ABC Classification of Inventory
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By classifying your Inventory into A, B, C categories you can manage your Inventory in a more productive and economic manner through relaxed controls on low valued items whilst applying more stringent controls of high valued items. This cuts down the costs involved in checking every item - every time by applying greater emphasis on key items.
Let us first address what we mean by ABC Classification. Whenever you mention ABC Class (almost simultaneously) people think of the rule of 80/20, or Pareto's Law. Pareto's Law is a concept developed by Vilfredo Pareto, a 19th century Italian economist, sociologist, and political scientist (he was actually schooled as an engineer). The law states that a small percentage of a group accounts for the largest fraction of the impact, value, etc. For example:
This rule seems to apply to many things in life, as well as, managing your inventory.
In the 1950's Pareto's Law was applied to management theory. The ABC principle basically states that managing a vital few will go a long way toward controlling the situation. Furthermore, the effort saved through relaxed controls on low valued items can be applied to improve control of high valued items. To understand the principle, you must first understand inventory value.
Most firms measure inventory value in dollars and cents. The quantity on hand * the unit cost gives us the inventory value for each stock keeping unit. Financial types also desire to measure the movement, or velocity, of the inventory. To accomplish this, we typically use a ratio called inventory turnover.
Inventory turnover is defined as the cost of goods sold divided by the average value of inventory. If your cost of sales is $1,500,000 and average inventory value $250,000, your turnover would be 6. Six turns in the electronics industry is a respectable number. The higher the number the better. A high turnover means that your company has been able to operate with a relatively small investment in inventory. It may also suggest that your inventories are current and stable; that since they have not been on the shelves too long, they probably contain few unusable items.
To obtain a higher inventory turn, we need to reduce the average value of inventory in respect to cost of sales. How do we reduce inventory?
If Pareto was right, 20% of our items make up 80% of our inventory value. It makes sense that if we can identify those items, and manage them, we should be able to reduce our inventory. We need to classify each part on the basis of relative importance (i.e. value) and establish different management controls for each classification. The degree of management control must be commensurate with the ranked importance of each classification.
Classifying Inventory Items
Which of the following are acceptable ways of classifying parts for the purpose of ABC analysis:
(A) Unit cost.
The correct answer is "D", the extended value of future requirements. The first cut on an ABC analysis should be to multiply expected future usage times the standard unit cost. This will give you the future expected usage in dollars. Sorting this report by descending usage will put the largest contributors at the top of the report. If the future requirements are not available then, as a ‘second best’ you can use “E”, the extended value of past Issues. If you chose answers "A" or "B", you have made a fatal error and your analysis is doomed. Answer "C" is totally incorrect.
ABC analysis should be first performed using expected usage (dollars) and then other subjective factors. Often we find parts that financially are classified as a "C" item, but are critical to the manufacturing of the product. If the item is a sole source item, has a highly variable lead time, or can be used elsewhere outside of manufacturing (as with computer components), we may wish to elevate the item to a higher classification such as:-
Keep in mind we are trying to identify the parts that require special attention. We do not want a high percentage of the parts to be Class A or B. In the example given at the beginning of this article, the company with 2% of the parts classified as A is doing a better job than the company with 17%.
At this point, we have classified the parts, now we need to establish different management controls for each classification.
Once the mechanics of classifying A, B, or C is done, we must provide the different control attentiveness in handling the items. In general "A" items should be reviewed frequently since changes in direction can be very costly if not identified and corrected quickly. In general, "B" items should get similar controls as "A", but not as frequently. "C" items should be reviewed infrequently while providing plenty on hand since their annual volume expectation is rarely a large expense. Having plenty on hand also reduces the chance of stockouts. The following are examples of controls that might be used for different classifications:
A ITEMS (To be frequently checked – say – 12 times per year)
B ITEMS (To be frequently checked – say – 4 times per year)
C ITEMS (To be frequently checked – say – Twice per year)
Other Points of Interest
ABC analysis is not limited to inventory control and may be applied to other areas of your implementation. Areas to apply ABC principles:
The ABC principle gives us the guidance to spend most of our time and effort controlling the important few items that have the largest impact on our inventory. This focus will go a long way in keeping inventory down.
Where is this used in Ostendo?
Each Item in Ostendo contains a field called 'ABC Classification' (can be found by clicking the 'Additional Inventory Settings' button on the Item's main screen. This means that:
Items can be segregated and assessed by their Classification
If you wish to let Ostendo evaluate your ABC Classifications then you should go to Help>Training and find 13. Report and View Developer>Reports>The Report>Other Report Features>Updating Ostendo Database. This takes you through a script (which you can amend as required) that not only evaluates the ABC Category of each Item but also allows you to update the Item Master file with the results.