Inventory Fundamentals

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Inventory Fundamentals

Contents

1. Introduction

2. Aggregate I nventory Management

3. Item Inventory Management

4. Inventory And The Flow Of Material

5. Supply And Demand Patterns

6. Functions Of Inventories

7. Objectives Of Inventory Management

8. Inventory Costs

9. Financial Statements And Inventory

10. Abc Inventory Control

1. Introduction

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

Financially, inventories are very important to manufacturing companies. On the balance sheet, theyusually represent from 20% to 60% of total assets. As inventories are used, their value is convertedinto 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 stageto the customer. Since inventory either results from production or supports it, the two cannot bemanaged separately and, therefore, must be coordinated. Inventory must be considered at each of theplanning levels and is thus part of production planning, master production scheduling, and material

requirements planning. Production planning is concerned with overall inventory, master planning withenditems,and material requirements planning with component parts and raw material.

2. Aggregate Inventory Management

Aggregate inventory management deals with managing inventories according to their class ification (rawmaterial, work-in-process, and finished goods) and the function they perform rather than at the individualitem level. It is financially oriented and is concerned with the costs and benefits of carrying the differentclassifications 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.

3. Item Inventory Management

Inventory is not only managed at the aggregate level but also at the item level. Management mustestablish decision rules about inventory items so the staff responsible for inventory control can do their

job effecti vely. These rules inc lude the f ollowing:

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 inventorymanagement decisions, which include:

Types of inventory based on the flow of material.

Supply and demand patterns.

Functions performed by inventory.

Objectives of inventory management.

Introduction to Material Management

Master Scheduling

Material Requirements Planning

Capacity Management

Production Activity Control

Purchasing

Forecasting

Inventory Fundamentals

Order Quantities

Independent Demand Ordering Systems

Physical Inventory and Warehouse Management

Physical Distribution
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Inventory costs.

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

4. Inventory And The Flow Of Material

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

Rawmaterials. These are purchased items received which have not entered the productionprocess. They include purchased materials, component parts, and subassemblies.

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

Finishedgoods. The finished products of the production process that are ready to be sold ascompleted items. They may be held at a factory or central warehouse or at various points in thedistribution system.

Distributioninventories. Finished goods located in the distribution system.

Maintenance, repair, andoperational supplies (MROs).Items used in production thatdo not become part of the product. These include hand tools, spare parts, lubricants, andcleaning supplies.

Classification of an item into a particular inventory depends on the production environment. Forinstance, sheet steel or tires are finished goods to the supplier but are raw materials and componentparts 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 thesame rate as demand, and no inventory would build up. For this situation to exist, demand must bepredictable, 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 toanother is balanced so little work-in-process inventory is required, and goods are delivered to thecustomer at the rate the customer needs them. Flow manufacturing systems were discussed in Chapter1. Because the variety of products they can make is so limited, demand has to be large enough to

justify economically s etting up the s ystem. These sys tems are characteristic of just-in-timemanufacturing and will be discussed in Chapter 15.

Demand for most products is neither sufficient nor constant enough to warrant setting up a line-flowsystem, and these products are usually made in lots or hatches. Workstations are organized byfunction, 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


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system, inventory will build up in raw materials, work-in-process, and finished goods.

6. Functions Of Inventories

In batch manufacturing, the basic purpose of inventories is to decouple supply and demand. Inventoryserves 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, inventoriescan be classified according to the function they perform.

a. Anticipation Inventory

Anticipationinventoriesare built up in anticipation of future demand. For example, theyare created ahead of a peak selling season, a promotion program, vacation shutdown, orpossibly the threat of a strike. They are built up to help level production and to reducethe costs of changing production rates.

b. Fluctuation Inventory (Safety Stock)

Fluctuationinventoryis held to cover random unpredictable fluctuations in supply and

demand or lead time. If demand or lead time is greater than forecast, a stockout willoccur. Safetystock is carried to protect against this possibility. Its purpose is to preventdisruptions in manufacturing or deliveries to customers. Safety stock is also calledbuffer stock or reserve stock.

c. Lot-Size Inventory

Items purchased or manufactured in quantities greater than needed immediately createlot-sizeinventories. This is to take advantage of quantity discounts, to reduceshipping, clerical, and setup costs, and in cases where it is impossible to make orpurchase items at the same rate they will be used or sold. Lot-size inventory is some-times called cyclestock. It is the portion of inventory that depletes gradually ascustomers orders come in and is replenished cyclically when suppliers orders arereceived.

d. Transportation Inventory

Items purchased or manufactured in quantities greater than needed immediately createlot-sizeinventories. This is to take advantage of quantity discounts, to reduceshipping, clerical, and setup costs, and in cases where it is impossible to make orpurchase items at the same rate they will be used or sold. Lot-size inventory is some-times called cyclestock. It is the portion of inventory that depletes gradually ascustomers orders come in and is replenished cyclically when suppliers orders arereceived.

tAI = .

