• ABC analysis

ABC analysis
• In materials management, the ABC analysis is an inventory categorization
technique.

• The ABC analysis suggests that inventories of an organization are not of equal
value.

• Thus, the inventory is grouped into three categories (A, B, and C) in order of their
estimated importance.

• The ABC analysis provides

o a mechanism for identifying items that will have a significant impact on
overall inventory cost,
o a mechanism for identifying different categories of stock that will require
different management and controls.

• ABC analysis divides an inventory into three categories:

• "A items" with very tight control and accurate records,
• "B items" with less tightly controlled and good records, and
• "C items" with the simplest controls possible and minimal records.
 ABC analysis helps us in segregating the items from one another and tells us how
much valued the items are and controlling it to what extent is in the best interest of
the organisation.

• In ABC analysis, the entire lot of inventory is

classified into three groups based on their annual High A
value and not on their individual cost given as-
Annual
$ value B
A items- Represents high annual value items. of items
B items- Intermediate annual value items. C
C items- Low annual value items. Low
Low High
Percentage of Items

Annual value(a) is defined as: A= VQ,

Where, Q= annual consumption on quantity items
V= value (cost) per items.
CLASS A- high values items which accounts for major share of annual inventory value.
 Stricker control must obviously be applied on these items right from the initial
stages of estimating requirements, fixing the minimum stocks, and lead time.
 Rigorous value analysis.
 Rigid estimates.
 Strict and close watch.
 Items should be managed at the top level.
 Centralized purchasing and storage
CLASS B- medium value items, which do not belong to either of the classes and not
so strict control procedures needed to be followed in regard to the items in this
group.
• Moderate control.
• Purchase based on rigid requirements.
• Reasonably strict watch and control.
• Management be done at minimal level.

CLASS C- low values items, but are required in large quantities and consists of various
types and varieties like clips, washers.
It needs only a simple and inexpensive system of control in which some of the routine
may be existed.
• Ordinarily control measures.
• Purchased based on usage estimates.
• Controls exercise by store keeper.
• Management done at lower levels.
• Decentralized purchasing.
ABC Analysis is similar to the Pareto principle in that the 'A' items will typically
account for a large proportion of the overall value but a small percentage of the
number of items.

There are no fixed threshold for each class, different proportion can be applied
based on objective and criteria.

Examples of ABC class are

'A' items – 20% of the items accounts for 70% of the annual consumption
value of the items
'B' items – 30% of the items accounts for 25% of the annual consumption value
of the items
'C' items – 50% of the items accounts for 5% of the annual consumption value
of the items

Another recommended breakdown of ABC classes:

"A" approximately 10% of items or 66.6% of value
"B" approximately 20% of items or 23.3% of value
"C" approximately 70% of items or 10.1% of value
 Steps for the classification of items:

1. Find out the unit cost and the usage of each material over a given
period;

2. Multiply the unit cost by the estimated annual usage to obtain the net
value; annual consumption value = (Annual demand) x (item cost per
unit)

3. List out all the items and arrange them in the descending value (Annual
Value);

4. Accumulate value and add up number of items and calculate

percentage on total inventory in value and in number;

5. Draw a curve of percentage items and percentage value;

6. Mark off from the curve the rational limits of A, B and C categories.
The ABC analysis
Example 1

Percentage
Percentage
value of
of items
annual usage
Close day
Class A items About 20% About 80% to day
control
Regular
Class B items About 30% About 15%
review
Infrequent
Class C items About 50% About 5%
review
Step 1
Calculate the total spending per year

Item number Unit cost Annual demand Total cost per year
101 5 48,000 240,000
102 11 2,000 22,000
103 15 300 4,500
104 8 800 6,400
105 7 4,800 33,600
106 16 1,200 19,200
107 20 18,000 360,000
108 4 300 1,200
109 9 5,000 45,000
110 12 500 6,000
Total usage 737,900

Total cost per year: Unit cost * total cost per year
Step 2
Calculate the usage of item in total usage
Usage as a
Item Unit Annual Total cost
% of total
number cost demand per year
usage
101 5 48,000 240,000 32,5%
102 11 2,000 22,000 3%
103 15 300 4,500 0,6%
104 8 800 6,400 0,9%
105 7 4,800 33,600 4,6%
106 16 1,200 19,200 2,6%
107 20 18,000 360,000 48,8%
108 4 300 1,200 0,2%
109 9 5,000 45,000 6,1%
110 12 500 6,000 0,8%
Total usage 737,900 100%

Usage as a % of total usage = usage of item/total usage

 Step 3
Sort the items by usage
Item Cumulative Unit Annual Total cost per Usage as a % Cumulative % of
number % of items cost demand year of total usage total

107 10% 20 18,000 360,000 48,8% 48,8%

101 20% 5 48,000 240,000 32,5% 81,3%

109 30% 9 5,000 45,000 6,1% 87,4%

105 40% 7 4,800 33,600 4,6% 92%

102 50% 11 2,000 22,000 3,0% 94,9%

106 60% 16 1,200 19,200 2,6% 97,5%

104 70% 8 800 6,400 0,9% 98,4%

110 80% 12 500 6,000 0,8% 99,2%

103 90% 15 300 4,500 0,6% 99,8%

108 100% 4 300 1,200 0,2% 100%

Total usage 737,900 100%

 Step 4
Results of calculation

Percentage of Percentage
Cathegory Items Action
items usage (%)

Class A 107, 101 20% 81,6% Close control

109, 105, 102, Regular

Class B 40% 16,2%
106 review

104, 110, 103, Infrequent

Class C 40% 2,5%
108 review
ABC Worked Example

• Item Usage and Value

ABC Worked Example

• Annual Usage Values

ABC Worked Example

• Ascending Usage Values

ABC Worked Example

• ABC Chart Showing Classifications

Inventory management policies
Each item should receive a treatment corresponding to its class:
A-items should have
• tight inventory control,
• more secured storage areas
• better sales forecasts;
• reorders should be frequent, with weekly or even daily reorder;
• avoiding stock-outs on A-items is a priority.

