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Inventory Fundamentals

 

Contents

  • inventories are materials and supplies that a business or institution carries either for sale or to provide inputs or supplies to the production process. All businesses and institutions require inventories. Often they are a substantial part of total assets.

  • Financially, inventories are very important to manufacturing companies. On the balance sheet, they usually represent from 20% to 60% of total assets. As inventories are used, their value is converted into cash, which improves cash flow and return on investment. There is a cost for carrying inventories, which increases operating costs and decreases profits. Good inventory management is essential.

  • Inventory management is responsible for planning and controlling inventory from the raw material stage to the customer. Since inventory either results from production or supports it, the two cannot be managed separately and, therefore, must be coordinated. Inventory must be considered at each of the planning levels and is thus part of production planning, master production scheduling, and material requirements planning. Production planning is concerned with overall inventory, master planning with end items, and material requirements planning with component parts and raw material.

  • Aggregate inventory management deals with managing inventories according to their classification (raw material, work-in-process, and finished goods) and the function they perform rather than at the individual item level. It is financially oriented and is concerned with the costs and benefits of carrying the different classifications of inventories. As such, aggregate inventory management involves:

    • Flow and kinds of inventory needed.

    • Supply and demand patterns.

    • Functions that inventories perform.

    • Objectives of inventory management.

    • Costs associated with inventories.

  • Inventory is not only managed at the aggregate level but also at the item level. Management must establish decision rules about inventory items so the staff responsible for inventory control can do their job effectively. These rules include the following:

    • Which individual inventory items are most important.

    • How individual items are to be controlled.

    • How much to order at one time.

    • When to place an order.

  • This chapter will study aggregate inventory management and some factors influencing inventory management decisions, which include:

    • Types of inventory based on the flow of material.

    • Supply and demand patterns.

    • Functions performed by inventory.

    • Objectives of inventory management.

    • Inventory costs.

  • Finally, this chapter will conclude with a study of the first two decisions, deciding the importance of individual end items and how they are controlled. Subsequent chapters will discuss the question of how much stock to order at one time and when to place orders.

  • There are many ways to classify inventories. One often-used classification is related to the flow of materials into, through, and out of a manufacturing organization, as shown in Figure 9.1.

    • Raw materials. These are purchased items received which have not entered the production process. They include purchased materials, component parts, and subassemblies.

    • Work-in-process (WIP). Raw materials that have entered the manufacturing process and are being worked on or waiting to be worked on.

    • Finished goods. The finished products of the production process that are ready to be sold as completed items. They may be held at a factory or central warehouse or at various points in the distribution system.

  • Distribution inventories. Finished goods located in the distribution system.

  • Maintenance, repair, and operational supplies (MROs). Items used in production that do not become part of the product. These include hand tools, spare parts, lubricants, and cleaning supplies.

  • Classification of an item into a particular inventory depends on the production environment. For instance, sheet steel or tires are finished goods to the supplier but are raw materials and component parts to the car manufacturer.

5. Supply And Demand Patterns

  • If supply met demand exactly, there would be little need for inventory. Goods could be made at the same rate as demand, and no inventory would build up. For this situation to exist, demand must be predictable, stable, and relatively constant over a long time period.

  • If this is so, manufacturing can produce goods on a line-flow basis, matching production to demand. Using this system, raw materials are fed to production as required, work flow from one workstation to another is balanced so little work-in-process inventory is required, and goods are delivered to the customer at the rate the customer needs them. Flow manufacturing systems were discussed in Chapter 1. Because the variety of products they can make is so limited, demand has to be large enough to justify economically setting up the system. These systems are characteristic of just-in-time manufacturing and will be discussed in Chapter 15.

  • Demand for most products is neither sufficient nor constant enough to warrant setting up a line-flow system, and these products are usually made in lots or hatches. Workstations are organized by function, for example, all machine tools in one area, all welding in another, and assembly in another. Work moves in lots from one workstation to another as required by the routing. By the nature of the system, inventory will build up in raw materials, work-in-process, and finished goods.

  • In batch manufacturing, the basic purpose of inventories is to decouple supply and de¬mand. Inventory serves as a buffer between:

    • Supply and demand.

    • Customer demand and finished goods.

    • Finished goods and component availability.