365

where I is the average annual inventory in transit, t is transit time in days, and A isannual demand. Notice that the transit inventory does not depend upon the shipmentsize but on the transit time and the annual demand. The only way to reduce theinventory 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 is5200 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


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Some products such as minerals and commodities, for example, grains or animalproducts, are traded on a worldwide market. The price for these products fluctuatesaccording to world supply and demand. If buyers expect prices to rise, they canpurchase hedgeinventory when prices are low. Hedging is complex and beyond thescope of this text.

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

MROs are items used to support general operations and maintenance but which do notbecome directly part of a product. They include maintenance supplies, spare parts, andconsumables such as cleaning compounds, lubricants, pencils, and erasers.

7. Objectives Of Inventory Management

A firm wishing to maximize profit will have at least the f ollowing 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 ofcustomers. In inventory management, the term is used to describe the availability ofitems when needed and is a measure of inventory management effectiveness. Thecustomer can be a purchaser, a distributor, another plant in the organization, or theworkstation where the next operation is to be performed.

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

Inventories help to maximize customer service by protecting against uncertainty. If wecould forecast exactly what customers want and when, we could plan to meet demandwith no uncertainty. However, demand and the lead time to get an item are oftenuncertain, possibly resulting in stockouts and customer dissatisfaction. For thesereasons, 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:

a. Inventories allow operations with different rates of production to operateseparately and more economically. If two or more operations in a sequence havedifferent rates of output and are to be operated efficiently, inventories must buildup between them.

b. Chapter 2 discussed production planning for seasonal products in which demandis nonuniform throughout the year. One strategy discussed was to levelproduction and build anticipation inventory for sale in the peak periods. Thiswould 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 amountequal to the average demand. The advantage of this strategy is that the costs ofchanging production levels are avoided. Figure 9.2 shows this strategy.

c. Inventories allow manufacturing to run longer production runs, which result in thefollowing:

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

An inc rease in production c apacity due to production resources beingused 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. Outputoccurs only when an item is being worked on and not when setup istaking place. If larger quantities are produced at one time, there are fewersetups required to produce a given annual output and thus more time isavailable for producing goods. This is most important with bottleneckresources. Time lost on setup on these resources is lost throughput (totalproduction) and lost capacity.4. Inventories allow manufacturing to purchase in larger quantities, which


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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 thefollowing:

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

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

fluctuates with demand.c. Cost of placing orders. Lower inventories can be achieved by ordering smaller

quantities more often, but this practice results in higher annual ordering costs.

d. Transportation costs. Goods moved in small quantities cost more to move perunit than those moved in large quantities. However, moving large lots implieshigher inventory.

If inventory is carried, there has to be a benefit that exceeds the costs of carrying thatinventory. Someone once said that the only good reason for carrying inventory beyondcurrent needs is if it costs less to carry it than not. This being so, we should turn ourattention 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

Itemcost is the price paid for a purchased item, which consists of the cost of the itemand any other direct costs associated in getting the item into the plant. These couldinclude such things as transportation, custom duties, and insurance. The inclusive cost

is often called the landedprice. For an item manufactured in-house, the cost includesdirect material, direct labor, and factory overhead. These costs can usually be obtainedfrom either purchasing or accounting.

b. Carrying Costs

Carryingcostsinclude all expenses incurred by the firm because of the volume ofinventory carried. As inventory increases, so do these costs. They can be broken downinto three categories:

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

II. Storage costs. Storing inventory requires space, workers and equipment. Asinventory increases, so do these costs.

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

a. Obsolescence loss of product value resulting from a model or stylechange or technological development.

b. Damage inventory damaged while being held or moved.

c. Pilferage goods lost, strayed, or stolen.


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d. Deterioration inventory that rots or dissipates in storage or whose shelflife is limited.

