move is to try to use the available resources to control inventory in the best way. In other words, focus on the most important items in inventory.
In the 19th century, Villefredo Pareto, in a study of the distribution of wealth in Milan, found that 20% of the people controlled 80% of the wealth. This logic of the few having the greatest importance and the many having little importance has been broadened to include many situations and is termed the Pareto principle. This is true in our everyday lives (most of our decisions are relatively unimportant, but a few shape our future) and is certainly true in inventory systems (where a few items account for the bulk of our investment).
Any inventory system must specify when an order is to be placed for an item and how many units to order. Most inventory control situations involve so many items that it is not practical to model and give thorough treatment to each item. To get around this problem, the ABC classification scheme divides inventory items into three groupings: high dollar volume (A), moderate dollar volume (B) and low dollar volume (C). Dollar volume is a measure of importance; an item low in cost but high in volume can be more important than a high-cost item with low volume.
ABC Classification: If the annual usage of items in inventory is listed according to dollar volume, generally, the list shows that a small number of items account for a large dollar volume and that a large number of items account for a small dollar volume.
The ABC approach divides this list into three groupings by value: A constitutes roughly the top 15% of the items, B items the next 35%, and C items the last 50%. Segmentation may not occur always so neatly. The observation, though, is to try to separate the important from the unimportant. Where the lines actually break depends on the particular inventory under question and on how much personnel time is available.
The purpose of classifying items into groups is to establish the appropriate degree of control over each item. On a periodic basis, for example, class A items may be more clearly controlled with weekly ordering, B items may be ordered biweekly, and C items may be ordered monthly or bimonthly. Note that the unit cost of items is not related to their classification. An A item may have a high dollar volume through a combination of either low cost and high usage or high cost and low usage. Similarly, C items may have a low dollar volume because of either low demand or low cost. In an automobile service station, for example, gasoline would be an A item with daily or weekly replenishment; tires, oil, batteries, grease and transmission fluid may be B items and ordered every two to four weeks; and C items would consist of valve stems, windshield wiper blades, radiator caps, hoses, fan belts, oil and gas additives, car wax, and so on. C items may be ordered every two or three months or even be allowed to run out before reordering because the penalty for stock out is not serious.
Sometimes an item may be critical to a system if its absence creates a sizeable loss. In this case, regardless of the item’s classification, sufficiently large stocks should be kept on hand to prevent run out. One way to ensure closer control is to designate this item an A or B, forcing it into the category even if its dollar volume does not warrant such inclusion.
Inventory Accuracy and Cycle Counting
Inventory records usually differ from the actual physical count; inventory accuracy refers to how well the two agree. Companies such as Wal-Mart understand the importance of inventory accuracy and expend considerable effort ensuring it. The question is how much error is acceptable? If the record shows a balance of 683 of part X and an actual count shows 652, is this within reason? Supposedly, the actual count shows 750, an excess of 67 over the record; is this any better?
Every production system must have agreement, within some specified range, between what the records says is in inventory and what actually is in inventory. There are many reasons why records and inventory may not agree. For example, an open stockroom area allows items to be removed or both legitimate and unauthorized purposes. The legitimate removal may have been done in a hurry and simply not recorded. Sometimes parts are misplaced, turning up months later. Parts are often stored in several locations, but records may be lost or the location recorded incorrectly. Sometimes stock replenishment orders are recorded as received, when in fact they never were. Occasionally, a group of parts is replaced in inventory without cancelling the record. To keep the production systems flowing smoothly without parts shortages and efficiently without excess balances, records must be accurate.
How can a firm keep accurate, up-to-date records? The first general rule is to keep the storeroom locked. If only storeroom personnel have access, and one of their measures of performance for personnel evaluation and merit increases is record accuracy, there is a strong motivation to comply. Every location of inventory storage, whether in a locked storeroom or on the production floor, should have a recordkeeping mechanism. A second way is to convey the importance of accurate records to all personnel and depend on them to assist in this effort. This all boils down to this: Put a fence that goes all the way to the ceiling around the storage area so that workers cannot climb over to get parts; put a lock on the gate and give one person the key. Nobody can pull parts without having the transaction authorized and recorded.
Cycle Counting: Another way to ensure accuracy is to count inventory frequently and match this against records. A widely used method is called Cycle Counting. It is a physical inventory-taking technique in which inventory is counted frequently rather than once or twice a year. The key to effective cycle counting and, therefore, to accurate records lies in deciding which items are to be counted, when, and by whom.
Virtually all inventory systems these days are computerized. The computer can be programmed to produce a cycle count notice in the following cases:
- When the record shows a low or zero balance on hand; it is easier to count fewer items.
- When the record shows a positive balance but a backorder was written (indicating a discrepancy).
- After some specified level of activity.
- To signal a review based on the importance of the item, as in the ABC system.
The easiest time for stock to be counted is when there is no activity in the stockroom or on the production floor. This means on the weekends or during the second or third shift, when the facility is less busy. If this is not possible, more careful logging and separation of items are required to count inventory while production is going on and transactions are occurring.
The counting cycle depends on the available personnel. Some organizations schedule regular stockroom personnel to do the counting during lulls in the regular working day. Other companies hire private firms that come in and count inventory. Still other firms use full-time cycle counters who do nothing but count inventory and resolve differences with the records. Although this last method sounds expensive, many firms believe that it is actually less costly than the usual hectic annual inventory count generally performed during the two- or three-week annual vacation shutdown.
The question of who much error is tolerable between physical inventory and records has been much debated. Some firms strive for 100% accuracy, whereas, others accept 1, 2 or 3% error. The accuracy level often recommended by experts is + 0.2% for A items, + 1% for B items, and + 5% for C items.
Regardless of the specific accuracy decided on, the important point is that the level be dependable so that safety stocks may be provided as a cushion. Accuracy is important for a smooth production process so that customer orders can be processed as scheduled and not held up because of unavailable parts.
