ABC Classification / Analysis of Inventory

The ABC classification process is an analysis of a range of objects, such as finished products ,items lying in inventory or customers into three categories. It's a system of categorization, with similarities to Pareto analysis, and the method usually categorizes inventory into three classes with each class having a different management control associated :  A - outstandingly important; B - of average importance; C - relatively unimportant as a basis for a control scheme. Each category can and sometimes should be handled in a different way, with more attention being devoted to category A, less to B, and still less to C. Popularly known as the "80/20" rule ABC concept is applied to inventory management as a rule-of-thumb. It says that about 80% of the Rupee value, consumption wise, of an inventory remains in about 20% of the items. This rule , in general , applies well and is frequently used by inventory managers to put their efforts where greatest benefits , in terms of cost reduction as well as maintaining a  smooth availability of stock, are attained. The ABC concept is derived from the Pareto's 80/20 rule curve. It is also known as the 80-20 concept. Here, Rupee / Dollar value of each individual inventory item is calculated on annual consumption basis. Thus, applied in the context of inventory, it's a determination of the relative ratios between the number of items and the currency value of the items purchased / consumed on a repetitive basis : 10-20% of the items ('A' class) account for 70-80% of the consumption the next 15-25% ('B' class) account for 10-20% of the consumption and the balance 65-75% ('C' class) account for 5-10% of the consumption 'A' class items are closely monitored because of the value involved (70-80% !). High value (A), Low value (C) , intermediary value (B)   20% of the items account for 80% of total inventory consumption value (Qty consumed X unit rate) Specific items on which efforts can be concentrated profitably Provides a sound basis on which to allocate funds and time A,B & C , all have a purchasing / storage policy - "A", most critically reviewed , "B" little less while "C" still less with greater results. ABC Analysis is the basis for material management processes and helps define how stock is managed. It can form the basis of various activity including leading plans on alternative stocking arrangements (consignment stock), reorder calculations and can help determine at what intervals inventory checks are carried out (for example A class items may be required to be checked more frequently than c class stores Inventory Control Application: The ABC classification system is to grouping items according to annual issue value, (in terms of money), in an attempt to identify the small number of items that will account for most of the issue value and that are the most important ones to control for effective inventory management. The emphasis is on putting effort where it will have the most effect. All the items of inventories are put in three categories, as below : A Items : These Items are seen to be of high Rupee consumption volume. "A" items usually include 10-20% of all inventory items, and account for 50-60% of the total Rupee consumption volume. B Items : "B" items are those that are 30-40% of all inventory items, and account for 30-40% of the total Rupee consumption volume of the inventory. These are important, but not critical, and don't  pose sourcing difficulties. C Items : "C" items account for 40-50% of all inventory items, but only 5-10% of the total   Rupee consumption volume. Characteristically, these are standard, low-cost and readily available items. ABC classifications allow the inventory manager to assign priorities for inventory control. Strict control needs to be kept on A and B items, with preferably low safety stock level. Taking a lenient view, the C class items can be maintained with looser control and  with high safety stock level. The ABC concept puts emphasis on the fact  that every item of inventory is critical and has the potential of affecting ,adversely, production, or sales to a customer or operations. The categorization helps in better  control on A and B items. In addition to other management procedures, ABC classifications can be used to design cycle counting schemes. For example, A items may be counted 3 times per year, B items 1 to 2 times, and C items only once, or not at all Suggested policy guidelines for A , B & C classes of items A items (High cons. Val)        B items (Moderate cons.Val)          C item (Low cons. Val) Very strict cons. control     Moderate control Loose control No or very low safety stock Low safety stock High safety stock Phased delivery (Weekly) Once in three months Once in 6 months Weekly control report Monthly control report Quarterly report Maximum follow up Periodic follow up Exceptional As many sources as possible Two or more reliable Two reliable Accurate forecasts Estimates on past data Rough estimate Central purchasing /storage Combination purchasing Decentralised Max.efforts to control LT Moderate Min.clerical efforts To be handled by Sr.officers Middle level  Can be delegated

Cost Effective Inventory Management

Inventory management is very crucial for every manufacturing or merchandising company. We will use a case study of a business Dolphin Videos to understand the basic concepts of inventory management. In this post we will address the following key issues related to cost effective inventory management:
1. What are the different types of costs associated with Inventory Management?
2. How to determine the minimal purchase order quantity which should be ordered to minimize the cost of Inventory Management?
3. How to determine the optimal number of purchase orders per year to meet the annual demand?
4. How to forecast annual relevant total cost?
5. What inventory level should trigger a new purchase order?
6. How much safety stock should be carried to address unexpected increase in demand?
7. How an ERP like Microsoft Dynamics AX can help manage your inventory cost effectively?