What does it cost to carry inventory? Actual figures vary from industry to industry andcompany to company. Capital costs may vary depending upon interest rates, the creditrating of the firm, and the opportunities the firm may have for investment. Storagecosts vary with location and type of storage needed. Risk costs can be very low or canbe close to 100% of the value of the item for perishable goods. The carrying cost isusually defined as a percentage of the dollar value of inventory per unit of time (usuallyone year). Textbooks tend to use a figure of 2030% in manufacturing industries. Thisis realistic in many cases but not with all products. For example, the possibility ofobsolescence with fad or fashion items is high, and the cost of carrying such items isgreater.

c. Example Problem

A company c arries an average annual inventory of $2,000,000. I f they estimate thecost of capital is 10%, storage costs are 7%, and risk costs are 6%, what does it costper 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 asupplier. 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 areessentially the same. However, the annual cost of ordering depends upon the numberof orders placed in a year.

Ordering costs in a factory include the following:

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

Setup and teardown costs. Every time an order is issued, work centers have toset up to run the order and tear down the setup at the end of the run. Thesecosts do not depend upon the quantity ordered but on the number of ordersplaced 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 ofcapacity and is directly related to the number of orders placed. It is particularlyimportant and costly with bottleneck work centers.

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

The annual cost of ordering depends upon the number of orders placed in a year. Thiscan 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


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stockout can potentially be expensive because of back-order costs, lost sales, andpossibly lost customers. Stockouts can be reduced by carrying extra inventory toprotect 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-associatedcostscan be avoided by levelingproduction, 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 mak es and sells a s easonal product. Based on a s ales f orecast of 2000,3000, 6000, and 5000 per quarter, calculate a level production plan, quarterly endinginventory, and average quarterly inventory.

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

Answer

Quarter I Quarter2

Quarter3

Quarter4

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 sheetshows assets, liabilities, and owners equity. The income statement shows the revenues made and theexpenses incurred in achieving that revenue.

a. Balance Sheet

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

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

Owners equityis the difference between assets and liabilities. After all the liabilitiesare paid, it represents what is left for the owners of the business. Owners equity iscreated either by the owners investing money in the business or through the operationof the business when it earns a profit. It is decreased when owners take money out ofthe business or when the business loses money.

The accountingequation. The relationship between assets, liabilities, and ownersequity 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 befound.

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

Assets Liabilities

Cash $100,000 Notes payable $5,000

Accountsreceivable

$300,000 Accountspayable

$20,000

Inventory $500,000 Long-term debt $500,000

Fix ed a ss ets $ 1,0 00 ,0 00 Tota l lia bilit ie s $ 52 5,0 00

Owners equity

Capital $1,000,000

Retainedearnings $375,000

Total assets $1,900,000 Total liabilitiesand

$1,900,000

owners equity

Capitalis the amount of money the owners have invested in the company.


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Retainedearningsare increased by the revenues a company makes and decreasedby the expenses incurred. The summary of revenues and expenses is shown on theincome statement.

b. Example Problem

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

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

Answer

a. Assets = Liabilities + owners equity

Assets = $800 + $1,000 = $1,800

b. 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 bymaking a profit. For this reason owners equity is broken down into a series ofaccounts, called revenue accounts, which show what increased owners equity, andexpense accounts, which show what decreased owners equity.

Income = revenue expenses

Revenuecomes from the sale of goods or services. Payment is sometimes immediatein the form of cash, but often is made as a promise to pay at a later date, called anaccount receivable.

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

Costofgoodssoldare costs that are incurred to make the product. They includedirect labor, direct material, and factory overhead. Factory overhead is all other factorycosts except direct labor and direct material.

Generalandadministrativeexpensesinclude all other costs in running a business.Examples of these are advertising, insurance, property taxes, and wages and benefitsother 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 administrativeexpenses

$100,000

N et inc ome (profit) $ 10 0,0 00

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 administrativeexpenses

= $ 150,000

How much would profits increase if, through better materials management, materialcosts 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 a dministrativeexpenses

$150,000


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N et inc om e (pr ofit) $1 50 ,0 00

If material costs are reduced by $50,000, income increases by $50,000. Materialsmanagement can have a direct impact on the bottom linenet income.

e. Cash Flow Analysis

When inventory is purchased as raw material, it is recorded as an asset. When it entersproduction, 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 overheadattributed to its processing. The material is said to absorb overhead. When the goodsare 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 anotherfinancial issue:

Businesses must have the cash to pay their bills. Cash is generated by sales and theflow 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 thebusiness. Any shortfall of cash must be provided for, perhaps by borrowing or in someother 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 tiedup and cannot be used for other purposes. As we saw earlier in this chapter, inventoryhas a carrying costthe costs of capital, storage, and risk. Finance wants as littleinventory as possible and needs some measure of the level of inventory. Totalinventory 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 isimpractical, since inventory is needed to support manufacturing and often tosupply customers. How much inventory is enough? There is no one answer.

