Inventory – Dr. Vidya Hattangadi

What is ABC Analysis in Inventory Management?

Dr Vidya Hattangadi — Mon, 27 Jun 2022 00:01:25 +0000

The word inventory in management science refers to the process of counting or listing items. As an accounting term, inventory gets listed in current assets and refers to all stock in the different production stages such as raw materials, work-In-process (WIP), finished goods, and maintenance, repair, and overhaul (MRO). Inventory management is one of the vital management processes. A good inventory management system prevents product and production shortages. It also prevents excess stock and stacking of additional raw materials.

ABC analysis (Always Best Control) is an inventory management method that helps to regulate the value of inventory items based on their importance in the business. ABC ranks items based on demand, cost, and risk data which inventory managers cluster into classes based on those criteria. This helps the organization to understand which products or services are most critical for them. ABC Analysis allows easy inventory analysis on any device.

Amazon does not stock every single item offered on its site. It stocks only those items that are popular and frequently purchased. If an ‘unpopular’ item is ordered, Amazon would then request it from its distributor who then ships it to the company. The item would then be unpacked and shipped to the respective customer.

The most important stock-keeping units (SKUs) are created on the basis of either sales volume or profitability, they are “A” category items, the next-most important are “B” category and the least important are “C” category. Some companies may choose a classification system that breaks products into more than just those three groups.

ABC analysis in cost accounting or activity-based costing is loosely related but different from ABC analysis for inventory management. Accountants use activity-based costing in manufacturing to assign indirect or overhead costs like utilities or salaries to products and services. Classifying inventory with ABC analysis helps organizations to optimize operations, and make clear decisions.

ABC Analysis is based on Pareto’s 80/20 rule

80/20 is a maxim that says that 80% of outputs result from 20% of all inputs for any given event. In business, a goal of the 80-20 rule is to identify inputs that are potentially the most productive and make them the priority. The rule signifies that 20% of goods deliver about 80% of the value therefore about 20% of a company’s inventory accounts for 80% of its value. Therefore, most businesses have a small number of ‘A’ items as compared to a larger group of B products and a big group of C goods. C category occupies the majority of items. ‘A’ items are annually consumed highest value. They are the highest priority items that cannot be afforded to be out of stock. ‘B’ items in inventory are required regularly but not as much as compared A items. Often B Items inventory costs more to hold than A items. C items occupy the rest of the inventory which has the lowest inventory value and make up the bulk of the inventory cost.

Toyota believes in making only what is needed when it is needed, and in the amount needed. This way, the company eliminates waste, inconsistencies, and unreasonable requirements, resulting in improved productivity. In fact, Toyota functions a bit like a supermarket. They make sure to stock the items that customers want when they want them, but, at a quantity that helps them optimize cost savings.

Inventory categorization is essential with physical products because it protects the profit margins and prevents write-offs and losses for damaged inventory. It is also the first step in reducing outdated inventory which is calculated and considered for supply chain optimization, increasing prices, and forecasting demand.

How Is ABC Inventory Analysis Calculated?

ABC analysis is calculated by multiplying the annual sales of a certain item by its cost. The results tell which goods are high priorities and which yield a low profit this helps organizations to organize investment on inventory and focus on human and capital resources.

Platforms for the usage of ABC inventory analysis: Organizations use Microsoft Excel to do a basic ABC inventory analysis by listing each product or resource in descending order according to its product usage value; this helps the organization to calculate the total of each item in the cumulative amount. Determining the values for the A, B, and C categories helps in assigning group names to each item. The goods with the highest value get the closest attention.

Using ABC analysis for inventory helps better control working capital costs. The information gained from the analysis reduces outdated inventory and this can boost the inventory turnover rate, or how often a business needs to replace items after selling through them. Almost every type of business can benefit from ABC analysis. Companies worldwide use the method to improve processes and increase profitability.