    • Requirements for an operation and the output from the preceding operation.

    • Parts and materials to begin production and the suppliers of materials. Based on this, inventories can be classified according to the function they perform.

a. Anticipation Inventory

  • Anticipation inventories are built up in anticipation of future demand. For example, they are created ahead of a peak selling season, a promotion program, vacation shutdown, or possibly the threat of a strike. They are built up to help level production and to reduce the costs of changing production rates.

b. Fluctuation Inventory (Safety Stock)

  • Fluctuation inventory is held to cover random unpredictable fluctuations in supply and demand or lead time. If demand or lead time is greater than forecast, a stockout will occur. Safety stock is carried to protect against this possibility. Its purpose is to prevent disruptions in manufacturing or deliveries to customers. Safety stock is also called buffer stock or reserve stock.

c. Lot-Size Inventory

  • Items purchased or manufactured in quantities greater than needed immediately create lot-size inventories. This is to take advantage of quantity discounts, to reduce shipping, clerical, and setup costs, and in cases where it is impossible to make or purchase items at the same rate they will be used or sold. Lot-size inventory is some-times called cycle stock. It is the portion of inventory that depletes gradually as customers’ orders come in and is replenished cyclically when suppliers’ orders are received.

d. Transportation Inventory

  • Items purchased or manufactured in quantities greater than needed immediately create lot-size inventories. This is to take advantage of quantity discounts, to reduce shipping, clerical, and setup costs, and in cases where it is impossible to make or purchase items at the same rate they will be used or sold. Lot-size inventory is some-times called cycle stock. It is the portion of inventory that depletes gradually as customers’ orders come in and is replenished cyclically when suppliers’ orders are received.

     tA

I =           .

      365

  • where I is the average annual inventory in transit, t is transit time in days, and A is annual demand. Notice that the transit inventory does not depend upon the shipment size but on the transit time and the annual demand. The only way to reduce the inventory in transit, and its cost, is to reduce the transit time.

e. Example Problem

  • Delivery of goods from a supplier is in transit for ten days. If the annual demand is 5200 units, what is the average annual inventory in transit?

Answer

                                                    10 x 5200

                                          I =                            = 142.5 units

                                                         365

  • The problem can be solved in the same way using dollars instead of units.

f. Hedge Inventory

  • Some products such as minerals and commodities, for example, grains or animal products, are traded on a worldwide market. The price for these products fluctuates according to world supply and demand. If buyers expect prices to rise, they can purchase hedge inventory when prices are low. Hedging is complex and beyond the scope of this text.

g. Maintenance, Repair, and Operating Supplies (MRO)

  • MROs are items used to support general operations and maintenance but which do not become directly part of a product. They include maintenance supplies, spare parts, and consumables such as cleaning compounds, lubricants, pencils, and erasers.

  • A firm wishing to maximize profit will have at least the following objectives:

    • Maximum customer service.

    • Low-cost plant operation.

    • Minimum inventory investment.

a. Customer Service

  • In broad terms, customer service is the ability of a company to satisfy the needs of customers. In inventory management, the term is used to describe the availability of items when needed and is a measure of inventory management effectiveness. The customer can be a purchaser, a distributor, another plant in the organization, or the workstation where the next operation is to be performed.

  • There are many different ways to measure customer service, each with its strengths and weaknesses, but there is no one best measurement. Some measures are percentage of orders shipped on schedule, percentage of line items shipped on schedule, and order-days out of stock.

  • Inventories help to maximize customer service by protecting against uncertainty. If we could forecast exactly what customers want and when, we could plan to meet demand with no uncertainty. However, demand and the lead time to get an item are often uncertain, possibly resulting in stockouts and customer dissatisfaction. For these reasons, it may be necessary to carry extra inventory to protect against uncertainty. This inventory is called safety stock and will be discussed in Chapter 11.

b. Operating Efficiency

  • Inventories help make a manufacturing operation more productive in four ways:

    1. Inventories allow operations with different rates of production to operate separately and more economically. If two or more operations in a sequence have different rates of output and are to be operated efficiently, inventories must build up between them.

    2. Chapter 2 discussed production planning for seasonal products in which demand is nonuniform throughout the year. One strategy discussed was to level production and build anticipation inventory for sale in the peak periods. This would result in the following:

      • Lower overtime costs.