A convenient measure of how effectively inventories are being used is theinventoryturnsratio:

annualcost of goods sold Inventory turns =

. average

inventory in dollars

The calculation of average inventory can be complicated and is asubject 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 theaverage 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 $500,000of inventory a company is able to generate $1 million in sales. If,through better materials management, the firm is able to increase itsturns ratio to 10, the same sales are generated with only $100,000 ofaverage inventory, lithe annual cost of carrying inventory is 25% of theinventory value, the reduction of $400,000 in inventory results in a costreduction (and profit increase) of $100,000.

g. Example Problem

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

Answer

annual cost ofgoods sold Inventory turns =

. average inventoryin dollars


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24,000,000 = = 4 6,000,000

b. What would be the reduction in inventory if inventory turns were increased to 12 timesper year?

Answer

annual cost ofgoods sold

Average inventory =.inventory turns

24,000,000 = .

12

= $2,000,000

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

c. If the cost of carrying inventory is 25% of the average inventory, what will the savingsbe?

Answer

Reduction in inventory = $4,000,000

Savings = $4,000,000 X0.25 = $1,000,000

h. Days of supply

Daysofsupply 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 dailyusage

i. Example Problem

A company has 9000 units on hand and the annual usage is 48,000 units. There are240 working days in the year. What is the days of supply?

Answer 48,000

Average daily usage = = 200 units 240

inventory onhand 9000 Days of supply =

= = 45 days average dailyusage 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 oninventory. If there is little change in the price of an item, any of the four ways willproduce about the same results. However, in rising or falling prices, there can be apronounced difference. There is no relationship with the actual physical movement ofactual items in any of the methods. Whatever method is used is only to account forusage.

First in first out (FIFO).


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This method assumes that the oldest (first) item in stock is sold first.In rising prices, replacement is at a higher price than the assumedcost. This method does not reflect current prices and replacement willbe 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 istrue in a falling price market. However, the company is left with aninventory that may be grossly understated in value.

Average cost.

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

Standard cost.

This method uses cost determined before production begins. The costincludes direct material, direct labor, and overhead. Any differencebetween 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). Incontrolling inventory, four questions must be answered:

a. What is the importance of the inventory item?

b. How are they to be controlled?

c. How much should be ordered at one time?

d. When should an order be placed?

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

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

The ABC principle is based on the observation that a small number of items often dominate the resultsachieved in any situation. This observation was first madeby an Italian economist, Vilfredo Pareto, and is called Paretos law. As applied to inventories, it isusually found that the relationship between the percentage of items and the percentage of annual dollarusage follows a pattern in which:

a. About 20% of the items account f or about 80% of the dollar usage.

b. About 30% of the items account f or about 15% of the dollar usage.

c. About 50% of the items account f or about 5% of t he dollar usage.

The percentages are approximate and should not be taken as absolute. This type of distribution can beused 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 ofmaterial.

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 groupsbased on percentage of annual usage.


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b. Example Problem

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

a. Calculate the annual dollar usage for each item.

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

c. Calculate the cumulative annual dollar usage and the cumulative percent ofitems.

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

Answer

I. 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

II. 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 suchas 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 butaccount for only about 5% percent of the total inventory value. Carrying extrastock of C items adds little to the total value of the inventory. C items arereally only important if there is a shortage of one of themwhen they becomeextremely importantso a supply should always be on hand. For example,order a years supply at a time and carry plenty of safety stock. That way thereis only once a year when a stockout is even possible.

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


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Different controls used with different classifications might be the following:

A Items: high priority. Tight control including c omplete accurate records,regular and frequent review by management, frequent review of demandforecasts, 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 controlsmake sure there areplenty. Simple or no records perhaps use a two-bin system or periodic reviewsystem. Order large quantities and carry safety stock.

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Inventory Fundamentals