ABC Analysis Benefits

There is a long list of benefits of applying ABC analysis to inventory management:

Better optimization of warehouse: The analysis identifies the products that are in demand. A company can then use its limited warehouse space to adequately stock those goods and maintain lower stock levels for B or C items. By carrying the correct proportion of stock based on A, B, or C classes, you can reduce the inventory carrying costs that come with holding excess inventory.
Enhanced Inventory Forecasting: Monitoring and collecting data about products that have high customer demand can increase the accuracy of sales forecasting. Executives can use this information to set inventory levels and prices to increase overall revenue for the company.
Improved product pricing: A surge in sales for a specific item implies increased demand and a price increase for those products may be sensible which improves profitability.
Helps in negotiations with suppliers: Since companies earn 70% to 80% of their revenue on ‘A’ items, it makes sense to negotiate better terms with suppliers for those items. If the supplier doesn’t agree to lower the prices, organizations can negotiate post-purchase services, free shipping, or other benefits for cost savings.
Planned resource allocation: ABC analysis is a way to continuously evaluate resource allocation to ensure that ‘A’ category items align with customer demand. When demand lowers, re-classify the item into ‘B’ or ‘C’ can help in making space for the new Class A products.
Better customer service: Service levels depend on many factors, like quantity sold, item cost, and profit margins. Once the most profitable items are determined it helps offer better service levels for those items.
Better product life cycle management: ABC Analysis helps in understanding the stages of the product life cycle (launch, growth, maturity, or decline) which are critical for forecasting demand and stocking inventory levels suitably.
Maintaining and regulating high-cost Items: Category ‘A’ inventory needs to be observed closely and is important to a company’s success. Prioritizing and monitoring demand is important for maintaining suitable stock levels so that enough key products are always at hand.
Streamlined supply chain management: Use of ABC analysis of inventory helps in determining and consolidating the selection of suppliers or shifting to a single source to reduce carrying costs and simplify operations. ABC ranks items on-demand, cost, and risk data, and inventory managers group items into classes based on those criteria.

Apple, the consumer electronics giant keeps as little inventory on hand as possible. By lowering the amount of stock on hand, Apple carries a lower risk of overstocking and chalking up dead stock in its warehouses. As explained by Tim Cook, CEO of Apple, “Inventory is fundamentally evil” You kind of want to manage it like you’re in the dairy business. If it gets past its freshness date, you have a problem.”

Why is inventory management important?

Dr Vidya Hattangadi — Sun, 20 Nov 2016 17:03:53 +0000

Inventory appears in current asset in an organization’s balance sheet. It is a major activity of any business operation. For manufacturers, inventory includes raw materials, work in progress and finished goods. For resellers, it includes products acquired by him to resell to customers. Inventory management consists of the function of defining the size of inventory establishing procedure of effective inventory handling, maintaining control on inventory making efforts to reduce costs related to inventory. Every organization needs inventory for smooth running of its activities. The basic difference between a merchandising company and a manufacturing company is that a manufacturer creates products and a merchandiser sells them. Merchandisers include both wholesalers and retailers.

Good management of inventory usually ensures availability of materials in sufficient quantity as and when required and also helps to minimize investment in inventories. The efficiency of a firm to earn profits depends to a great extent on its ability to manage working capital because part of working capital is invested in the inventory. It involves many types of costs associated with it such as purchase cost, ordering cost, carrying cost, storage cost, service cost, risk cost, warehouse cost, pilferage cost, obsolescence cost etc. It is the only item of current assets which has direct influence on the prices and income of a firm.

To curtail losses in inventory, HUL implements risk mitigation strategies such as shorter response and planning cycles to deal with the high volatility in business operations related to input costs, demand trends, commodity prices, inflation and interest rates. HUL has rolled out a new go-to-market distribution model. This model reduces complexity at the front-end and enables efficiencies across one extended supply chain and consequently considerable reduction in cost. HUL is pumping in higher investments in advertising and promoting smaller brands, such as Rexona, Breeze or Hamam in soaps. It also dropped prices of brands like Wheel or Surf and restored rummage or product quantity across brands, such as Wheel and Lux, to take on the growing competition from more price competitive national and regional brands.