      • Lower hiring and firing costs.

      • Lower training costs.

      • Lower subcontracting costs.

      • Lower capacity required.

      By leveling production, manufacturing can continually produce an amount
      equal to the average demand. The advantage of this strategy is that the costs of changing production levels are avoided. Figure 9.2 shows this strategy.

    3. Inventories allow manufacturing to run longer production runs, which result in the following:

      • Lower setup costs per item. The cost to make a lot or batch depends upon the setup costs and the run costs. The setup costs are fixed, but the run costs vary with the number produced. If larger lots are run, the setup costs are absorbed over a larger number, and the average (unit) cost is lower.

      • An increase in production capacity due to production resources being used a greater portion of the time for processing as opposed to setup. Time on a work center is taken up by setup and by run time. Output occurs only when an item is being worked on and not when setup is taking place. If larger quantities are produced at one time, there are fewer setups required to produce a given annual output and thus more time is available for producing goods. This is most important with bottleneck resources. Time lost on setup on these resources is lost throughput (total production) and lost capacity.
        4. Inventories allow manufacturing to purchase in larger quantities, which results in lower ordering costs per unit and quantity discounts.

  • But all of this is at a price. The problem is to balance inventory investment with the following:

    1. Customer service. The lower the inventory, the higher the likelihood of a stockout and the lower the level of customer service. The higher the inventory level, the higher customer service will be.

    2. Costs associated with changing production levels. Excess equipment capacity, overtime, hiring, training, and layoff costs will all be higher if production fluctuates with demand.

    3. Cost of placing orders. Lower inventories can be achieved by ordering smaller quantities more often, but this practice results in higher annual ordering costs.

    4. Transportation costs. Goods moved in small quantities cost more to move per unit than those moved in large quantities. However, moving large lots implies higher inventory.

  • If inventory is carried, there has to be a benefit that exceeds the costs of carrying that inventory. Someone once said that the only good reason for carrying inventory beyond current needs is if it costs less to carry it than not. This being so, we should turn our attention to the costs associated with inventory.

8. Inventory Costs

  • The following costs are used for inventory management decisions:

    • Item cost.

    • Carrying costs.

    • Ordering costs.

    • Stockout costs.

    • Capacity-associated costs.

a. Item Cost

  • Item cost is the price paid for a purchased item, which consists of the cost of the item and any other direct costs associated in getting the item into the plant. These could include such things as transportation, custom duties, and insurance. The inclusive cost is often called the landed price. For an item manufactured in-house, the cost includes direct material, direct labor, and factory overhead. These costs can usually be obtained from either purchasing or accounting.

b. Carrying Costs

  • Carrying costs include all expenses incurred by the firm because of the volume of inventory carried. As inventory increases, so do these costs. They can be broken down into three categories:

    1. Capital costs. Money invested in inventory is not available for other uses and as such represents a lost opportunity cost. The minimum cost would be the interest lost by not investing the money at the prevailing interest rate, and it may be much higher depending on investment opportunities for the firm.

    2. Storage costs. Storing inventory requires space, workers and equipment. As inventory increases, so do these costs.

    3. Risk costs. The risks in carrying inventory are:

      1. Obsolescence; loss of product value resulting from a model or style change or technological development.

      2. Damage; inventory damaged while being held or moved.

      3. Pilferage; goods lost, strayed, or stolen.

      4. Deterioration; inventory that rots or dissipates in storage or whose shelf life is limited.

  • What does it cost to carry inventory? Actual figures vary from industry to industry and company to company. Capital costs may vary depending upon interest rates, the credit rating of the firm, and the opportunities the firm may have for investment. Storage costs vary with location and type of storage needed. Risk costs can be very low or can be close to 100% of the value of the item for perishable goods. The carrying cost is usually defined as a percentage of the dollar value of inventory per unit of time (usually one year). Textbooks tend to use a figure of 20—30% in manufacturing industries. This is realistic in many cases but not with all products. For example, the possibility of obsolescence with fad or fashion items is high, and the cost of carrying such items is greater.

c. Example Problem

  • A company carries an average annual inventory of $2,000,000. If they estimate the cost of capital is 10%, storage costs are 7%, and risk costs are 6%, what does it cost per year to carry this inventory?

