The economic order quantity and the reorder points as inventory management techniques. have explained to keep the discussion simply, on the assumption of a conditions. That we had assumed (i) constant fixed requirement of inventory and (ii) instantaneous inventory. The assumptions are however, of questionable validity innocturnasituationsons, that is under conditions of uncertainty. For instance, the demand for inventory is likely to fluctuate from: In particular. It certain points of time till demand exceed the anti pared level. In other words a discrepancy between the assumed (unuci patch expected) actual usage rate of inventory is likely to occur in practice. Similarly, the receipt of inventory from the suppliers may be delayed the expected lead time. The delay may arise from strikes, flood transportation and other bonk necks. Thus, a firm would come across situations in which the actual usage of inventory is higher than the anticipated level and or the delivery of the inventory from the suppliers is delayed.
The effect of increased and or slower delivery would be a shortage of inventory. That is, the firm would face a stock out situation. This, in turn, as explained in detail below would disrupt the production schedule and alienate the customers. The firm would, therefore, the well advised to keep a sufficient safety margin by having additional inventory to guard against stock out situations. Such stocks are called safety stocks. This would act as a buffer or cushion against a possible shortage of inventory caused either by increased usage or delayed delivery of inventory. The safety stock may, then, be defined as the minimum additional as a safety buffer or cushion to meet an unanticipated increase in usage resulting from all unusually high demand and or all uncontrollable late receipt of incoming.
How can a financial manager determine the safety stock? What is his responsibility? The safety stock involves a types of costs: (i) stock-out, and (ii) carrying costs. The job of the financial manager is to determine the appropriate level of safety stock on the trade off between these two types of conflicting costs.
The term stock-out costs refers to the cost associated with the shortage (stock-out) of inventory, It is, in fact, an opportunity cost in the sense that due to the shortage of inventory the firm would be deprived of certain benefits. The denial of those benefits which would otherwise be available to the firm at the stock out costs. The first and the most obvious, of these cots is the loss of profit which the firm could have earned from increased sales if there was no shortage of inventory. Another category of stock out costs is the damage to the relationship with the customers to shortage of inventory, the firm would not be able to meet the customer’s requirements and the latter may rum to the firm’s competitors. It should, of course, be clearly understood that this type of cost cannot be easily and precisely quantified. Last, the shortage of inventory may disrupt the production schedule of the firm. The production process would grind to that involving idle time.
The adjusting costs, as already explained in the earlier pan of this chapter, are the red with the maintenance of inventory. Since the firm is required to maintain additional inventory, in excess of the normal usage, additional carrying costs.
The stock-out and the carrying costs are counterbalancing. The safety stock, the larger would be the carrying costs and conversely, the safety rock, the smaller would be the stock out costs. In other words, if the firm minisvs the carving the stock-out costs are likely to rise: on the other hand, an attempt to minimize the stock-out implies increased costs. The object of the should be to have the lowest total cost plus stock-out. The stock with minimum carrying and stockout costs is the economic (appropriate). Which Natural should aim at. In brief, the appropriate level of safety stock is determined by the trade off between the stock-out and the carrying costs. WC illustrate in using a method.