Chapter Three
Inventory classification and stock taking
3.1 Introduction
Maintaining inventory through counting, placing orders, receiving stock, and so on takes
personnel time and costs money. When there are limits on these resources, the logical move is
to try to use the available resources to control inventory in the best way. In other words, focus
on the most important items in inventory. In the nineteenth century Villefredo Pareto, in a
study of the distribution of wealth in Milan, found that 20 percent of the people controlled 80
percent of the wealth. This logic of the few having the greatest importance and the many
having little importance has been broadened to include many situations and is termed the
Pareto principle. This is true in our everyday lives (most of our decisions are relatively
unimportant, but a few shape our future) and is certainly true in inventory systems (where a
few items account for the bulk of our investment).
Any inventory system must specify when an order is to be placed for an item and how many
units to order. Most inventory control situations involve so many items that it is not practical to
model and give thorough treatment to each item. To get around this problem, the ABC
inventory classification scheme divides inventory items into three groupings: high dollar
volume (A), moderate dollar volume (B), and low dollar volume (C). Dollar volume is a measure
of importance; an item low in cost but high in volume can be more important than a high-cost
item with low volume.
3.2 ABC Classification
The main objective of inventory control is to minimize the carrying costs of inventory. Very
often all kinds of inventory are not equally important. A small number of important items
account for the dominant part of total inventory investment while a large number of items
constitute so small a value that they have little effect on the results.
If the annual usage of items in inventory is listed according to dollar volume, generally, the list
shows that a small number of items account for a large dollar volume and that a large number
of items account for a small dollar volume. Figure A illustrates the relationship.
The ABC approach divides this list into three groupings by value: A items constitute roughly the
top 15 percent of the items, B items the next 35 percent, and C items the last 50 percent. From
observation, it appears that the list in Figure 1A can be meaningfully grouped with A including
20 percent (2 of the 10), B including 30 percent, and C including 50 percent. These points
show clear delineations between sections. The result of this segmentation is shown in Figure
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1B and plotted in Figure 1C. Segmentation may not always occur so neatly. The objective,
though, is to try to separate the important from the unimportant. Where the lines actually
break depends on the particular inventory under question and on how much personnel time is
available. (With more time, a firm could define larger A or B categories.)
The purpose of classifying items into groups is to establish the appropriate degree of control
over each item. On a periodic basis, for example, class A items may be more clearly controlled
with weekly ordering, B items may be ordered biweekly, and C items may be ordered monthly
or bimonthly. Note that the unit cost of items is not related to their classification. An A item
may have a high dollar volume through a combination of either low cost and high usage or
high cost and low usage. Similarly, C items may have a low dollar volume because of either low
demand or low cost. In an automobile service station, gasoline would be an A item with daily or
weekly replenishment; tires, batteries, oil, grease, and transmission fluid may be B items and
ordered every two to four weeks; and C items would consist of valve stems, windshield wiper
blades, radiator caps, hoses, fan belts, oil and gas additives, car wax, and so forth. C items may
be ordered every two or three months or even be allowed to run out before reordering because
the penalty for stock out is not serious.
Sometimes an item may be critical to a system if its absence creates a sizable loss. In this case,
regardless of the item’s classification, sufficiently large stocks should be kept on hand to
prevent run-out. One way to ensure closer control is to designate this item an A or a B, forcing
it into the category even if its dollar volume does not warrant such inclusion.
Figure 1 ABC classification.
A. Annual Usage of Inventory by Value
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Figure 2 ABC procedures.
3.2.1 Procedure for an ABC Inventory Analysis
The first step for an ABC inventory analysis is to determine the annual usage for each item. We
calculate the total annual dollar volume by multiplying the annual usage by the item cost. We
then rank items in descending order based on total dollar volume and calculate the total
inventory investment.
a) Calculate the annual dollar usage for each item.
b) List the items in descending order based on annual dollar usage.
c) Calculate the cumulative annual dollar volume.
d) Classify the items into groups.