Answer

Total cost of carrying inventory = 10% + 7% + 6% = 23%

Annual cost of carrying inventory = 0.23 x $2,000,000 = $460,000

d. Ordering Costs

  • Ordering costs are those associated with placing an order either with the factory or a supplier. The cost of placing an order does not depend upon the quantity ordered. Whether a lot of 10 or 100 is ordered, the costs associated with placing the order are essentially the same. However, the annual cost of ordering depends upon the number of orders placed in a year.

  • Ordering costs in a factory include the following:

    • Production control costs. The annual cost and effort expended in production control depend on the number of orders placed, not on the quantity ordered. The fewer orders per year, the less cost. The costs incurred are those of issuing and closing orders, scheduling, loading, dispatching, and expediting.

    • Setup and teardown costs. Every time an order is issued, work centers have to set up to run the order and tear down the setup at the end of the run. These costs do not depend upon the quantity ordered but on the number of orders placed per year.

    • Lost capacity cost. Every time an order is placed at a work center, the time taken to set up is lost as productive output time. This represents a loss of capacity and is directly related to the number of orders placed. It is particularly important and costly with bottleneck work centers.

    • Purchase order cost. Every time a purchase order is placed, costs are incurred to place the order. These costs include order preparation, follow-up, expediting, receiving, authorizing payment, and the accounting cost of receiving and paying the invoice. The annual cost of ordering depends upon the number of orders placed.

  • The annual cost of ordering depends upon the number of orders placed in a year. This can be reduced by ordering more at one time, resulting in the placing of fewer orders. However, this drives up the inventory level and the annual cost of carrying inventory.

e. Example Problem

  • Given the following annual costs, calculate the average cost of placing one order.

Production control salaries = $60,000

Supplies and operating expenses for production control department = $15,000

Cost of setting up work centers for an order = $120

Orders placed each year = 2000

Answer

                                                fixed costs

                         Average cost =                                    + variable cost

                                                        number of orders

                                                 

                                                      $60.000 + $15.000

                                                 =                                      + $120 =$157.50

                                                                 2000

f. Stockout Costs

  • If demand during the lead time exceeds forecast, we can expect a stockout. A stockout can potentially be expensive because of back-order costs, lost sales, and possibly lost customers. Stockouts can be reduced by carrying extra inventory to protect against those times when the demand during lead time is greater than forecast.

g. Capacity-Associated Costs

  • When output levels must be changed, there may be costs for overtime, hiring, training, extra shifts, and layoffs. These capacity-associated costs can be avoided by leveling production, that is, by producing items in slack periods for sale in peak periods. However, this builds inventory in the slack periods.

h. Example Problem

  • A company makes and sells a seasonal product. Based on a sales forecast of 2000,
    3000, 6000, and 5000 per quarter, calculate a level production plan, quarterly ending
    inventory, and average quarterly inventory.

  • If inventory carrying costs are $3 per unit per quarter, what is the annual cost of carrying inventory? Opening and ending inventories are zero.

Answer

 

Quarter I

Quarter 2

Quarter 3

Quarter 4

Total

Forecast Demand

2000

3000

6000

5000

16,000

Production

4000

4000

4000

4000

16,000

Ending Inventory 

0

2000

3000

1000

0

 

Average Inventory

1000

2500

2000

500

 

Inventory Cost (dollars)

3000

7500

6000

1500

18,000

 

9. Financial Statements And Inventory

  • The two major financial statements are the balance sheet and the income statement. The balance sheet shows assets, liabilities, and owners’ equity. The income statement shows the revenues made and the expenses incurred in achieving that revenue.

a. Balance Sheet

  • An asset is something that has value and is expected to benefit the future operation of the business. An asset may be tangible such as cash, inventory, machinery, and buildings, or may be intangible such as accounts receivable or a patent.

  • Liabilities are obligations or amounts owed by a company. Accounts payable, wages payable, and long-term debt are examples of liabilities.

  • Owners equity is the difference between assets and liabilities. After all the liabilities are paid, it represents what is left for the owners of the business. Owners’ equity is created either by the owners investing money in the business or through the operation of the business when it earns a profit. It is decreased when owners take money out of the business or when the business loses money.

