FINANCIAL MANAGEMENT & COST ACCOUNTING

Module 7. Inventory management

Lesson 40
ECONOMIC ORDER QUANTITY MODEL AND ABC ANALYSIS

40.1 ABC Analysis

In 1906, Ville redo Pareto, in a study of "Distribution of Wealth” in, Milan Italy found that – only 20% of total population controlled 80% of total wealth. This principle of "Vital – few and Trivial many" has been known as Pareto's principle and has application in many situations in life. If we look at different of items in the inventory of a firm, we many find that there may be around 20,000 to 50,000 or more inventory items in a large scale manufacturing unit. All the 20,000 inventory items are not of the same importance. They have different prices and different annual consumption values.

Let as further assume that, the total inventory value of all these 20,000 items is Rs. 50 crores. Then we can understand that all the 20,000 items do not have the same contribution in the total inventory value of 50 crores. Out of 20,000 items, it is possible that only 2000 items contribute Rs. 30 crores in total inventory. (A class items, which are less in number but have more inventory value)(65.70%) Further, some 7000 items accounting for 12 crores of inventory value (20 – 25%) (B class items, which are moderate in number and have moderate contribution in total inventory value) (C Class items are those which are large in Number but have very less contribution in inventory value)

By such a classification, it is clear for the manager to devote these resources in A – Class and B – Class items (rather than wasting efforts in controlling low value C – class items)

40.2 Steps for Making ABC Analysis

1. Find the Monetary value of Annual usage of the item by the following formula:-

Annual Usage = (Annual Demand or Annual consumption of the item in quantity) x Prince per unit of the item

2. After calculating Annual usage for each item, arrange the items in the Descending order of their annual usage value.

3. From the above list, select a few TOP items (around 10 – 15% or total items) which account for around 65 – 70% of Total Annual Usage value. These items are called A– class items.

4. Similarly, select next few items, which are modulate in number (15-25% of total inventory items) and account for 25 – 35% of Total Annual Usage value. (AUV)

There is B – class items

Remaining large number of items which account for only 5 – 10% of annual usage values are classified as C – Class items.

Table40.1 Example of ABC Analysis

Item No.	Annual Demand (Units)	Price per unit (Rs.)	Annual Usage (Rs) Value (A.U.V.)
1	100	2500	25000
2	1000	2	2000
2	2	1500	3000
4	100000	1.00	100000
5	10	50	500
6	3750	8	30000
7	100	25	2500
8	50000	200	100000
9	10000	6.00	30000
10	1500	1	1500
11	300000	0.5	150000
12	10	400	4000
13	200	200	40000
14	350	10	3500
15	400	20	8000

The above table is then rearranged in the decreasing order of the Annual Usage Value of each item. From the Annual Usage Value column the first few items from the top of the column are selected and their total is determined. These items which are few in number but contribute almost 70 to 80% of the total inventory value are classified as A class items. Similarly the next items in table below A class items are the B class items, which are slightly more in number and have low inventory value. C Class items are those which are large in numbers and have only 5-10% contribution in the inventory value.

Item No.	Annual Demand (Units)	Price per unit (Rs.)	Annual Usage Value (A.U.V.) (Rs)	% of total	Cumulative %	Class
11	300000	0.5	150000	30.00%	30.00%	A ( 70%)
4	100000	1	100000	20.00%	50.00%
8	50000	200	100000	20.00%	70.00%
13	200	200	40000	8.00%	78.00%	B (26.6 %)
6	3750	8	30000	6.00%	84.00%
9	10000	6	30000	6.00%	90.00%
1	100	2500	25000	5.00%	95.00%
15	400	20	8000	1.60%	96.60%
12	10	400	4000	0.80%	97.40%	C (3.4%)
14	350	10	3500	0.70%	98.10%
2	2	1500	3000	0.60%	98.70%
7	100	25	2500	0.50%	99.20%
2	1000	2	2000	0.40%	99.60%
10	1500	1	1500	0.30%	99.90%
5	10	50	500	0.10%	100.00%
		Total	500000	100

40.3 HML Classification

In high medium and low (HML) classification all the inventory items are classified into these three groups High, Medium and Low on the basis of price per unit. The Management may decide regarding the meaning of H, M and L, for example they may decide that items having price per unit above 2,00,000 is H-Class, items with price per unit of 50,000 – 2,00,000 as M – Class and items whose price per unit is less than 50,000 as L – Class items. Generally such a classification is done at the department level.

40.4 VED (Vital, Essential, Desirable) Classification

Here inventory items are classified on the basis of the Importance of criticality of the item. Vital items are those items which are very critical from the organization’s point of view. Essential items are slightly less critical and of less importance for the organization. Desirable items are those items which do not have significant effect on the organization or its production or its business.

40.5 SDE (Scarce, Difficult and Easy to procure)

In SDE classification, all the imputing items are classified on the basis of availability of the items. Scare items, which are short in supply and are mostly imported, are classified as s – class items. Items which are generally available indigenously but are difficult to procure are called D – Class items. E – Class items are easy to obtain and are available in the local markets and have large number of suppliers.

40.6 FSN (Fast Moving, Slow Moving and Non – Moving Items)

In FSN analysis, the inventory items are classified as Fast moving items, slow moving items and non – moving items. The basis of classification can be "The time elapsed since the date of last issue of the material". (Or the number of issues during the period) FSN analysis helps in finding out the Non – moving items which should be disposed off at the earliest.