Chapter 5 - Business Arithmetic . ABC analysis
The inventory control technique known as ABC analysis builds on Pareto's Principle. In ABC analysis, a company reviews its inventory and sorts all SKUs into three categories, called "A" , "B" and "C" items. The typical breakdown might look like this: "A" inventory: 20 percent of SKUs, 80 percent of value. "B" inventory: 30 percent of SKUs, 15 percent of value. "C" inventory: 50 percent of SKUs, 5 percent of value. Pareto's Principle and ABC analysis for control
Whether or not you're familiar with the economic principle known as
Pareto's Principle
, you may have observed its effects. This principle holds that in a given system, a relative handful of "causes" will produce the majority of "effects." For example, one may find that 20 percent of customers are responsible for 80 percent of sales, or that 30 percent of the product lines result in 70 percent of returns. The principle is named for Vilfredo Pareto, an Italian economist who studied land ownership in
Italy in the early 1900‘s and found that roughly 20 percent of the population held title to about
80 percent of the land. Legend has it that he further developed the theory upon observing that 20 percent of the pea pods in his garden produced 80 percent of the peas. For this reason, Pareto's Principle is often referred to as the "80/20" rule.
2. INVENTORY- MEANING
The term inventory means the value or amount of
materials on hand. It includes raw material, semi-
finished goods, spare parts, finished goods.
Inventory is required directly or indirectly to make
a sale of the end- product and may also represent
different stages in the process of getting the final
product
3. INVENTORY CONTROL
Inventory Control system is expected to achieve
desirable behaviour of the inventory items
Inventory Control is the process by which
inventory is measured and regulated according to
predetermined norms such as economic order
quantity, lead time, reorder level etc.
Inventory control pertains primarily to the
administration of established policies, systems &
procedures in order to reduce the inventory cost.
4. OBJECTIVES OF INVENTORY CONTROL
To meet unforeseen future demand due to
variation in forecast figures and actual figures.
To average out demand fluctuations due to
seasonal or cyclic variations.
To meet the customer requirement timely,
effectively, efficiently, smoothly and
satisfactorily.
5. ITEMS THAT MAKE UP THE INVENTORY CONTROL
SYSTEM
Stock- Keeping Unit (SKU)-Unique code based on
colour, size, combination of alpha and
numeric.(Bar Codes)
Motley Crowd – Classified as Raw material, spare
parts , Semi-finished goods, finished goods.(One
monetary value in Accounting statement)
Space-Many bulky items with low value. High value
items with low space ( diamonds)
Lead time- variations due to standard or special
raw material, distance between source and user
point
6. ITEMS THAT MAKE UP THE INVENTORY CONTROL
SYSTEM
Standard vs made to order
Seasonsal supply
Demand not uniform or unpredicatable
Shelf life
Safety aspects – Special storage (hazardous
chemicals)
Obsolescence
8. IMPORTANT TERMS
Minimum Level – It is the minimum stock to be
maintained for smooth production.
Maximum Level – It is the level of stock, beyond
which a firm should not maintain the stock.
Reorder Level – The stock level at which an order
should be placed.
Reorder formula =
usage rate x lead time
Safety stock -Safety stock is the stock held by a
company in excess of its requirement for the lead
time. Companies hold safety stock to guard
against stock-out
9. TYPES OF INVENTORY COSTS
Ordering costs- includes paperwork for placing
order, receiving, inspection, warehouse handling
etc.)
Inventory carrying (holding) costs – includes cost
of money tied up i.e interest, space cost,
insurance etc.
11. ECONOMIC ORDER QUANTITY (EOQ)
EOQ is the technique of ordering materials
whenever stock reaches the reorder point.
Objective is to avoid no stock situation.
In this technique, the order quantity is larger than
a single period’s requirement so that ordering
costs & holding costs balance out.
12. ASSUMPTIONS OF EOQ
Demand for the product is constant
Lead time is constant
Price per unit is constant
Inventory carrying cost is based on average
inventory
Ordering costs are constant per order
13. BASIC FIXED ORDER QUANTITY MODEL (EOQ)
H
DS
EOQ
2
D = Demand
S = Cost of placing order/setup cost
H = Annual holding and storage cost
per unit of inventory
15. PARETO’S PRINCIPLE
Pareto's Principle
This principle holds that in a given system, a
relative handful of "causes" will produce the
majority of “effects.”
For example, one may find that 20 percent of
customers are responsible for 80 percent of sales,
Pareto's Principle is often referred to as the "80/20"
rule.
16. ABC (ALWAYS BETTER CONTROL )ANALYSIS
The inventory control technique known as ABC
analysis builds on Pareto's Principle.
In ABC analysis, a company reviews its inventory
and sorts all SKUs into three categories, called "A"
"B" and "C" items.
The typical breakdown might look like this:
"A" inventory: 20 percent of SKUs, 80 percent of
purchase/consumption value.
"B" inventory: 30 percent of SKUs, 15 percent of
purchase/consumption value.
"C" inventory:50 percent of SKUs, 5 percent of
purchase/consumption value.
17. ABC ANALYSIS
Items in "A" inventory are tightly controlled,
meaning
the company keeps close tabs on how much it has
in stock
pays close attention to current demand and
forecasts for future demand
carefully plans its ordering so that it neither runs
out nor winds up with too much excess inventory.
18. ABC ANALYSIS
Items in "B" inventory are also watched closely,
but the company reviews its ordering strategy
less often.
Since items in "C" inventory are the least
expensive, the company can order them in bulk
and exercise minimal controls; all that really
matters is that the company doesn't run out.
A - outstandingly important; B - of average
importance; C - relatively unimportant as a basis
for a control scheme