  • The accounting equation. The relationship between assets, liabilities, and owners’ equity is expressed by the balance sheet equation:

Assets = liabilities + owners’ equity

  • This is a basic accounting equation. Given two of the values the third can always be found.

  • Balance sheet. The balance sheet is usually shown with the assets on the left side and the liabilities and owners’ equity on the right side as follows.

Assets

 

Liabilities

 

Cash

$100,000

Notes payable

$5,000

Accounts receivable

$300,000

Accounts payable

$20,000

Inventory

$500,000

Long-term debt

$500,000

Fixed assets

$1,000,000

Total liabilities

$525,000

 

 

Owners’ equity

 

 

 

Capital

$1,000,000

 

 

Retained earnings

$375,000

Total assets

$1,900,000

Total liabilities and

$1,900,000

 

 

owners’ equity

 

  • Capital is the amount of money the owners have invested in the company.

  • Retained earnings are increased by the revenues a company makes and decreased by the expenses incurred. The summary of revenues and expenses is shown on the income statement.

b. Example Problem

  1. If the owners’ equity is $1,000 and liabilities are $800, what are the assets?

  2. If the assets are $1,000 and liabilities are $600, what is the owners’ equity?

Answer

  1. Assets = Liabilities + owners’ equity

 Assets = $800 + $1,000 = $1,800

  1. Owners’ equity = assets — liabilities

                                 = $1,000 — $600 = $400

c. Income Statement

  • Income (profit). The primary purpose of a business is to increase the owners’ equity by making a profit. For this reason owners’ equity is broken down into a series of accounts, called revenue accounts, which show what increased owners’ equity, and expense accounts, which show what decreased owners’ equity.

Income = revenue — expenses

  • Revenue comes from the sale of goods or services. Payment is sometimes immediate in the form of cash, but often is made as a promise to pay at a later date, called an account receivable.

  • Expenses are the costs incurred in the process of making revenue. They are usually categorized into the cost of goods sold and general and administrative expenses.

  • Cost of goods sold are costs that are incurred to make the product. They include direct labor, direct material, and factory overhead. Factory overhead is all other factory costs except direct labor and direct material.

  • General and administrative expenses include all other costs in running a business. Examples of these are advertising, insurance, property taxes, and wages and benefits other than factory.

  • The following is an example of an income statement.

Revenue

 

$1,000,000

Cost of goods sold

 

 

 Direct labor

$200,000

 

 Direct material

400,000

 

 Factory overhead

200,000

$800,000

Gross margin (profit)

 

$200,000

General and administrative expenses

 

$100,000

Net income (profit)

 

$100,000

d. Example Problem

  • Given the following data, calculate the gross margin and the net income.

Revenue

= $ 1,500,000

Direct labor

= $ 300,000

Direct material

= $ 500,000

Factory overhead

= $ 400,000

General and administrative expenses

= $ 150,000

  • How much would profits increase if, through better materials management, material costs are reduced by $50,000?

Revenue

 

$1,500,000

Cost of goods sold

 

 

Direct labor

$300,000

 

Direct material

500,000

 

Overhead

400,000

$1,200,000

Gross margin (gross profit)

 

$300,000

General and administrative expenses

 

$150,000

Net income (profit)

 

$150,000

  • If material costs are reduced by $50,000, income increases by $50,000. Materials management can have a direct impact on the bottom line—net income.

e. Cash Flow Analysis

  • When inventory is purchased as raw material, it is recorded as an asset. When it enters production, it is recorded as work-in-process inventory (WIP) and, as it is processed, its value increases by the amount of direct labor applied to it and the overhead attributed to its processing. The material is said to absorb overhead. When the goods are ready for sale, they do not become revenue until they are sold. However, the expenses incurred in producing the goods must be paid for. This raises another financial issue:

  • Businesses must have the cash to pay their bills. Cash is generated by sales and the flow of cash into a business must be sufficient to pay bills as they become due. Businesses develop financial statements showing the cash flows into and out of the business. Any shortfall of cash must be provided for, perhaps by borrowing or in some other way. This type of analysis is called cash flow analysis

f. Financial Inventory Performance Measures

  • From a financial point of view, inventory is an asset and represents money that is tied up and cannot be used for other purposes. As we saw earlier in this chapter, inventory has a carrying cost—the costs of capital, storage, and risk. Finance wants as little inventory as possible and needs some measure of the level of inventory. Total inventory investment is one measure, but in itself does not relate to sales. Two measures that do relate to sales are the inventory turns ratio and days of supply.