Reordering C-items is made less frequently;

Procurement and Warehouse Applications
Review of stocking levels:
• “A” items will generally have greater impact on projected
investment and purchasing spend, and therefore should be
managed more aggressively in terms of minimum and maximum
inventory levels;
• the bottom of the “C” category is the best place to start when
performing a periodic obsolescence review.

Cycle counting:
• The higher the usage, the more activity an item is likely to have; to
ensure accurate record balances, higher priority items are cycle
counted more frequently;
o“A” items are counted once every quarter;
o“B” items once every 6 months; and
o“C” items once every 12 months.
ADVANTAGES
• Provides a mechanism for identifying items that will have a significant impact on
overall inventory cost.
• It helps in economizing ones effort to achieve greater results.
• It helps to segregating those items which ought to be given priority to maximize
results.
• Proper use of valuable time of store personnel.
• Simple formulas are involved.

LIMITATIONS
• When number of items run into several thousands, it is not convenient to compute
and carry out this analysis.
• More chances of deterioration in storage exist since class C are purchased in bulk
• Loose control on C may result in stockout.
• ABC focuses on money value and not on functional importance of such items,
resulting in shortages of critical items.
• ABC does not take into account variation of prices of items as time goes.
• ABC ignores market conditions, market availability , competitions, seasonal
variations etc.
VED ANALYSIS
V- Vital
E- Essential
D- Desirable
• In ABC analysis, annual consumption value; quantity of materials consumed and unit
cost plays a vital role.

• In addition to the market value of materials, there is sometimes a nuisance value to

the materials.

• The nuisance Value is the cost associated with materials due to their absence
(stockout cost). Some of the materials are important by their absence.

• In case they are not available, the whole production system may come to standstill
and involve high cost of loss of production.

• The investment in these materials may be small but for non – availability of the item
the costs or losses the company going to involve will be very high.

• These are critical items, which are required in adequate quantity.

• The materials may be classified depending upon their criticality that is on
functional basis.

• The degree of criticality can be stated as whether the material is vital to the
process of production, or essential to the process of production or desirable for
the process of production.

• This classification is known as VED analysis, V stands for vital, E stands for
essential and D stands for desirable items.

• VED ranking may be done on the basis of the shortage costs of materials, which
can be either quantified or qualitatively expressed.
Vital-
Items without which production comes to standstill: i.e. non- availability can not be
tolerated. The vital items are stocked in abundance , essential items and very strict
control.

Essential-
Items whose non- availability can be tolerated for 2-3 days, because similar or
alternative items are available. Essential items are stocked in medium amounts,
purchase is based on rigid requirements and reasonably strict watch.

Desirable-
Items whose non –availability can be tolerated for a long period. Desirable items
are stocked in small amounts and purchase is based on usage estimates.
COMBINATION OF MATRIX OF ABC & VED ANALYSIS

• We can combine both and classify the materials depending on both the
consumption value and the criticality; it will give us a fruitful result.
• This matrix is more relevant in hospitals.
• This can be done in nine ways
• The AV category becomes the most important for inventory control because the
items are very much cost consuming being ‘A’ category and also vital for uses.

• These items can be controlled by the top-level management.

• The CD category items are not very costly and at the same time of desirable
category.

• These items are controlled at the lower level.

By combining ABC and VED analysis, the medicines can be coupled into the
following group (Gupta, et al., 2007):
• Class I: AV+BV+CV+AE+AD
• Class II: BE+CE+BD
• Class III: CD

• Class I is the highest priority group, needing greatest attention.

o The management of class I medicines by top management would help in
keeping a check on the annual budget and their availability.

• Moderate attention should be devoted by middle level management for class II,
• Loose attention is devoted by lower level management for class III.
• The V class items by their extreme critical nature need to be held in large quantity
in the inventory. As stockout cost of these items are very high therefore the service
level for these items will be very high.
• The service levels for subsequent E and D class materials will be lower and lowest
respectively.
• Class D items are easily available in the market. They do not hold up production and
may be substituted well. Therefore, we can maintain very low inventory of these
items.

• The A class items incorporate a large turnover value in them and are very few in
numbers. They are always monitored and followed up with respect to their stock
level, their availability in market and available substitutes. Since they are directly
under vision of management they can be kept in small quantity in inventory.
• Class C items contribute very little to the annual consumption value and , therefore
even if they are kept in large quantity in inventory, it does not significantly add to
inventory related cost.
 ABC-VED MATRIX SHOWING SERVICE LEVEL

The service level of inventory, therefore, increases from D to V and from A to C.

This suggest that maximum service level will be for CV class items and lowest
service level will for AD class Items. Others fall in between.

Q. Why service level of inventory, increases from D to V and from A to C?

Q. Why maximum service level will be for CV class items and lowest service level will for
AD class Items in combined ABC-VED analysis?