Page 177 - DMGT409Basic Financial Management

Basic Financial Management

Notes Order Point Problem

After determination of EOQ, then at what level should the order be placed? If the inventory level
is too high, it will be unnecessary blocks the capital, and if the level is too low, it will disturb
the production by frequent stock out and also involves high ordering cost. Hence, an effi cient
management of inventory needs to maintain optimum inventory level, where there is no stock
out and the costs are minimum.
The different stock levels are as follows:

1. Minimum Level: Minimum stock is that level that must be maintained always production
will be disturbed, if it is less than the minimum level. How to fix minimum level? While

determination of minimum stock level, lead time, consumption rate, the material nature
must be considered
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Did u know? What is Lead time?
Lead-time is the time taken to receive the delivery after placing orders with the supplier. In
other words, the number of days required to receive the inventory from the date of placing
order. Lead time also called as procurement time of inventory.
Minimum stock level = Re-order level – [Normal Usage x Average delivery time]

2. Reordering Level: Reorder level is that level of inventory at in weeks, which an order should
be placed for replenishing the current stock of inventory. Generally, the reorder level lies
between minimum stock level and maximum stock level.

Re-order point = Lead time (in days) x Average Daily usage
The above formula is based on the assumption that (a) Consistent daily usage, and (b)
Fixed lead-time.

3. Safety Stock: Prediction of average daily usage and lead-time is difficult. Raw materials
may vary from day-to-day or from week-to-week, it is in the case of lead-time also. Lead-
time may be delayed, if the usage increases then the company faces problem of stock out.

To avoid stock out firm may require to maintain safety stock.
Formula (under uncertainty of usage and lead time)
Re-order point = Lead time (in days) × Average usage + Safety stock

4. Maximum Level: Maximum level of stock, is that level of stock beyond which a fi rm should
not maintain the stock. If the firm stocks inventory beyond the maximum stock level it

is called as overstocking. Excess inventory (overstock) involves heavy cost of inventory,
because it blocks firms funds in investment inventory, excess carrying cost, wastage,

obsolescence, and theft cost. Hence, firm should not stock above the maximum stock

level.
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Did u know? What is Safety Stock?
Safety stock is that minimum additional inventory to serve as a safety margin or better
or buffer or cushion to meet an unanticipated and increase in usage resulting from an
unusually high demand and or an uncontrollable late receipt of incoming inventory.
Maximum Stock Level = Reorder Level + Reorder Quantity - (Minimum Usage x Minimum
Delivery Time)

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