1. Different Types of Inventory Costs:

There are 5 different types of costs associated with inventory:
1.1 Purchasing Costs:
Purchasing costs are the costs of goods acquired from suppliers including incoming freight or transportation costs. These costs usually make up the largest single cost category of goods for sale. Discounts for different purchase order sizes and supplier credit terms affect purchasing costs.
1.2 Ordering Costs:
Ordering costs are the costs of preparing, issuing, and paying purchase orders, plus receiving and inspecting the items included in the orders. Purchase approval and special processing costs are related to the number of purchase orders processed.
1.3 Carrying Costs:
Carrying costs arise when an organization holds an inventory of goods for sale. These costs include the opportunity cost of the investment tied up in inventory and the costs associated with storage such as space rental, insurance, obsolescence, and spoilage.
1.4 Stockout Costs:
A stockout cost occurs when an organization runs out of a particular item for which there is a customer demand. Expediting costs of a stockout include:

• Additional ordering costs
• Associated transportation costs

Opportunity cost of a stockout includes:

• Lost contribution margin to be earned on the sale
• Any contribution margin lost on future sales
• Customer loses confidence for the company

1.5 Quality Costs:
Quality costs of a product or service is its lack of conformance with a predetermined standard or benchmark. Following are the four categories of quality costs:

• Prevention costs
• Appraisal costs
• Internal failure costs
• External failure costs

2. Minimal Purchase Order Quantity

We use Economic-Order-Quantity (EOQ) decision model to determine the minimal purchase order quantity to ensure cost effectiveness. The simplest version of this model considers only ordering cost and carrying cost in calculations.
Consider for example, Dolphin Videos sells packages of blank video tapes:

• Purchases the inventory (blank video tapes) from Acme Videos at $15/package
• Annual demand is 12,844 packages, at the rate of 247 packages per week
• Dolphin Videos requires a 15% annual return on investment
• Purchase-order lead time is 2 weeks
• Relevant ordering cost per purchase order is $209
• Relevant carrying cost per package per year is $5.50

Formula is:

Where,

• D is annual demand in units (12, 844 units)
• P is Relevant ordering cost per purchase order ($209)
• C is Relevant carrying cost per unit ($5.50)

 88 packages. This means Dolphin Videos should purchase 988 packages per order to minimize total ordering cost and carrying cost.

3. Optimal Number of Purchase Orders Per Year

We can find optimal number of purchase orders per year by dividing annual demand by EOQ:
D/EOQ = 12,844/988 = 13 purchase orders annually.

4. Forecasting annual relevant total cost

Annual relevant total cost (RTC) is calculated as follows:
RTC = DP/Q + QC/2 = $5,434

5. Reorder Point

To determine the inventory level which should trigger a new purchase order can be calculated as:
Reorder point = Number of units sold per unit of time X Purchase order lead time
Reorder point = (247 packages) X (2 weeks) = 494 packages
This means Dolphin Videos should order 988 packages of video tapes each time its inventory stock falls to 494 packages.

6. Safety Stock

Safety stock is inventory held at all times regardless of the quantity of inventory ordered using the EOQ model. Safety stock is used as a buffer against unexpected increases in demand or lead time and unavailability of stock from suppliers.

• Dolphin Videos’ expected annual demand per week is 247 packages
• Management feels that a maximum demand of 350 packages per week may occur
• Excess demand per week is Maximum demand (350) – Expected demand (247) = 103 packages per week

Safety stock = Excess demand (103) X Purchase order lead time (2 weeks) = 206 packages of safety stock.

EOQ - Expalined

The Economic Order Quantity (EOQ) is the number of units that a company should add to inventory with each order to minimize the total costs of inventory—such as holding costs, order costs, and shortage costs. The EOQ is used as part of a continuous review inventory system in which the level of inventory is monitored at all times and a fixed quantity is ordered each time the inventory level reaches a specific reorder point. The EOQ provides a model for calculating the appropriate reorder point and the optimal reorder quantity to ensure the instantaneous replenishment of inventory with no shortages. It can be a valuable tool for small business owners who need to make decisions about how much inventory to keep on hand, how many items to order each time, and how often to reorder to incur the lowest possible costs.