Inventory turns.

  • Inventory turns. Ideally, a manufacturer carries no inventory. This is impractical, since inventory is needed to support manufacturing and often to supply customers. How much inventory is enough? There is no one answer. A convenient measure of how effectively inventories are being used is the inventory turns ratio:

                                        annual cost of goods sold

          Inventory turns =                                                   .

                                        average inventory in dollars

  • The calculation of average inventory can be complicated and is a subject for cost accounting. In this text it will be taken as a given.

  • For example, if the annual cost of goods sold is $1 million and the average inventory is $500,000, then

                                         $1,000,000

         Inventory turns =                               = 2

                                           $500,000

  • What does this mean? At the very least, it means that with $500,000 of inventory a company is able to generate $1 million in sales. If, through better materials management, the firm is able to increase its turns ratio to 10, the same sales are generated with only $100,000 of average inventory, lithe annual cost of carrying inventory is 25% of the inventory value, the reduction of $400,000 in inventory results in a cost reduction (and profit increase) of $100,000.

g. Example Problem

  1. What will be the inventory turns ratio if the annual cost of goods sold is $24 million a year and the average inventory is $6 million?

Answer

                                                    annual cost of goods sold

                    Inventory turns =                                                     .

                                                    average inventory in dollars

                                                     24,000,000

                                             =                             =  4

                                                      6,000,000

  1. What would be the reduction in inventory if inventory turns were increased to 12 times per year?

Answer

                                                           annual cost of goods sold

                      Average inventory =                                                  .

                                                                      inventory turns

                                                          24,000,000

          =                      .

                                                                 12

                                                      = $2,000,000

 

               Reduction in inventory = 6,000,000 2,000,000 = $4,000,000

  1. If the cost of carrying inventory is 25% of the average inventory, what will the savings be?

Answer

               Reduction in inventory = $4,000,000

                                       Savings = $4,000,000 X 0.25 = $1,000,000

h. Days of supply

  • Days of supply is a measure of the equivalent number of days of inventory on hand, based on usage. The equation to calculate the days of supply is

                                                       inventory on hand

                       Days of supply =                                       .

                                                       average daily usage

i. Example Problem

  • A company has 9000 units on hand and the annual usage is 48,000 units. There are 240 working days in the year. What is the days of supply?

Answer

                                                 48,000

       Average daily usage =                   = 200 units

                                                      240

 

                                                 inventory on hand             9000

                 Days of supply =                                          =                =  45 days

                                                average daily usage            200

j. Methods of Evaluating Inventory

  • There are four methods accounting uses to “cost” inventory: first in first out, last in first out, average cost, and standard cost. Each has implications for the value placed on inventory. If there is little change in the price of an item, any of the four ways will produce about the same results. However, in rising or falling prices, there can be a pronounced difference. There is no relationship with the actual physical movement of actual items in any of the methods. Whatever method is used is only to account for usage.

First in first out (FIFO).

  • This method assumes that the oldest (first) item in stock is sold first. In rising prices, replacement is at a higher price than the assumed cost. This method does not reflect current prices and replacement will be understated. The reverse is true in a falling price market.

Last in first out (LIFO).

  • This method assumes the newest (last) item in stock is the first sold. In rising prices, replacement is at the current price. The reverse is true in a falling price market. However, the company is left with an inventory that may be grossly understated in value.

Average cost.

  • This method assumes an average of all prices paid for the article. The problem with this method in changing prices (rising or falling) is that the cost used is not related to the actual cost.

Standard cost.

  • This method uses cost determined before production begins. The cost includes direct material, direct labor, and overhead. Any difference between the standard cost and actual cost is stated as a variance.

10. Abc Inventory Control

  • Control of inventory is exercised by controlling individual items called stock-keeping units (SKUs). In controlling inventory, four questions must be answered:

    1. What is the importance of the inventory item?

    2. How are they to be controlled?

    3. How much should be ordered at one time?

    4. When should an order be placed?

  • The ABC inventory classification system answers the first two questions by determining the importance of items and thus allowing different levels of control based on the relative importance of items.

