Inventories include raw material inventory, work-in process inventory and finished goods inventory. The goal of effective inventory management is to minimize the total costs – direct and indirect – that are associated with holding inventories. However, the importance of inventory management to the company depends upon the extent of investment in inventory. It is industry-specific.
In the case of a manufacturing company of reasonable size the number of items of inventory runs into hundreds, if not more. From the point of view of monitoring information for inventory control, it becomes extremely difficult to consider each one of these items. The ABC analysis comes in quite handy and enables the management to concentrate attention and keep a close watch on a relatively less number of items which account for a high percentage of the value of annual usage of all items of inventory.
The ABC System of Inventory Control is based on the principle that a small portion of the items may typically represent the bulk of money value of the total inventory used in the production process, while a relatively large number of items may from a small part of the money value of stores. The money value is ascertained by multiplying the quantity of material of each item by its unit price. According to this approach to inventory control high value items are more closely controlled than low value items.
A firm using the ABC system segregates its inventory into three groups – A, B and C. The A items are those in which it has the largest dollar investment. A group consists about 10 percent of the inventory items that account approximately for 70 percent of the firm’s dollar investment. These are the most costly or the slowest turning items of inventory. The B group consists of the items accounting for the next largest investment. This group consists approximately 20 percent of the items accounting for about 20 percent of the firm’s dollar investment. The C group typically consists of a large number of items accounting for a small dollar investment. C group consists of approximately 70 percent of all the items of inventory but accounts for only about 10 percent of the firm’s dollar investment. Items such as screws, nails, and washers would be in this group.
Dividing its inventory into A, B, and C items allows the firm to determine the level and types of inventory control procedures needed. Control of the A items should be most intensive due to the high dollar investments involved, while the B and C items would be subject to correspondingly less sophisticated control procedures.
Steps in ABC System of Inventory Control
The steps involved in ABC analysis are as follows:
- Calculate the annual usage value of each item by multiplying the number used with the price of the item.
- Arrange the items in descending order according to the usage value.
- Compute percentage of total usage value for each item.
- Find out the average inventory of each item by dividing the usage value with 2 and number of orders.
The ABC analysis can be shown on a graph too. For this purpose the cumulative percentages of the number of items are shown on X-axis and percentage of values on F-axis. Where the plotted curve takes a sharp turn a point is marked.
Advantages of ABC System of Inventory Control
- It ensures control over the costly items in which a large amount of capital is invested.
- It helps in developing scientific method of controlling inventories. Clerical costs are considerably reduced and stock is maintained at optimum level.
- It helps in maintaining stock turnover rate at comparatively higher level through scientific control of inventories.
- It ensures considerable reduction in the storage expenses. It results in stock carrying stock.
- It helps in maintaining enough safety stock for C category of items.
Disadvantages of ABC System of Inventory Control
- This technique can be successfully employed only, if there is proper standardization of materials in the store.
- A good system of codification of materials should be in operation for the success of this analysis.
- The analysis is based on monetary value of the items in use. Other important factors one ignored.
In spite of the above mentioned limitations, the ABC analysis is very popular method of inventory control. It is an effective instrument in reducing the cost of materials in the store house.