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ABC Analysis for Inventory Management Essay

In supply chain, ABC analysis is an inventory categorization method which consists in dividing items into three categories, A, B and C: A being the most valuable items, C being the least valuable ones. This method aims to draw managers’ attention on the critical few (Aitems) and not on the trivial many (C-items).

Prioritization of the management attention Inventory optimization is critical in order to keep costs under control within the supply chain. Yet, in order to get the most from management efforts, it is efficient to focus on items that cost most to the business.

The Pareto principle states that 80% of the overall consumption value is based on only 20% of total items. In other words, demand is not evenly distributed between items: top sellers vastly outperform the rest.

The ABC approach states that, when reviewing inventory, a company should rate items from A to C, basing its ratings on the following rules:

A-items are goods which annual consumption value is the highest. The top 70-80% of the annual consumption value of the company typically accounts for only 10-20% of total inventory items.
C-items are, on the contrary, items with the lowest consumption value. The lower 5% of the annual consumption value typically accounts for 50% of total inventory items.
B-items are the interclass items, with a medium consumption value. Those 15-25% of annual consumption value typically accounts for 30% of total inventory items.

The annual consumption value is calculated with the formula: (Annual demand) x (item cost per unit).

Through this categorization, the supply manager can identify inventory hot spots, and separate them from the rest of the items, especially those that are numerous but not that profitable.

The following steps will explain to you the classification of items into A, B and C categories. 1. Find out the unit cost and and the usage of each material over a given period. 2. Multiply the unit cost by the estimated annual usage to obtain the net value. 3. List out all the items and arrange them in the descending value. (Annual Value) 4. Accumulate value and add up number of items and calculate percentage on total inventory in value and in number.

5. Draw a curve of percentage items and percentage value.
6. Mark off from the curve the rational limits of A, B and C categories.

eCommerce example

The graph above illustrates the yearly sales distribution of a US eCommerce in 2011 for all products that have been sold at least one. Products are ranked starting with the highest sales volumes. Out of 17000 references:

Top 2500 products (Top 15%) represent 70% of the sales.
Next 4000 products (Next 25%) represent 20% of the sales.
Bottom 10500 products (Bottom 60%) represents 10% of the sales.

Inventory management policies
Policies based on ABC analysis leverage the sales imbalance outlined by the Pareto principle. This implies that each item should receive a weighed treatment corresponding to its class: 

A-items should have tight inventory control, more secured storage areas and better sales forecasts. Reorders should should be frequent, with weekly or even daily reorder. Avoiding stock-outs on A-items is a priority.

Reordering C-items is made less frequently. A typically inventory policy for C-items consist of having only 1 unit on hand, and of reordering only when an actual purchase is made. This approach leads to stock-out situation after each purchase which can be an acceptable situation, as the C-items present both low demand and higher risk of excessive inventory costs. For C-items, the question is not so much how many units do we store? but rather do we even keep this item in store?

B-items benefit from an intermediate status between A and C. An important aspect of class B is the monitoring of potential evolution toward class A or, in the contrary, toward the class C.

Splitting items in A, B and C classes is relatively arbitrary. This grouping only represents a rather straightforward interpretation of the Pareto principle. In practice, sales volume is not the only metric that weighs the importance of an item. Margin but also the impact of a stock-out on the business of the client should also influence the inventory strategy. Procurement and Warehouse Applications

The results of an ABC Analysis extend into a number of other inventory control and management processes:
1. Review of stocking levels – As with investments, past results are no guarantee of future performance. However, “A” items will generally have greater impact on projected investment and purchasing spend, and therefore should be managed more aggressively in terms of minimum and maximum inventory levels.Obsolescence review – By definition, inactive items will fall to the bottom of the prioritized list. Therefore, the bottom of the “C” category is the best place to start when performing a periodic obsolescence review. 2. Cycle counting – The higher the usage, the more activity an item is likely to have, hence the greater likelihood that transaction issues will result in inventory errors. Therefore, to ensure accurate record balances, higher priority items are cycle counted more frequently. Generally “A” items are counted once every quarter; “B” items once every 6 months; and “C” items once every 12 months.

3. Identifying items for potential consignment or vendor stocking – Since “A” items tend to have a greater impact on investment, these would be the best candidates to investigate the potential for alternative stocking arrangements that would reduce investment liability and associated carrying costs.

4. Turnover ratios and associated inventory goals – By definition, “A” items will have greater usage than “B” or “C” items, and as a result should have greater turnover ratios. When establishing investment and turnover metrics, inventory data can be segregated by ABC classification, with different targets for each category. Definition of ‘Inventory Turnover’

A ratio showing how many times a company’s inventory is sold and replaced over a period. the

Periodic Review
To make the most effective use of ABC classifications, the analysis should be completed at least on an annual basis, and more often as necessary.

Other Inventory Classification Techniques
HML Classifications
The High, medium and Low (HML) classification follows the same procedure as is adopted in ABC classification. Only difference is that in HML, the classification unit value is the criterion and not the annual consumption value. The items of inventory should be listed in the descending order of unit value and it is up to the management to fix limits for three categories. For examples, the management may decide that all units with unit value of Rs. 2000 and above will be H items, Rs. 1000 to 2000 M items and less than Rs. 1000 L items. The HML analysis is useful for keeping control over consumption at departmental levels, for deciding the frequency of physical verification, and for controlling purchases. VED Classification

While in ABC, classification inventories are classified on the basis of their consumption value and in HML analysis the unit value is the basis, criticality of inventories is the basis for vital, essential and desirable categorization.

The VED analysis is done to determine the criticality of an item and its effect on production and other services. It is specially used for classification of spare parts. If a part is vital it is given V classification, if it is essential, then it is given E classification and if it is not so essential, the part is given D classification. For V items, a large stock of inventory is generally maintained, while for D items, minimum stock is enough.

SDE Classification
The SDE analysis is based upon the availability of items and is very useful in the context of scarcity of supply. In this analysis, S refers to scarce items, generally imported, and those which are in short supply. D refers to difficult items which are available indigenously but are difficult items to procure. Items which have to come from distant places or for which reliable suppliers are difficult to come by fall into D category. E refers to items which are easy to acquire and which are available in the local markets.

The SDE classification, based on problems faced in procurement, is vital to the lead time analysis and in deciding on purchasing strategies.
FSN Analysis
FSN stands for fast moving, slow moving and non-moving. Here, classification is based on the pattern of issues from stores and is useful in controlling obsolescence. To carry out an FSN analysis, the date of receipt or the last date of issue, whichever is later, is taken to determine the number of months, which have lapsed since the last transaction. The items are usually grouped in periods of 12 months.

FSN analysis is helpful in identifying active items which need to be reviewed regularly and surplus items which have to be examined further. Non-moving items may be examined further and their disposal can be considered.

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