Example. HU is considering doing an ABC analysis of its entire inventory but has decided to test
the technique on a small sample of 15 of its stock-keeping units. The annual usage and unit
cost for these items are shown in the table.
a) Calculate the annual dollar volume for each item.
b) List the items in descending order based on annual dollar usage.
c) Calculate the cumulative annual dollar volume.
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d) Group the items into classes.
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3.2.2 Inventory Control Using ABC Classification
After classifying inventory items into A, B, and C classes, we can determine the appropriate
level of inventory control. For our most important and expensive A items, we need very tight
control, highly accurate inventory records, and frequent or continuous review. A continuous
review system keeps track of an inventory item 24/7. It tracks every inventory transaction as it
occurs, whether it is more material going into inventory or material being withdrawn from the
stockroom. Consequently, the EOQ model
Figure 3 ABC classification of materials
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(To be discussed in chapter 5) is often used. B items need normal control, moderately accurate
inventory records, and a reasonable time period between reviews. For B items, a periodic
review system can be used. A periodic review system reviews the inventory level of the item at
regular intervals (daily, weekly, monthly) to determine whether a replenishment order is
needed. C items require the least amount of control. Possible options for C items are the two-
bin system or an infrequent periodic review system. A two-bin system splits an incoming
replenishment order into two separate bins. One bin is placed on the factory floor so workers
can take what they need. The other bin is kept in the storeroom. This second bin should have
enough items to cover normal demand during the replenishment lead time. Lead time is the
amount of time it takes from order placement until the ordered item is received. When the bin
on the floor is empty, workers go to the stockroom to request additional material. The bin in the
stockroom is released to the workers on the floor and a replenishment order is placed.
3.3 INVENTORY ACCURACY AND CYCLE COUNTING
Inventory records usually differ from the actual physical count; inventory accuracy refers to
how well the two agree. Companies such as Walmart understand the importance of inventory
accuracy and expend considerable effort ensuring it. The question is how much error is
acceptable? If the record shows a balance of 683 of part X and an actual count shows 652, is
this within reason? Suppose the actual count shows 750, an excess of 67 over the record; is this
any better? Every production system must have agreement, within some specified range,
between what the record says is in inventory and what actually is in inventory.
3.3.1 INVENTORY RECORD ACCURACY
For effective inventory use, the inventory records must accurately reflect the quantity of
materials available. Inaccurate inventory records can result in lost sales (finished good not
available at time of sale), disrupted operations (not enough of a component or raw material to
complete a job), poor customer service (late deliveries to customers), lower productivity
(additional setups to complete a job), poor material planning (the inventory records are critical
in determining MRP quantities), and excessive expediting (trying to obtain necessary items in
less than normal lead time).
There are many reasons why records and inventory may not agree. For example, an open
stockroom area allows items to be removed for both legitimate and unauthorized purposes. The
legitimate removal may have been done in a hurry and simply not recorded. Sometimes parts
are misplaced, turning up months later. Parts are often stored in several locations, but records
may be lost or the location recorded incorrectly. Sometimes stock replenishment orders are
recorded as received, when in fact they never were. Occasionally, a group of parts is recorded
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as removed from inventory, but the customer order is canceled and the parts are replaced in
inventory without canceling the record.
Inventory record errors occur because of unauthorized withdrawals of material, unsecured
stockrooms, inaccurate paperwork, and/or human errors. Since an accurate database is needed
to successfully use the information systems, it is important to detect errors in the inventory
records. Two methods are available for checking inventory record accuracy: periodically
counting all of the items (typically annually) and cyclically counting specified items (typically
daily).
