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Activity Based Costing, or ABC, is a method of allocating overhead and direct expenses related to the most important activities of the company first. This process allows business owners and managers an opportunity to better define the areas of manufacturing or sales that generate the most profit for the company. Inventory analyzed under the ABC method is classified in order of profitability to the company. Class A inventory accounts for80 percent of revenue, class B inventory for15 percent of revenue and class C inventory for5 percent of revenue.
The advantages:
Better Control of High-Priority Inventory.
More Efficient Cycle Counts.
The dis advantages:
Conflict with Other Cost Systems.
Requires Substantial Resources
ABC analysis helps management to categorize inventory based on the value contribution to total sales. It is based on the Pareto principle that80% of sales/consumption is from20% of the resources.
As such in Inventory Management it is often found that demand is not evenly distributed i.e.70-80% of sales is from20% of the items. As such it is beneficial to allocate most time and resources to these fast movers called 'A Class' items.
20-25% items account for about15-20% of sale 'B class' and the balance5-10% sale is from the60-70% of items.
ABC classification thus helps management allocate scarce resources and budgets to manage and stock items based on their sales/consumption value. This is especially important for firms with too many SKU's where it is not possible to individually review each SKU on a daily or even weekly basis.
The disadvantage or opportunity (for want of a better term) in ABC analysis is identifying the various factors that affect the ABC classification of inventory. e.g. sales promotion, demand spurt, essentiality, lead-time, etc
Systems need to be in place to identify exceptions to this rule. .e.g. High value items tend to be in the A class even if the volume of sale is occasional, whereas low value fast moving items may end up in B or C class even if it essential to have these in stock. These items need to be reviewed, identified and reclassified as may be needed.
Advantages of ABC Analysis:
1. Close and strict control is facilitated on the most important items which help in overall inventory valuation or overall material consumption.
2. Proper regulation of investment in inventory which will ensure optimum utilization of available funds.
3. Helps in maintaining a high inventory turnover rates.
Disadvantages of ABC Analysis:
Agreed with experts replies .......................
In any inventory which contains more than one stocked item, some items will be more important to the organization than others
Some might have a very high usage rate, like FMCG products or consumables, so if there is a stock out of these items, customers would be disappointed
Other items might be of very high value, so excessive inventory levels would not be cost effective
Some could be of very low value, and hence, higher levels of inventory would not affect the Inventory Performance in any way while ensuring un-interrupted supply of these materials to production or sales.
With different types of materials used in any production / distribution unit, monitoring the inventory levels and controlling the same needs scientific analysis
There are different ways of classifying material. Some of the major ones include:
Type of requirement
Frequency of procurement
Standard or stock items
Physical or chemical nature
Source
Cost
Type of Requirement
One way of classifying materials is whether they are used for direct production (i.e; go into the products being manufactured) or used indirectly for supporting the production process.
As an example, for a car manufacturer, the steering wheel assembly could be classified as direct material. Oil, used to lubricate the factory conveyor belt would be classified as indirect material.
Frequency of Purchase
Another way of classifying materials is based on how often they are purchased.
For the car manufacturer example, a welding robot which is expensive capital equipment may be purchased once in two years.
Tyres which go on every car, could be frequently purchased with weekly deliveries.
Standard Items
Standard or stock items - are those which are usually required and are always kept in stock.
These would be frequently purchased and the risk of buying a little excess may not be high.
Packaging material is an example of stock items.
Nature of Items
The physical or chemical nature of items may also be used for classification
Materials which typically need special handling are often classified separately.
Such material could need special transport and warehousing procedures.
These could be purchased separately as they often need additional licenses and approvals.
Source
Items procured locally will often be handled differently than those procured overseas (imports).
The purchasing, receiving and payment procedures are very different for local items when compared to imported items.
Cost
One common way of differentiating between different inventory items is to rank them by the usage value (their usage rate multiplied by their individual value)
Items with a particularly high usage value are deemed to warrant the most careful control, whereas those with low usage values need not be controlled quite so rigorously.
Generally, a relatively small proportion of the total range of items contained in an inventory will account for a large proportion of the total usage value. and Vice Versa.
