System
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system1.docxThe ABC Classification System
The ABC system is a method for classifying inventory according to several criteria, including its dollar value to the firm. Typically, thousands of independent demand items are held in inventory by a company, especially in manufacturing, but a small percentage is of such a high dollar value to warrant close inventory control. In general, about 5 to 15% of all inventory items account for 70 to 80% of the total dollar value of inventory. These are classified as A, or Class A, items. B items represent approximately 30% of total inventory units but only about 15% of total inventory dollar value. C items generally account for 50 to 60% of all inventory units but represent only 5 to 10% of total dollar value. For example, a discount store such as Walmart normally stocks a relatively small number of televisions, a somewhat larger number of bicycles or sets of sheets, and hundreds of boxes of soap powder, bottles of shampoo, and AA batteries. Figure 13.1 shows the approximate ABC classes.
Figure 13.1 ABC Classifications
ABC system role ="glossary"
an inventory classification system in which a small percentage of (A) items account for most of the inventory value.
In ABC analysis each class of inventory requires different levels of inventory monitoring and control—the higher the value of the inventory, the tighter the control. Class A items should experience tight inventory control; B and C require more relaxed (perhaps minimal) attention. However, the original rationale for ABC analysis was that continuous inventory monitoring was expensive and not justified for many items. The wide use of bar code scanners may have eroded that reasoning. At least for larger companies, bar codes have made continuous monitoring cheap enough to use for all item classes.
Along the Supply Chain: Inventory Management at Dell
Dell Inc., has annual revenues of approximately $58 billion and over 75,000 employees around the world. Dell’s business model bypasses retailers, and it sells directly to customers via phone or the Internet. This eliminates one major stage in its supply chain and the associated delays and costs. In Dell’s supply chain, once a customer places an order (by phone or via the Internet) a credit check is made and the technical feasibility of the computer configuration is checked, a process that takes two or three days. After an order is processed through these initial steps, it is sent to one of its assembly plants in Austin, Texas, where the product is built, tested, and packaged within eight hours. Dell carries very little components inventory itself. Technology changes occur so fast that holding inventory can be a huge liability; some components lose 0.5–2% of their value per week. In addition, many of Dell’s suppliers are located in Southeast Asia and their shipping times to Austin range from seven days for air transport to 30 days for water and ground transport. To compensate for these factors Dell’s suppliers keep inventory in small warehouses called “revolvers” (for revolving inventory), which are few miles from Dell’s assembly plants. Dell keeps very little inventory at its own plants so it withdraws inventory from the revolvers every few hours while most of Dell’s suppliers deliver to their revolvers three times per week. However, the cost of carrying inventory by Dell’s suppliers is ultimately charged to Dell as part of the component price, and is thus reflected in the final price of a computer. In order to maintain a competitive price advantage in the market Dell strives to help its suppliers keep inventory low and reduce inventory costs. Dell has a vendor managed inventory (VMI) arrangement with its suppliers. In this VMI system the suppliers decide how much to order and when to send their orders to the revolvers. Dell’s suppliers order in batches (to offset ordering costs) using a continuous ordering system with a batch order size, Q, and a reorder point, R, where R is the sum of the inventory on order and a safety stock. The order size estimate, based on long-term data and forecasts, is held constant. Dell sets target inventory levels for its suppliers—typically 10 days of inventory—and keeps track of how much suppliers deviate from these targets and reports this information back to suppliers so that they can make adjustment accordingly.
Why do you think Dell holds the order size Q, constant in its continuous order system?
Source: R. Kapuscinski, R. Zhang, P. Carbonneau, R. Moore, and B. Reeves, “Inventory Decisions in Dell’s Supply Chain,”Interfaces 34 (3; May–June 2004), pp. 191–205.
The first step in ABC analysis is to classify all inventory items as either A, B, or C. Each item is assigned a dollar value, which is computed by multiplying the dollar cost of one unit by the annual demand for that item. All items are then ranked according to their annual dollar value, with, for example, the top 10% classified as A items, the next 30% as B items, and the last 60% as C items. These classifications will not be exact, but they have been found to be close to the actual occurrence in firms with remarkable frequency.
A items require close inventory control because of their high value; B and C items less control
The next step is to determine the level of inventory control for each classification. Class A items require tight inventory control because they represent such a large percentage of the total dollar value of inventory. These inventory levels should be as low as possible, and safety stocks minimized. This requires accurate demand forecasts and detailed record keeping. The appropriate inventory control system and inventory modeling procedure to determine order quantity should be applied. In addition, close attention should be given to purchasing policies and procedures if the inventory items are acquired from outside the firm. B and C items require less stringent inventory control. Since carrying costs are usually lower for C items, higher inventory levels can sometimes be maintained with larger safety stocks. It may not be necessary to control C items beyond simple observation. In general, A items frequently require a continuous control system, where the inventory level is continuously monitored; a periodic review system with less monitoring will suffice for C items.
A items require close inventory control because of their high value; B and C items less control.
Although cost is the predominant reason for inventory classification, other factors such as scarcity of parts or difficulty of supply may also be reasons for giving items a higher priority. For example, long lead times for some parts might be a problem for a company in Australia ordering from Europe, thus requiring a higher-priority classification for those parts.
Example 13.1 ABC System
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Q: |
The maintenance department for a small manufacturing firm has responsibility for maintaining an inventory of spare parts for the machinery it services. The parts inventory, unit cost, and annual usage are as follows:
The department manager wants to classify the inventory parts according to the ABC system to determine which stocks of parts should most closely be monitored. |
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Solution |
First rank the items according to their total value and also compute each item’s percentage of total value and quantity.
Based on simple observation, it appears that the first three items form a group with the highest value, the next three items form a second group, and the last four items constitute a group. Thus, the ABC classification for these items is as follows:
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