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ABC Analysis - Technique of Inventory Control

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Helna is a postgraduate in Commerce who now working as a Manager and also love sharing informative information with her readers.

ABC Analysis Is A Type Of Analysis Of Material Dividing Into Three Groups.

ABC analysis also helps in reducing the clerical costs and results in better planning and improved inventory turnover.

ABC analysis also helps in reducing the clerical costs and results in better planning and improved inventory turnover.

What is ABC Analysis

ABC analysis is a type of analysis of material dividing into three groups called A-group items, B-Group items, and C-group items to exercise control over materials. Manufacturing concerns find it useful to divide materials into three categories.

An analysis of the annual consumption of materials of any organization would indicate that a handful of top high-value items (less than 10 percent of the total number) will account for a substantial portion of about 70 percent of total consumption value.

Remember: 10% of the total number of items carries 70% of the value. - "A" group items

Similarly, a large number of bottom items (over 70 percent of the total number of items) account for only about 10 percent of the consumption value.

Remember: 70% of the total number of items account for only about 10% of consumption value - "C"-group items.

Between these two extremes will fall those items the percentage number of which is more or less equal to their consumption value.

Remember: 20% of the total number of items account for only about 20% consumption value - "B" group items.

Items in the top category are treated as "A" category items. Items in the bottom category are called "C" category items and the items that lie between the top and the bottom are called "B" category items. Such an analysis of materials is known as ABC analysis or Proportional parts value analysis.

Graphical Representation of ABC Analysis

Graphical Representation of ABC Analysis

Graphical Representation of ABC Analysis

Classification of Items into A, B and C Categories

The logic behind this kind of analysis is that the management should study each item of stock in terms of its usage, lead time, technical, or other problems, and its relative money value in the total investment in inventories.

Critical items i.e., high-value items deserve very close attention and low-value items need to be devoted minimum expense and effort in the task of controlling inventories.

The Material Manager by concentrating on "A" class items can control inventories and show visible results in a short span of time. By controlling "A" items and doing a proper inventory analysis, obsolete stocks are automatically pinpointed.

ABC analysis also helps in reducing the clerical costs and results in better planning and improved inventory turnover. ABC analysis has to be resorted to because equal attention to A, B, and C items will not be worthwhile and would be very expensive.

The following steps will explain to you the classification of items into A, B, and C categories.

The following steps will explain to you the classification of items into A, B, and C categories.

  1. Find out the unit cost 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 the number of items and calculate the percentage on the total inventories in value and 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.

How to Maintain Optimum Stock Level?

Maintenance of proper stock of each item of materials is one of the main functions of the stores' department. A large quantity of material in-store leads to huge investments, deterioration in quality, large space requirements, etc. Less stock also leads to higher costs, frequent purchases, and loss of production, etc. Therefore, it is important to maintain the optimum stock level. One of the best ways to maintain stock is to determine the minimum and maximum stock levels as per the necessity and maintain it regularly.

Storekeepers usually use the scientific technique of material management to ensure the optimum quantity of material in-store and make purchases accordingly. To do that following levels are fixed in advance:


Maximum Stock Level
Minimum Stock level
Re-ordering level
Danger level

Reordering Level

The re-ordering level is a level at which the storekeeper will initiate the steps to purchase fresh supplies. This level is called the re-ordering level or ordering level. This level usually lies between the minimum and maximum stock levels. This level will usually be higher than the minimum stock level to cover the unexpected delay in the delivery of fresh supplies or abnormal usage of materials. The following points need to be taken into consideration while fixing the re-ordering level

1. Economic ordering quantity
2. Rate of consumption
3. Time required for the delivery of fresh supply.

The following formulas can be used for calculating the re-ordering level.

Reorder level = Maximum consumption x Maximum re-order period

or

Reorder level = Minimum level + consumption during the time required to get fresh deliveries

Example 1

Calculate the reorder level from the following information:
Maximum Consumption = 100 units per week
Minimum Consumption = 50 units per week
Maximum reorder period = 4 weeks

Solution:

Reorder level = Maximum consumption x Maximum reorder period
= 100 x 4 = 400 units.



Example 2
Find out the order level from the following information:
Maximum Stock: 250 units
Minimum stock: 100 units
The time required for receiving fresh supplies: 10 days
Daily consumption of material: 5 units

Solution:

Reorder level = Minimum level + consumption during the time required to get fresh deliveries
= 100 + (5 x 10)
= 150 units.