To keep the production system flowing smoothly without parts shortages and efficiently
without excess balances, records must be accurate. How can a firm keep accurate, up-to-date
records? Using bar codes and RFID tags is important to minimizing errors caused by inputting
wrong numbers in the system. It is also important to keep the storeroom locked. If only
storeroom personnel have access, and one of their measures of performance for personnel
evaluation and merit increases is record accuracy, there is a strong motivation to comply. Every
location of inventory storage, whether in a locked storeroom or on the production floor, should
have a recordkeeping mechanism. A second way is to convey the importance of accurate
records to all personnel and depend on them to assist in this effort. (This all boils down to this:
Put a fence that goes all the way to the ceiling around the storage area so that workers cannot
climb over to get parts; put a lock on the gate and give one person the key. Nobody can pull
parts without having the transaction authorized and recorded.)
Another way to ensure accuracy is to count inventory frequently and match this against
records. Widely used methods are periodic and cycle counting.
[Link] Periodic counting satisfies auditors that the inventory records accurately reflect the
value of the inventory on hand. For material planners, the physical inventory is an opportunity
to correct errors. The four steps in taking a physical inventory are
a) Count the quantity of the item and record the count on a ticket attached to the item.
b) Verify by recounting.
c) After verification, collect the tickets.
d) Reconcile inventory records with actual counts. For major discrepancies, investigate
further. For minor discrepancies, adjust the inventory records.
Taking physical inventories does not always improve inventory record accuracy. In many cases,
companies close down manufacturing to take the physical inventory; the job is often rushed
and is typically done by employees not trained for checking inventory. In some cases, inventory
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record errors are increased rather than reduced. The other alternative method is cycle
counting.
[Link] Cycle counting is a physical inventory-taking technique in which inventory is counted
frequently rather than once or twice a year. The key to effective cycle counting and, therefore,
to accurate records lies in deciding which items are to be counted, when, and by whom.
Virtually all inventory systems these days are computerized. The computer can be programmed
to produce a cycle count notice in the following cases:
When the record shows a low or zero balance on hand. (It is easier to count fewer
items.)
When the record shows a positive balance but a backorder was written (indicating a
discrepancy).
After some specified level of activity.
To signal a review based on the importance of the item (as in the ABC system) such as in
the following table:
The easiest time for stock to be counted is when there is no activity in the stockroom or on the
production floor. This means on the weekends or during the second or third shift, when the
facility is less busy. If this is not possible, more careful logging and separation of items are
required to count inventory while production is going on and transactions are occurring.
The counting cycle depends on the available personnel. Some firms schedule regular stockroom
personnel to do the counting during lulls in the regular working day. Other companies hire
private firms that come in and count inventory. Still other firms use fulltime cycle counters
who do nothing but count inventory and resolve differences with the records. Although this
last method sounds expensive, many firms believe that it is actually less costly than the usual
hectic annual inventory count generally performed during the two- or three-week annual
vacation shutdown.
The advantages of cycle counting are
Timely detection and correction of errors
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Elimination of lost production time since the company does not need to shut down
operations.
The use of employees dedicated to cycle counting.
The question of how much error is tolerable between physical inventory and records has been
much debated. Some firms strive for 100 percent accuracy, whereas others accept 1, 2, or 3
percent error. The accuracy level often recommended by experts is ±0.2 percent for A items, ±1
percent for B items, and ±5 percent for C items. Regardless of the specific accuracy decided on,
the important point is that the level be dependable so that safety stocks may be provided as a
cushion. Accuracy is important for a smooth production process so that customer orders can be
processed as scheduled and not held up because of unavailable parts.
Exercises:
I. Alpha Products, Inc., is having a problem trying to control inventory. There is
insufficient time to devote to all its items equally. Here is a sample of some items
stocked, along with the annual usage of each item expressed in dollar volume.
Use ABC analysis to specify where each item from the list would be placed.
II. DAT, Inc. produces digital audiotapes to be used in the consumer audio division. DAT
lacks sufficient personnel in its inventory supply section to closely control each item
stocked, so it has asked you to determine an ABC classification. Here is a sample from
the inventory records:
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Develop an ABC classification for these 10 items.
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