The EOQ model assumes that demand is constant, and that inventory is depleted at a fixed rate until it reaches zero. At that point, a specific number of items arrive to return the inventory to its beginning level. Since the model assumes instantaneous replenishment, there are no inventory shortages or associated costs. Therefore, the cost of inventory under the EOQ model involves a tradeoff between inventory holding costs (the cost of storage, as well as the cost of tying up capital in inventory rather than investing it or using it for other purposes) and order costs (any fees associated with placing orders, such as delivery charges). Ordering a large amount at one time will increase a small business's holding costs, while making more frequent orders of fewer items will reduce holding costs but increase order costs. The EOQ model finds the quantity that minimizes the sum of these costs.

The basic EOQ relationship is shown below. Let us look at it assuming we have a painter using 3,500 gallons of paint per year, paying $5 a gallon, a $15 fixed charge every time he/she orders, and an inventory cost per gallon held averaging $3 per gallon per year.

The relationship is TC = PD + HQ/2 + SD/Q '� where

• TC is the total annual inventory cost—to be calculated.
• P is the price per unit paid—assume $5 per unit.
• D is the total number of units purchased in a year—assume 3,500 units.
• H is the holding cost per unit per year—assume $3 per unit per annum.
• Q is the quantity ordered each time an order is placed—initially assume 350 gallons per order.
• S is the fixed cost of each order—assume $15 per order.

Calculating TC with these values, we get a total inventory cost of $18,175 for the year. Notice that the main variable in this equation is the quantity ordered, Q. The painter might decide to purchase a smaller quantity. If he or she does so, more orders will mean more fixed order expenses (represented by S) because more orders are handles—but lower holding charges (represented by H): less room will be required to hold the paint and less money tied up in the paint. Assuming the painter buys 200 gallons at a time instead of 350, the TC will drop to $18,063 a year for a savings of $112 a year. Encouraged by this, the painter lowers his/her purchases to 150 at a time. But now the results are unfavorable. Total costs are now $18,075. Where is the optimal purchase quantity to be found.
The EOQ formula produces the answer. The ideal order quantity comes about when the two parts of the main relationship (shown above)—"HQ/2" and the "SD/Q"—are equal. We can calculate the order quantity as follows: Multiply total units by the fixed ordering costs (3,500 × $15) and get 52,500; multiply that number by 2 and get 105,000. Divide that number by the holding cost ($3) and get 35,000. Take the square root of that and get 187. That number is then Q.
In the next step, HQ/2 translates to 281, and SD/Q also comes to 281. Using 187 for Q in the main relationship, we get a total annual inventory cost of $18,061, the lowest cost possible with the unit and pricing factors shown in the example above.

Thus EOQ is defined by the formula: EOQ = square root of 2DS/H. The number we get, 187 in this case, divided into 3,500 units, suggests that the painter should purchase paint 19 times in the year, buying 187 gallons at a time.

The EOQ will sometimes change as a result of quantity discounts offered by some suppliers as an incentive to customers who place larger orders. For example, a certain supplier may charge $20 per unit on orders of less than 100 units and only $18 per unit on orders over 100 units. To determine whether it makes sense to take advantage of a quantity discount when reordering inventory, a small business owner must compute the EOQ using the formula (Q = the square root of 2DS/H), compute the total cost of inventory for the EOQ and for all price break points above it, and then select the order quantity that provides the minimum total cost.

For example, say that the painter can order 200 gallons or more for $4.75 per gallon, with all other factors in the computation remaining the same. He must compare the total costs of taking this approach to the total costs under the EOQ. Using the total cost formula outlined above, the painter would find TC = PD + HQ/2 + SD/Q = (5 × 3,500) + (3 × 187)/2 + (15 × 3,500)/187 = $18,061 for the EOQ. Ordering the higher quantity and receiving the price discount would yield a total cost of (4.75 × 3,500) + (3 × 200)/2 + (15 × 3,500)/200 = $17,187. In other words, the painter can save $875 per year by taking advantage of the price break and making 17.5 orders per year of 200 units each.
EOQ calculations are rarely as simple as this example shows. Here the intent is to explain the main principle of the formula. The small business with a large and frequently turning inventory may be well served by looking around for inventory software which applies the EOQ concept more complexly to real-world situations to help purchasing decisions more dynamically.

