Q 396. What is ABC Analysis in Inventory Management? What are some of the shortcomings of ABC Analysis and how can they be overcome?

 

 

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ABC Analysis Overview-

 

ABC Analysis aka ABC Classification is crucial driver when it comes to material management. Inventory categorization is done through this method and it is helpful in classifying the inventory primarily into three salient categories basis revenue generation. This also helps to identify the essential products in stock and thus prioritize the management of the same on the value. Analyzing inventory is based on the principle of Pareto, a popular economic theory, which signifies that optimum growth occurs only due to a small part of the economy. The relation between input and output has always remained unequal. Pareto Principle denotes that 80% of the sales volume is generated from the top 20% of the items. In any group, following the 80/20 rule, there are significant few and insignificant many.

 

Category of ABC Analysis -

Theory - All inventory items can not have similar or equal value. There are three categories

• X - Products included in category X are one of the most important stock items having the highest value. It is also the smallest category that has minimal products.
• Y - Mid level category that has products of slightly higher value and less tightly controlled goods  are recorded. Items included in category Y are bigger in volume but of lesser utility compared to category X.
• Z - Usually Z is a general category that contains the largest volume of inventory goods containing the least value in terms of generating business revenue. These products would need the simplest controls and minimum records. 

ABC Analysis Calculations -

Calculation is done in 5 steps - for both individual product groups or a wide range of inventory.

1. Annual no of product gets multiplied wit each item's cost, and note the utility of the product
2. Create a category of each product (descending order) on basis of usage value
3. Sum up the usage value of the products, include total no of items
4. Get the percentages (cumulative) of items sold and annual consumption value
5. Divide the data into three categories, using an approximate ratio of 80:15:5

Criticality in Inventory management -

• Helps analyzing customer demand targeting particular product category
• Streamlines and optimizes the inventory process
• Supplier gets conducive negotiation
• Offers possibilities of strategic pricing of the products
• Customer service level enhancement
• Resource allocation made easier

 

Shortcomings of ABC Analysis -

• New Products - Using the product's sales metrics to identify which level it belongs to in the model. However, it is difficult to classify the new products as there is no historical sales data to examine.
• Seasonality - Holidays and weather - significantly affects the ranking of certain products. During the winter season, warm clothing products may be categorized as an A item, however - during the summer, the same would be brought down to the C rank. How to overcome - Classifications to continually evolve and get adapted every given period.
• Blindness - The ABC analysis depicts a product's importance, how often it is sold and how much revenue they are bringing into the company. Still, there are many factors that will eventually contribute to a product's importance. However, the may not have a large effect on a brand's profitability and good will. They will not rank high in the model. How to overcome - Example - A retail store can have specific products in display. it will help attracting customers. If these items need to be set with higher rank (analysis) and business owners to continue to substitute them with new ones in the display to to have more footfall in the store.

Inventory is divided into various categories for effective management. Some of the popular Inventory Management Techniques are ABC Analysis which is based on the Annual Rupee Value of the Store Keeping Unit (SKU), the FSO/FSN (Fast Slow, Occasional/Non-Moving) Analysis, is based on the movement of the SKU, the VED (Vital, Essential, Desirable) Analysis is based on the criticality of the item finally in the Kraljic matrix the inventory is classified into four categories based on its importance/profit and risk/complexity. Since ABC Analysis is based on both cost and consumption, hidden within the ABC Analysis is the FSO/FSN analysis.

 

Inventory Decisions. Based on these categories, Inventory decisions such as Safety Stock Levels, Level of Control, Order size, Reorder point, no of times to order in a year. Average Inventory, Maximum Inventory Level, Minimum Inventory Level, No of Suppliers, etc. are made.

 

ABC Analysis, sometimes called Always Better Control divides the inventory into Category A – High Annual Rupee value, Category B – Medium Annual Rupee value, and Category C – Low Annual Rupee value. The Annual Rupee value or Annual usage value is calculated by multiplying the Cost of the Item by the Consumption.  The Annual Rupee value is then put in descending order and the Pareto Principle is then used to divide the inventory into the three categories A, B, C. Category A is between 10-20% of the inventory, Category B is about 20-30% and Category C is about 50-70%. 

 

Category	Control	Accuracy	Level of Control	Order Size	Average Max/Min Inventory	No of Suppliers
A	Tight	High	Manager	Low	Low	Large
B	Medium	Medium	Asst Mgr.	Medium	Medium	Medium
C	Loose	Low	Supervisor	High	High	Few

 

Problems with ABC Analysis. ABC analysis only classifies the inventory into categories based on the cost. It does not take into consideration the criticality, risk, profit, strategic importance, or complexity of the item. The Indian Navy overcame this problem by combining it with the VED Analysis.

 

Inventory Control in the Indian Navy. The Indian Navy combines the ABC and VED Analysis into nine categories which takes into consideration the cost, movement and criticality. The nine categories are Vital - A, Vital - B, Vital - C, Essential - A, Essential - B, Essential - C, Desirable - A, Desirable - B, Desirable – C. The Inventory policies for each of these 9 Categories are very clearly defined with Vital – A SKUs being given the maximum attention and Desirable – C items given minimum attention.