  • Most companies carry a large number of items in stock. To have better control at a reasonable cost, it is helpful to classify the items according to their importance. Usually this is based on annual dollar usage, but other criteria may be used.

  • The ABC principle is based on the observation that a small number of items often dominate the results achieved in any situation. This observation was first made
    by an Italian economist, Vilfredo Pareto, and is called Pareto’s law. As applied to inventories, it is usually found that the relationship between the percentage of items and the percentage of annual dollar usage follows a pattern in which:

    1. About 20% of the items account for about 80% of the dollar usage.

    2. About 30% of the items account for about 15% of the dollar usage.

    3. About 50% of the items account for about 5% of the dollar usage.

  • The percentages are approximate and should not be taken as absolute. This type of distribution can be used to help control inventory.

a. Steps in Making an ABC Analysis

  1. Establish the item characteristics that influence the results of inventory management. This is usually annual dollar usage but may be other criteria, such as scarcity of material.

  2. Classify items into groups based on the established criteria.

  3. Apply a degree of control in proportion to the importance of the group.

  • The factors affecting the importance of an item include annual dollar usage, unit cost, and scarcity of material. For simplicity, only annual dollar usage is used in this text. The procedure for classifying by annual dollar usage is as follows:

  1. Determine the annual usage for each item.

  2. Multiply the annual usage of each item by its cost to get its total annual dollar usage.

  3. List the items according to their annual dollar usage.

  4. Calculate the cumulative annual dollar usage and the cumulative percentage of items.

  5. Examine the annual usage distribution and group the items into A, B, and C groups based on percentage of annual usage.

b. Example Problem

  • A company manufactures a line of ten items. Their usage and unit cost are shown in the following table along with the annual dollar usage. The latter is obtained by multiplying the unit usage by the unit cost.

    1. Calculate the annual dollar usage for each item.

    2. List the items according to their annual dollar usage.

    3. Calculate the cumulative annual dollar usage and the cumulative percent of items.

    4. Group items into an A, B, C classification.

Answer

  1. Calculate the annual dollar usage for each item.

Part Number

Unit Usage

Unit Cost $

Annual $ Usage

1

1100

2

2200

2

600

40

24,000

3

100

4

400

4

1300

1

1300

5

100

60

6000

6

10

25

250

7

100

2

200

8

1500

2

3000

9

200

2

400

10

500

1

500

Total

5510

 

$38,250

  1. b., c., and d.

Part

Annual $

Cumulative

Cumulative

Cumulative

Class

Number

Usage

$ Usage

% $ Usage

% of Items

2

24,000

24,000

62.75

10

A

5

6000

30,000

78.43

20

A

8

3000

33,000

86.27

30

B

1

2200

35,200

92.03

40

B

4

1300

36,500

95.42

50

B

10

500

37,000

96.73

60

C

9

400

37,400

97.78

70

C

3

400

37,800

98.82

80

C

6

250

38.05

99.48

90

C

7

200

38,250

100

100

C

  • The percentage of value and the percentage of items is often shown as a graph such as in Figure 9.3.

c. Control Based on ABC Classification

  • Using the ABC approach, there are two general rules to follow:

    1. Have plenty of low-value items. C items represent about 50% of the items but account for only about 5% percent of the total inventory value. Carrying extra stock of C items adds little to the total value of the inventory. C items are really only important if there is a shortage of one of them—when they become extremely important—so a supply should always be on hand. For example, order a year’s supply at a time and carry plenty of safety stock. That way there is only once a year when a stockout is even possible.

    2. Use the money and control effort saved to reduce the inventory of high-value items. A items represent about 20% of the items and account for about 80% of the value. They are extremely important and deserve the tightest control and the most frequent review.

  • Different controls used with different classifications might be the following:

    • A Items: high priority. Tight control including complete accurate records, regular and frequent review by management, frequent review of demand forecasts, and close follow-up and expediting to reduce lead time.

    • B Items: medium priority. Normal controls with good records, regular attention, and normal processing.

    • C Items: lowest priority. Simplest possible controls—make sure there are plenty. Simple or no records; perhaps use a two-bin system or periodic review system. Order large quantities and carry safety stock.