Introduction To ABC Analysis :
ABC Analysis ( Always Better Control )
Concept and the necessity:
- In inventory management, ABC analysis plays a vital role. It is an analysis of the range of items divided into three categories.
A- Outstandingly important items
B- Average important items
C- Relatively unimportant items
- So, items in our inventory can be classified into the above three categories. ‘A’ types of items are given more attention than B category. ‘C’ types of category items are given the least attention as they are relatively unimportant.
- ABC analysis is also called as Always Better Control. The reason is all items are not of equal status in the inventory. If the same attention is given to all, then the outstandingly important items may suffer (i.e. production flow may be seriously disturbed) or least important items may get unnecessary care (which is not required).
- Any organization usually deals with lots of items. It is very difficult to exercise control over all the items. Controlling means transactions related to inventory, degree of control, type of records to be maintained, lot sizes, frequency of review, size of safety stock to be maintained, etc.
- ABC analysis helps to classify the thousands or even millions of individual items into three groups namely items belonging to A group, B group, C group items respectively. ABC analysis is done based on the Pareto’s principle.
- Consumption value is the basis for ABC classification. Consumption value is the product of unit price and consumption.
Read more: ABC Inventory analysis
Mechanism of doing ABC classification:
1. Collect previous year consumption and unit price for each item.
2. Multiply the consumption and unit price for each item to get the consumption value.
3. Rank the items corresponding to the consumption value.
4. Calculate cumulative consumption value against each item.
5. Find the percentage of cumulative consumption value.
Usually to classify the items into ‘A’ class there is leverage available. The leverage is 60 to 70 percent of the consumption value.
This means the cut-off value can be fixed in between 60 to 70 percent of consumption and the corresponding items which contribute up to the cut-off value are classified as class items.
Similarly, to classify the items into B class, there is a leverage of the consumption value to the extent of 10 to 20 percentage of the consumption value. To classify the items into C class, there is a leverage of the consumption value to the extent of 10 to 20 percentage of the consumption value.
Kinds of Control
The purpose of classifying the items into ABC is to control over each item. The degree of control required for A class is not the same for B and C class items. The following table helps the material manager in the kind of control to be exercised on these items.
STEPS TO DO ABC ANALYSIS
1. Prepare a list of all items and estimate their annual consumption.
2. Determine the unit price of each item.
3. Obtain annual consumption in rupees by multiplication.
4. Arrange the items in descending order.
5. Calculate cumulative annual usage and number of items in %.
6. Draw the graph.
7. Classify in A, B, C categories.
8. Decide the policies of inventory control.
Important Considerations in ABC Analysis:
1. ABC curve is similar in shape for different industries.
2. All items that the company consumes should be considered together. ABC curve is common for all types of materials in the
3. Consumption of items may be annually, monthly or applicable for any period.
4. Some categorizations like A1, A2, B1, B2, C1, and C2 may be possible if required.
Managing Inventories by ABC:
ABC analysis is the method of classifying items involved in a decision situation on the basis of their relative importance. Its classification may be on the basis of monetary value, availability of resources, variations in lead-time, part criticality to the running of a facility, new customer parts unique to that product, and others.
Cycle inventory can be managed through ABC analysis:
“A” value items have to be counted more frequently i.e., once in a week to do accurate monitoring of these items which has more impact on the inventory value. “B” value items can be counted once in a month because they are moderate value items that have less impact on the inventory value. “C” items have to be counted once in three months or six months because they are least consumed value items and has very less impact on the inventory value.
Obsolescence budgeting also takes the management of ABC analysis into consideration.
“A” items have the most impact on the budget if it is determined to be obsolete and scrapped from inventory. These parts may fool the reviewer because the “A” parts may not have a use for several years, but due to its critical importance may be needed at a later date. The slow-moving activity report would not detect this need. Management and storeroom management need to consider all aspects of the parts before it is scrapped to obsolescence. ABC analysis puts a perspective that enhances this decision-making.
Other use of ABC analysis is in the reorganization of the storeroom.
Yearly, a review of parts storage areas needs to take place by the storeroom manager. In this analysis, ABC coding should be considered so that the “A” parts are continually being moved to the lower or easier access areas. ‘B” items are to be moved to middle areas, and “C” items placed in all other areas of the stores.
Advantages of ABC Analysis:
1. Better exercise of control over all materials.
2. The capital invested in inventory can be reduced to minimum levels.
3. Warehouse and storage costs can be reduced.
Limitations of ABC Analysis:
- ABC analysis mainly provides a guideline for inventory management. It needs to be supplemented by basic understanding and judgment as there are certain items that may fall into category C or category B due to their low usage value but are otherwise very critical for the production process of the firm. Their inventory levels have to be carefully monitored.
- The ABC analysis, to be effective, needs to be constantly undertaken and periodically reviewed by the management, as the number of items and value of items keeps on undergoing changes.
- The practical problem in the usage of ABC analysis is that generally, thousands of items fall in category C, as a result, a lot of time is spent on managing the inventory of items of this category (even if it needs simple control). The time left for controlling the inventory stocks of categories A is therefore much shorter than that required for their effective management.
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