Economic Order Quantity / Ordering quantity

One important question before the materials department, when placing an order before the supplier,  is to select an optimum order size  which is also called economic order quantity. Economic order quantity(EOQ) is the optimum ordering quantity i.e. the quantity for which cost of holding plus the cost of purchasing is the minimum. The factors that affect EOQ are material carrying charges and the ordering cost associated with placing the order. The basic aim behind setting of EOQ is to minimise both the costs. The material carrying costs include interest on the capital invested in stock of materials, rent of the storage space occupied, salary and wages of the store keeping department,insurance charges, any loss due to pilferage and deterioration of materials, taxes on materials etc. Ordering cost includes rent for the space occupied by purchase department, postage, stationery and other consumables, telephone charges of the purchase department, depreciation on the assets of the department, travelling expenses and cost of  inspection of the materials if any.

Economic order quantity is calculated using the following formula:

E.O.Q=√(2U×P/ S)

Here  U=annual consumption of materials in units

P= cost of placing an order

S=annual storage cost of one unit



Setting of Various Stock Levels

Determination of various levels of  inventory is one of the prime responsibility of Materials Department. The purpose behind setting of different stock levels is to ensure smooth operation of the enterprise and allocation of appropriate amount of monetary resources to different items in the inventory. A number of factors affect the determination of  stock levels for different items. Some of these are:

  • Rate of consumption
  • Lead time
  • Storage /warehousing /carrying costs
  • Insurance cost
  • Seasonal considerations
  • Price fluctuations
  • Economic Order Quantity (EOQ)
  • Quality of raw material
  • Availability of space
  • Availability of funds
  • Government and other legal and statutory requirements.

A  systematic material control results in economy and efficiency in the maintenance of each item of inventory and at the same time ensures that it is available as and when required.  It helps in avoiding blocking up of funds in unnecessary stock items.  Now, coming back to the topic under discussion, to ensure smooth running of production process, the materials department of an enterprise sets different levels for each item of inventory. These levels are:

  1. Maximum level
  2. Minimum level
  3. Reorder level
  4. Danger or safety stock level

Now lets have a detailed discussion on each one of these.

1. Maximum level: This is the maximum quantity above which stock should never be held at any time. It is fixed after considering the following factors:

  • Investment required in stores, raw materials and other items of inventory
  • Availability of storage space
  • Lead time for delivery of materials
  • Obsolescence rate
  • Consumption rate of materials
  • Economic Order Quantity
  • Storage and Insurance costs
  • Price advantage due to bulk purchases.

Maximum Level can be calculated as:

Maximum Level=Re-order Level ×  Re-order Quantity –( Minimum consumption × Minimum Re-order period)

2. Minimum Level: This is the minimum level below which an item of stoeck should never be allowed to fall. Minimum level depends on the following factors:

  • Consumption rate of materials.
  • Lead time for delivery of materials.
  • Production requirements.
  • Minimum order size fixed by suppliers.

Minimum level is computed using the following formula:

Minimum level=Re-order level – (Normal consumption × Normal reorder-period)

3. Danger or safety level: Safety or reserve stock is fixed to avoid stock out conditions. Carefully fixed safety stock level helps in minimising stock-out and carrying costs. This level is fixed usually between minimum level and zero level. On reaching this level, the storekeeper stops issuing materials. However sometimes for preventive measures, this stock is fixed above minimum level.

Formula for calculating Danger level is:

Danger/Safety level= Ordering Level–(Average rate of consumption×Re-order period)


(Maximum rate of consumption–Average rate of consumption)×Lead Time

4. Ordering Level: Ordering Level is that level on reaching which, a fresh order is placed with the suppliers. This level depends on:

  • Annual consumption of an item.
  • Lead time.
  • Expected usage during lead period.
  • Minimum Level.

Ordering level is calculated using the formula:

Ordering Level= Minimum Level + consumption during lead period


Maximum consumption × Lead time + Safety stock


Maximum consumption×Maximum re-order period


Inventory Control

Inventory means stocks i.e. stocks of raw material, stores, consumables, work in progress, finished products etc. In maximum business concerns, a large amount of funds are invested in buying stocks of materials. This not only results in unnecessary blocking of funds in stocks but also an increse in the cost of production due to increased expenditure on insurance and storage of additional  stocks. This increased cost can add to the price of our product and make our product uncompetitive in the market, which can result in lesser sales and hence lower profits.  An efficient inventory control system  can result in optimum level of investment in inventories to avoid blocking and wastage of funds and a reduced cost of product. Hence the main purpose of inventory control is to attain efficiency in production and sales with the minimum investment in inventories.