Generates Revenue: For any firm, inventory is the driving force because it has the ability to generate revenue and profits. Revenue is the money the firm receives at the time it sells inventory. Profit equals the final income after subtracting variable costs. This means the ability to get inventory at the lowest cost possible and sell it at the highest price is key to a successful, profitable operation.

If a firm orders too much inventory, it pays more money for employees to organize it and manage it. It also spends more for storage and handling expenses to hold it. It also holds risk on wastage on expired or pilferage of items. Simultaneously, having too little inventory can lead to stock-outs, which is bad for customer service.

Turnover: Turning over inventory efficiently is very important for firms. Calculating the inventory turnover ratio helps the firm to see how efficiently it sells through its inventory. The formula is costs of goods sold divided by average inventory level for a given period. A high turnover rate means the firm gets products off the shelf while they have maximum value to customers. Which also makes room for newer merchandise of products in demand. A lower turnover ratio leads to higher management costs and more waste. It also forces the firm to have more sales promotions to clear out excess products.

Just-in-Time: A common approach to inventory management in the latter 20th and early 21st centuries is just-in-time or JIT inventory. This is a technology-driven method which helps in keeping the inventory at ideal levels where a firm checks whether it has enough stock on hand to cover customer demand, but not too much to lead to high costs. Firms need to have strong relationship with key suppliers to integrate their inventory data through shared software databases. One of the key factor of JIT is that it allows automated ordering so that suppliers can quickly supply new material as needed by the firm. Most of the organizations have raw material inventory warehouses attached to the production facilities where raw materials, consumables and packing materials are stored and issued for production on JIT basis. The reasons for holding inventories can vary from case to case basis.

Good inventory management is advantageous in terms of price management: If a price rise is expected few months down the line due to changes in demand and supply in the national or international market, impact of taxes and budgets forces the firm’s pricing. Therefore, buying materials in advance and holding stocks helps firms as hedging against increased costs. Smart companies resort to buying in bulk and holding raw material inventories to take advantage of the quantity discounts offered by the supplier. In such cases the savings on account of the discount enjoyed would be substantially higher that of inventory carrying cost.

Safety stock reduces transit cost and transit times: In case of raw materials are being imported from a foreign country or from a far-off or distant vendor within the country, firms can save a lot in terms of transportation cost, buying in bulk and transporting as a container load or a full truck load. Part shipments often are costlier. In terms of transit time too, full container shipment or a full truck load is direct and faster unlike part shipment load where the freight forwarder waits for other loads to fill the container which can take several weeks. In terms of saving time due to shipping delays and transportation, which can further hamper the supply chain, holding safety stock of raw material inventories is always preferable.

ITC has invested in automated information technology (IT) systems and has lined up a number of initiatives in stock tracking and stock clearance more efficiently. With new businesses and diversification, ITC’s stock keeping units (SKUs) have increased by over 50 per cent in the last few years. To keep track of stocks, to bring down distribution costs and to ensure prompt stock clearance, the firm has invested substantially in IT and have lined up a number of new projects to ensure ease in operations. So far, all ITC products were bar coded at the retail level. But now, ITC has started bar-coding its products at the warehouse itself. This is expected to help ITC keep track of product manufacturing time, thereby enabling implementation of first-manufactured-first-out (FMFO) strategy, which means items manufactured first are shipped out of the factory and the warehouse earlier. This has been facilitated by the implementation of identification technologies and controlled batch management processes. The automation in IT systems helps ITC to keep track of date-of-manufacturing and details like weightage and the factory location that manufactured respective products. ITC has over 39 warehouses in India and uses close to 500-800 trucks per day for shipmen

Conclusion: Inventory management helps make a business more profitable by reducing the cost of goods sold and increasing the sales. It helps increase speed, accuracy, accountability and mobility in all the operations and processes within a business. Both small and large business can benefit from inventory management by boosting efficiency in the supply chain and reducing costs and waste.