– In a computer,
A large proportion of the total cost is made up of small number of high value components like CPU.
While a large number of components like mouse, connectors, cables, key board, etc would constitute smaller proportion of the total cost.
– So, in a computer manufacturing company, inventory planning for CPU and Mouse are treated differently
This phenomenon is known as the Pareto Rule.
The Pareto principle (also known as the80-20 rule, the law of the vital few,) states that, for many events, roughly80% of the results come from20% of the efforts.
Conversely: The remaining20% results come from80% efforts.
Italian economist Vilfredo Pareto, observed in1897 that:
80% of the land in England was owned by20% of the population; Surprisingly, It was true for other countries too.
20% of the pea pods in his garden contained80% of the peas.
Based on these observations he formulated the Pareto Principle
80% of your sales come from20% of clients.
80% of world’s wealth is controlled by20% of population
20% of patients use80% of health care services
20% of the workers produce80% of the output
20% of the bugs cause80% of the crashes
80% of users use20% of features of any product
It takes20% effort to complete the first80% of a project, the remaining20% work takes80% effort
Typically,80 per cent of an operation’s sales are accounted for by only20 per cent of all stocked item types.
The relationship can be used to classify the different types of items kept in an inventory by their usage value.
ABC inventory control allows inventory managers to concentrate their efforts on controlling the more significant items of stock.
The Pareto Rule has been applied to this Classification called ABC, with a slight improvisation.
A category Items constitute10% of the total materials and contribute to70% of value
B category Items constitute20% of total materials and contribute to20% of value.
C category Items constitute70% of total materials and contribute to10% of value.
Class A items constitute approximately10% of the number of items in inventory, and their value typically ranges from70-80% of the total value of inventory.
Class B ranges from between11-20% of the items in inventory, and their value ranges from between10-20% of the total inventory value.
The last category, Class C make up70-80% of the items in inventory, and their value is only between5-10% of the total inventory value.
By clearly identifying the high value of A class items this allows purchase managers to focBy doing an Inventory classification, of items into A, B and C:
use their efforts on areas which will have the maximum impact to the organization.
The first step in ABC analysis is to classify all inventory items as either A, B, or C.
Calculate value for each item: Cost x Annual demand
Rank items according to their annual value (descending order).
Classify -top10% as A items, the next20% as B items, and the last70% as C items.
These classifications will not be exact, but they have been found to be close to the actual occurrence
The next step is to determine the level of inventory control for each classification.
Class A items require tight inventory control as they represent a large percentage of the total value of inventory. These levels should be as low as possible, with minimum safety stocks.
They require accurate forecasts and detailed record keeping.
They also need appropriate inventory control system and cost effective procedure to determine order quantities
In addition, close attention should be given to purchasing policies and procedures of Class A items
B and C items require less stringent inventory control.
Since carrying costs are usually lower for C items, higher inventory levels can sometimes be maintained with larger safety stocks.
It may not be necessary to control C items beyond simple observation.
In general, A items frequently require a continuous control system, where the inventory level is continuously monitored
B items require monitoring at a lessor frequency
A periodic review system with occasional monitoring will suffice for C items.
How does the usage of ABC Analysis help the purchase manager?
As can be seen from the table, a smaller number of items contribute to a large amount of value.
Therefore the purchase manager can spend more time in planning and managing ‘A class’ items and ‘B class’ items than on the many ‘C class’ items.
Since ‘A class’ items are higher in value, low levels of inventory are maintained of such items. They are also ordered and reviewed very frequently and they are often monitored by specialized buyers.
‘B class’ items are ordered and reviewed less frequently than ‘A class’ items and moderate levels of inventory are carried of such items.
Although it is important to provide necessary supply of all items, there are some common purchasing techniques that are used to manage ‘C class’ items.
They include:
keeping slightly higher levels of inventory levels
having a few suppliers to manage multiple items
allowing the end-user to directly manage ordering
reviewing the items infrequently
Doing so reduces the paperwork and transaction cost of purchasing these items. And since their value is typically low, slightly higher levels of inventory that may result will not impact the organization.
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