Techniques of Inventory Control

Different techniques applied for inventory control are:

  1. Setting of different stock levels
  2. ABC analysis
  3. Determination of Economic Order Quantity
  4. Two bin system
  5. Use of perpetual inventory records
  6. Continuous stock taking
  7. Establishment of a system of budgets
  8. Review of slow and non-moving items
  9. Control ratios


Pre-requisites for the success of standard costing

For establishing a system of standard costing, a number of requirements are to be fulfilled, which are;

1. Establishment of Cost Centres

2. Classification of Accounts

3. Types of Standards

4. Setting Standard Costs

Let’s have a discussion on each of them to have a good understanding of the process.

1. Establishment of Cost Centres:

A cost centre is a person, location or an equipment or ( a group of these ) In respect of which costs are to be ascertained. For example there may be 10 machines in a manufacturing concern, each machine can be classified as a cost centre. Each department or function  in a business enterprise forms a cost centre. Further, there can be a number of Cost centres in each department or function. A cost centre which relates to a person is called personal cost centre and a cost centre which relates to location or equipments is called impersonal cost centre. The purpose of setting cost centre is cost ascertainment and cost control. So while establishing a cost centre, the person who is responsible for that particular cost centre should be ascertained.

2. Classification of Accounts:

Accounts are classified on the basis of functions, revenue item, assets and liabilities items to meet a required purpose. To meet speedy collection and analysis of accounts, codes and symbols are used.

3. Types of Standards:

A standard is the level of performance which the management accepted by the management. On the basis of these levels , standard costs are determined. There are mainly four types of Standards:

a) Ideal Standard:

The standard which is set under ideal conditions e.g. maximum sales, best possible prices for materials, least possible rates for labour etc. But this standard is of little practical use as ideal conditions are difficult to attain and moreover  do not remain ideal for long. Hence though we can fix a target for employees but these targets are not possible to attain.

b) Expected Stardard:

The standard which is actually expected to be achieved, under current conditions, in  the budget period, is called expected stadard. An expected standard is more realistic than ideal stadard. These Stardards are set on expected performance after allowing a resonable allowance for unavoidable losses and deviations from perfect efficiency. Expected stadards are set for short term basis and are frequently revised.

c) Normal Standard:

Normal stadard represents an average figure which is based on average past performance of the business after considering seasonal and cyclic changes.

d) Basic Standard:

This is a standard fixed in relation to a base year using the principle of index numbers. Just like an index number against which we measure subsequent price changes, basic standard us fixed for a long term of period without any adjustment for the present conditions. Basic standard can be used as a tool for cost control but this cannot be a reliable standard for measuring efficiency.

4. Setting Standard Costs:

The success of the standard costing system in an enterprise depends upon the reliability and accuracy of Standards. Hence utmost care should be taken while setting standards. In an enterprise, Standard Costing committee is formed for this purpose Consisting of Produnction manager, Production engineer, Personnel manager, Sales manager, Cost accountant and other important departmental heads. Cost accountant is entrusted  with the  responsibility of supplying required cost figures as well as coordinating the activities of the budget committee. He must ensure that the standards set are accurate and realistic for the success of Standard costing system.



Standard Costing – An Introduction

One of the primary function of management accounting is to help in managerial control and cost control is perhaps the most crucial part of managerial control. The success of management of a business enterprise depends to a large extent on efficient cost control. Standard costing is one of the most important tool in the hands of management which helps it to plan and control costs of business operations. Under standard costing, the costs of different business operations are predetermined. These predetermined costs are called Standard costs. The actual costs are then measured and compared with the standards set for that particular business process. The difference between the standard costs and actual costs is known as variance. These variances are analysed and reasons are investigated so that management can take remedial steps to check them in time. Hence standard costing is an important tool for planning, decision making and controlling costs of business operations. Continue Reading