Minimum Stock Level

The minimum stock level is a level of stock that must be kept in-store at all times. This is a level of an item of material below which the stock in hand is not allowed to fall. The objective of this limit is to avoid the possibility of interruption of production due to the shortage of material. The following points need to be taken into consideration while fixing the minimum stock level.


  1. The time required for the fresh supply of material - the lead time.
  2. Rate of consumption of material during the lead time.
  3. Reorder level


The following formula can be used to determine the minimum stock level.

Minimum stock level = Reorder level - (Normal consumption x Normal reorder period)

Example:
Calculate the minimum stock level from the following data:
Net normal consumption = 500 units per day
Normal reorder period = 10 days
Reorder level = 8,000 units

Solution:
Minimum stock level = Reorder level - (Normal consumption x Normal reorder period)
= 8,000 - (500 x 10)
= 3,000 units


Maximum Stock Level

The maximum stock level is a quantity of material above which the stock of any item should not be allowed. To avoid blocking working capital and making undue investments in stock, the maximum stock level is to be fixed. It also helps to maintain the proper quality of raw materials. The following points must be taken into consideration while fixing the maximum stock level:


  1. Availability of storage space
  2. The cost of carrying the inventory
  3. The amount of working capital available
  4. Economic ordering quantity
  5. The possibility of change in market trend
  6. The normal rate of consumption of material during the reordering process.
  7. The time necessary for a fresh delivery of materials.
  8. The possibility of loss due to deterioration/evaporation, etc.
  9. Price fluctuation.
  10. Insurance costs if any.


The following formula is normally in use for calculating the Maximum stock level.

Maximum stock level = Reorder level + reorder quantity - (maximum consumption X minimum re-order period)

Example:
Find out the Maximum stock level from the following information:
Reorder Level = 32,000 units
Reorder quantity = 30,000 units
Minimum Consumption = 3,000 units per month
Minimum reorder period = 2 months.

Solution:
Maximum stock level = Reorder level + reorder quantity - (maximum consumption X minimum re-order period)

Maximum stock level = 32000 + 30000 - (3,000 x 2)
= 62000 - 6,000 = 56,000 units.

Danger Level

The danger level is a level below the minimum level. This is a level at which urgent action must be taken to procure new stock otherwise the stock may exhaust and could affect the production. This level is calculated by taking into account the time required to get the materials by the shortest possible means. Generally, the following formula is used to calculate the Danger level:

Danger level = average consumption x Maximum reorder period for an emergency purchase.


Average stock level

The average stock level can be determined by using the following formula:

Average Stock Level = 1/2 of (Maximum stock level + Minimum Stock level)

or

Average Stock Level = Minimum stock level + Half of the reordering quantity.

Reorder Quantity or Economical Order Quantity

It is better to determine in advance how much is to be purchased when the material reaches the reorder level. This quantity is called the reorder quantity. It is the quantity when it is received, it will not exceed the maximum stock level. It is also called Economic Order Quantity, because the purchase of this quantity of material is most economical as well. The frequent purchase will result in an increase in the cost of transportation. Too many goods may block the working capital for a long time. The following points need to be taken into consideration while fixing the reorder quantity.

  1. Cost of transportation.
  2. Cost of storage (warehouse rent, insurance, heating, and lighting expenses).
  3. Cost of ordering.
  4. The availability of working capital.
  5. Minimum and maximum consumption for the lead time.
  6. The time necessary to obtain deliveries.
  7. The possibility of loss due to evaporation or deterioration.
  8. Changes in the fashion trend.
  9. Interest on investment.
  10. Obsolescence losses.
  11. Store staff expenses.


This content is accurate and true to the best of the author’s knowledge and is not meant to substitute for formal and individualized advice from a qualified professional.

© 2011 Helna

Comments

situla situla on October 30, 2012:

this is the best information i waned .please continue with this . student at evelyn hone college ,zambia.

devender on October 16, 2012:

we can understand that we need minimun level for reorder level but for calculte for minimum level we also need reorder level

williamline30@yahoo.com on October 09, 2012:

contented

kmekh on October 01, 2012:

Very useful thanks. One problem : is it Minimum or Maximum Consumption taken to calculate Maximum stock level ?

Kamlesh K S on June 15, 2012:

This is very Important for those people who are going for material management.

venkatesan on June 08, 2012:

i am utilising this analysis my examination point of view.

very nice

teja on March 28, 2012:

very useful