Economic Order Quantity (EOQ)

Economic order quantity (EOQ) is the order quantity of inventory that minimizes the total cost of inventory management.

Two most important categories of inventory costs are ordering costs and carrying costs. Ordering costs are costs that are incurred on obtaining additional inventories. They include costs incurred on communicating the order, transportation cost, etc. Carrying costs represent the costs incurred on holding inventory in hand. They include the opportunity cost of money held up in inventories, storage costs, spoilage costs, etc.

Ordering costs and carrying costs are quite opposite to each other. If we need to minimize carrying costs we have to place small order which increases the ordering costs. If we want minimize our ordering costs we have to place few orders in a year and this requires placing large orders which in turn increases the total carrying costs for the period.

We need to minimize the total inventory costs and EOQ model helps us just do that.

Total inventory costs = Ordering costs + Holding costs

By taking the first derivative of the function we find the following equation for minimum cost

EOQ = SQRT(2 × Quantity × Cost Per Order / Carrying Cost Per Order)

Example

ABC Ltd. is engaged in sale of footballs. Its cost per order is $400 and its carrying cost unit is $10 per unit per annum. The company has a demand for 20,000 units per year. Calculate the order size, total orders required during a year, total carrying cost and total ordering cost for the year.

Solution

EOQ = SQRT(2 × 20,000 × 400/10) = 1,265 units

Annual demand is 20,000 units so the company will have to place 16 orders (= annual demand of 20,000 divided by order size of 1,265). Total ordering cost is hence $64,000 ($400 multiplied by 16).

Average inventory held is 632.5 ((0+1,265)/2) which means total carrying costs of $6,325 (i.e. 632.5 × $10)

Inventory Control Records

Inventory Control Records

Inventory control records are essential to making buy-and- sell decisions. Some companies control their stock by taking physical inventories at regular intervals, monthly or quarterly. Others use a dollar inventory record that gives a rough idea of what the inventory may be from day to day in terms of dollars. If your stock is made up of thousands of items, as it is for a convenience type store, dollar control may be more practical than physical control. However, even with this method, an inventory count must be taken periodically to verify the levels of inventory by item.

Perpetual inventory control records are most practical for big- ticket items. With such items it is quite suitable to hand count the starting inventory, maintain a card for each item or group of items, and reduce the item count each time a unit is sold or transferred out of inventory. Periodic physical counts are taken to verify the accuracy of the inventory card.

Out-of-stock sheets, sometimes called want sheets, notify the buyer that it is time to reorder an item. Experience with the rate of turnover of an item will help indicate the level of inventory at which the unit should be reordered to make sure that the new merchandise arrives before the stock is totally exhausted.

Open- to-buy records help to prevent ordering more than is needed to meet demand or to stay within a budget. These records adjust your order rate to the sales rate. They provide a running account of the dollar amount that may be bought without departing significantly from the pre- established inventory levels. An open-to-buy record is related to the inventory budget. It is the difference between what has been budgeted and what has been spent. Each time a sale is made, open-to-buy is increased (inventory is reduced). Each time merchandise is purchased; open-to-buy is reduced (inventory is increased). The net effect is to help maintain a balance among product lies within the business, and to keep the business from getting overloaded in one particular area.

Purchase order files keep track of what has been ordered and the status or expected receipt date of materials. It is convenient to maintain these files by using a copy of each purchase order that is written. Notations can be added or merchandise needs updated directly on the copy of the purchase order with respect to changes in price or delivery dates.

Supplier files are valuable references on suppliers and can be very helpful in negotiating price, delivery and terms. Extra copies of purchase orders can be used to create these files, organized alphabetically by supplier, and can provide a fast way to determine how much business is done with each vendor. Purchase order copies also serve to document ordering habits and procedures and so may be used to help reveal and/or resolve future potential problems.

Returned goods files provide a continuous record of merchandise that has been returned to suppliers. They should indicate amounts, dates and reasons for the returns. This information is useful in controlling debits, credits and quality Issues.

Price books, maintained in alphabetical order according to supplier, provide a record of purchase prices, selling prices, markdowns, and markups. It is important to keep this record completely up to date in order to be able to access the latest price and profit information on materials purchased for resale.