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ABC Analysis

ABC analysis is an inventory categorization method which consists in dividing items into three categories (A, B, C): A being the most valuable items, C being the least valuable ones.

This method aims to draw managers’ attention on the critical few (A-items) not on the trivial many (C-items).

The ABC approach states that a company should rate items from A to C, basing its ratings on the following rules:

A-items are goods which annual consumption value is the highest; the top 70-80% of the annual consumption value of the company typically accounts for only 10-20% of total inventory items.

B-items are the interclass items, with a medium consumption value; those 15-25% of annual consumption value typically accounts for 30% of total inventory items.

C-items are, on the contrary, items with the lowest consumption value; the lower 5% of the annual consumption value typically accounts for 50% of total inventory items.

The ABC analysis

The annual consumption value is calculated with the formula:

(Annual demand) x (item cost per unit)

Through this categorization, the supply manager can identify inventory hot spots, and separate them from the rest of the items, especially those that are numerous but not that profitable.

Steps for the classification of items:

1.Find out the unit cost and and the usage of each material over a given period

2.Multiply the unit cost by the estimated annual usage to obtain the net value

3.List out all the items and arrange them in the descending value (Annual Value)

4.Accumulate value and add up number of items and calculate percentage on total inventory in value and in number.

5.Draw a curve of percentage items and percentage value.

6.Mark off from the curve the rational limits of A, B and C categories.

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Example: 1 ABC Analysis

Step Wise ABC Analysis Method
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Inventory management policies

Each item should receive a treatment corresponding to its class:

A-items should have tight inventory control, more secured storage areas and better sales forecasts; reorders should be frequent, with weekly or even daily reorder; avoiding stock-outs on A-items is a priority.

B-items benefit from an intermediate status between A and C; an important aspect of class B is the monitoring of potential evolution toward class A or, in the contrary, toward the class C.

Reordering C-items is made less frequently; a typically inventory policy for C-items consist of having only 1 unit on hand, and of reordering only when an actual purchase is made; this approach leads to stock-out situation after each purchase which can be an acceptable situation, as the C-items present both low demand and higher risk of excessive inventory costs.

Procurement and Warehouse Applications

The results of an ABC Analysis extend into a number of other inventory control and management processes:

Review of stocking levels: “A” items will generally have greater impact on projected investment and purchasing spend, and therefore should be managed more aggressively in terms of minimum and maximum inventory levels; inactive items will fall to the bottom of the prioritized list; the bottom of the “C” category is the best place to start when performing a periodic obsolescence review

Cycle counting: the higher the usage, the more activity an item is likely to have; to ensure accurate record balances, higher priority items are cycle counted more frequently; “A” items are counted once every quarter; “B” items once every 6 months; and “C” items once every 12 months.

Identifying items for potential consignment or vendor stocking: since “A” items tend to have a greater impact on investment, these would be the best candidates to investigate the potential for alternative stocking arrangements that would reduce investment liability and associated carrying costs.

Turnover ratios and associated inventory goals: “A” items will have greater usage than “B” or “C” items, and as a result should have greater turnover ratios; when establishing investment and turnover metrics, inventory data can be segregated by ABC classification, with different targets for each category

Example : 2 ABC Analysis

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Conclusion

The boundary between class A and class B might not be as sharply defined;

The purpose of this classification is to ensure that purchasing staff use resources to maximum efficiency by concentrating on those items that have the greatest potential savings → selective control will be more effective than an approach that treats all items identically.
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