ABC Analysis is used for Inventory Control. There are other Inventory Control models such as FSO (Fast, Slow, Occasional) which is based on the demand or usage of the item, VED (Vital, Essential, Desirable) which is based on the criticality/risk/strategic importance of the item.

Inventory Decisions. Inventory policies such as safety stocks, inventory levels, audit, checks, level of control, number of suppliers, Review Policy, etc, are decided based on the category an item is placed into.

How to do an ABC Analysis.

A Spreadsheet of the Item Code, Cost of Purchase and Issue details (consumption) of the item is available. The consumption value for each line is obtained by multiplying the Purchase Cost with the Issue Details. These are then grouped by the Item Code to get the Annual Usage Value per Item Code. Since the procurement cost of an item may vary throughout the year, this is one of the methods that could be used. An alternate method would be to multiply the Average Procurement Cost with the Annual Usage.  The data is then sorted on Annual Consumption Value in descending order. Finally, Pareto’s Principle is used to divide the items into the A, B and C Categories. The A category would generally contain 10 – 20% of the items which would generally account for 70 – 80% of the Annual Consumption Value. The C Category items would generally contain about 50 to 60% of the items and would account for about 5 to 10% of the Annual Consumption items. The B Category items would constitute the remaining items that fall in between the A and C categories and would constitute about 15 – 25% of the value.

Since the A items are of high value and a few items, the control of these items are generally done at a higher Management level, whereas the C items being of lower value and in a large number, the control of these items are done by the clerical staff.

Problem with ABC Analysis.

ABC Model of Inventory Management is based on the Annual Consumption Value of the items. This only takes into account the cost and the consumption of the item. A critical item with low consumption would be classified as a C category item and not get the required priority in its management. Similarly, an item that has a low consumption and is of strategic importance to the company may land up in the C Category. Furthermore, there is a risk of items which affect the profit of the company, or items with less no of suppliers or items which are complex in nature to land up in the C Category.

Leverage items and not-critical which are cheap, have a large number of suppliers and easier to manage. These items generally get classified as A Category items due to high consumption levels. These items could be easily managed at lower levels having controls in place to ensure their management.

How to Overcome the Problems with ABC Analysis.

ABC Analysis used independent of other systems would have the inherent problems elucidated above.

ABC and VED. Combining it with the VED Analysis would avert the problem of classifying critical items as C Category and giving priority to the Vital and Essential Items. Also, the management could have a relook of the Desirable items that fall into the A Category. These expensive or high consumption items in the Desirable Category could be reassessed for their requirement.

ABC and Kraljic Matrix. Combining the ABC analysis with the Kraljic Matrix would focus attention not only based on the Annual Consumption Value but also asking questions such as – Are these items of strategic importance, are these items Bottleneck items or Leverage items or non-Critical items?

It is a technique of categorizing the material in terms of it's value (Higher the value "A" will be the category and lower the value "B" will be the category and lowest the value "C" will be the category) in order to identify and prioritize the inventory losses happening in the organization. 

Shortcomings:

1) It's a localised approach of inventory control ( not a universal one).

2.Prices may be dynamic in nature and hence frequent analysis is required. 

3.ABC categorization considers only the cost of the material but not other aspects like Durability,Cycle life and other quality of the material.

4.B and C category may get less or no importance during analysis which may result in further losses.

5.Note suitable for small scale industry as it may need higher resources because of complexity in the Process. 

Overcome by: 

1)Post ABC analysis,introducing the Pareto analysis of all categories,which will help us to prioritize vital few causes in all categories.

2)Identifying the potential modes of inventory shoot ups and establishing a control mechanism.

3.Along with the cost, focus to be given on other factors like Quality,Durability etc

ABC analysis is a technique in an inventory management which helps in classifying the value of inventory items based on their criteria or the importance of the products to the business.

Three main criteria’s on basis of which they are classified are demand, cost and risk. Store Managers or Inventory Managers group these items into different classes based on the above criteria.

This also helps company to understand the most successful product which is in demand and contributes highest in profit sharing of the business.

This is also known as Always Better Control, as this analysis helps to have sufficient stock as per the demand and thus helps companies to earn profit with a systematic and calculative way.

Now let’s see how it is calculated?

Multiply the annual sales of specific item by its cost, this will give the status of products which needs are high on demand and needs to be stocked; also will help to analyze the products which yield less profit. Accordingly company can take a call on having structured approach.

Number of items sold in a yr. X Cost per item = Annual value of sold product

 

After identifying the value of each product with the help of Pareto Analysis i.e with 80/20 rule, it will be easy to conclude the ranks and can accordingly place them under the classes made which is “A”, “B”, “C”

 

Let’s identify Strengths v/s Shortcoming with the help of an example;

Categorize the inventory (products) according to the value and importance.

 

Company: Dettol

High valued items in class “A” – Disinfection products >> Sprays, Handwash, Soaps, Floor cleaners etc

Average valued products in class “B” – Antiseptic products >> Original Dettol liquid, 

Least valued material in class “C” – Band aid / Handplast, Skin care products, Bandage

 

While all published answers are very well written, there are 2 answers which stand out - Somnath and Darryl. Somnath's answer highlights the pertinent shortcomings beautifully while Darryl provides an interesting example of how ABC analysis is applied in combination with other inventory management methods.

 

Hence both the answers have been selected as winners!