There may be thousands of items required in an industry. Each item has its different importance, cost, consumption pattern and lead time to purchase. There are costs associated with carrying inventory. At the same, if an item is out of stock, the down time costs may be significant. You need to use some way to optimize the system of inventory control. The first step in the management of the inventory is to classify the inventory to easily control the various categories using different systems.
ABC inventory analysis is one of the ways of classifying the inventory. Not all the items have equal importance and therefore they do not require the same management attention. The ABC analysis provides you helpful information to evaluate each item and decide the method to monitor and control it. It is a basic inventory management tool. An ERP (Enterprise Resource Planning) system also constitutes both ABC analysis and a control mechanism within itself.
With ABC inventory analysis, the inventory is classified into three categories: A, B and C and each category is given a different treatment:
Class A materials – these are usually the most expensive, highly important items and main raw materials in the production. A class items need tight monitoring and control. They should be managed by JIT (Just in Time) since its close management is most cost-effective.
Class B materials – these materials are usually the medium expensive items that still require more control and some management effort. They may not require a micromanagement by JIT, but they should also be tracked methodically. Kanban system can be more appropriate for their control.
Class C materials – these items have low value and lower importance. C class items require the minimum controls and they generally consist of the largest volume of the inventory. They are mostly managed by two bin system. When a bin is empty or when the system sends a signal of reaching a minimum stock level, an order is placed.
Process of ABC Inventory Analysis:
The ABC classification can be done in a few simple steps.
List all the items. Note down the units of measurement of each item. Collect and note data on consumption of every item and its price per unit. Find the annual consumption value of all items. The annual consumption value of each item is calculated by multiplying the annual consumption quantity in units of the item by its unit price.
Annual Consumption Value = No. of units of the item consumed in a year x unit price of the item.
The annual consumption value of every item can be listed in a table. Next, rank the items depending on their annual consumption value in a descending order. Find the total annual consumption value of all items by adding. Calculate the percentage annual consumption value of each item as =100 x Annual consumption value of item/ Total annual consumption value of all items.
Classifying the Items:
The different industries follow varying rules for grouping the items. Typically, A Class Materials may include items that have jointly approximately 80% of the total annual consumption value –these will include expensive items. B Class Materials may include items that together have approximately 15% of the overall annual consumption value. The C Class Material will have all items included that have approximately 5% of the overall annual consumption value.
The picture will be different when you consider the number of items included in each group. Typically, A, B, and C group will respectively have close to 20%, 30%, and 50% of total number of items.
A practical problem is that generally thousands of items may fall in category C and it may require a lot of time managing these items even when they need a simple control. The criteria for classification must be used judicially to minimize such problems.
Advantages of ABC Inventory Analysis:
This analysis enables a better control over the material inventories. The capital employed, the storage, stock out and inventory management costs are also minimized.
The ABC inventory analysis needs to be periodically undertaken to be effective.