Primarily there are four types on inventory levels:
- 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 business might stop due to shortage of materials.
Following factors are taken into account while deciding minimum stock level:
- Lead Time: A business needs some time to process a purchase order and time is also required by the supplier/vendor to send the goods. The time taken in processing the order and then executing it is known as lead time. It is essential to maintain some inventory during this period to meet production requirements. If lead time of a supplier is 4 days, business must ensure inventory level doesn't go to danger level until goods are received.
- Rate of Consumption: It is the average consumption of material items in the business.
- Nature of Material: The nature of material also affects the minimum level. If a material is required only against special orders of the customer then minimum stock will not be required for such materials. Wheldon has given the following formula for calculating minimum stock level:
Re-ordering Level – (Normal Consumption x Normal Reorder Period)
- Re-ordering Level: When the quantity of materials reaches a certain level then fresh purchase order is sent to the suppliers. The order is sent before the materials reach minimum stock level. Reordering level is fixed between minimum level and maximum level. The rate of consumption, number of days required to replenish the stocks and maximum quantity of materials required on any day are taken into consideration while fixing reordering level. Re-ordering level is fixed with following formula shown below:
Reordering Level = Maximum Consumption Rate x Maximum Reorder period.
- Maximum Level: It is the quantity of materials beyond which a firm should not exceed it's stocks. If the quantity exceeds maximum level limit then it will be termed as overstocking. A firm avoids overstocking because it will result in high material costs. Overstocking will lead to the requirement of more capital, more space for storing the materials and more charges of losses from obsolescence.
- Danger Level: It is the level below which stocks should not fall in any case. If danger level approaches then immediate steps should taken to replenish the stocks even if more cost is incurred in arranging the materials. Danger level can be determined with the following formula:
Danger Level = Average Consumption x Maximum reorder period for emergency purchases.
- Average Stock level: The Average stock level is calculated such as:
Lets assume your minimum stock level is 5 units and average reorder qty is 50. Under this equation your Average stock level would be 5+25(50% of reorder Qty) i.e 30.
Average Stock Level = Minimum stock Level + 1/2 of Reorder Quantity.