[ABC & VED ANALYSIS]

METHODS OF INVENTORY CONTROL

2013
ROHITH K R
I Sem MTech Polymer Technology

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INTRODUCTION
Inventory is the stock of any item or resource used in an organization, including raw materials, component parts, work in process, supplies, and finished goods. Inventory is one of the most expensive assets of many organizations, representing as much as 50% of total invested capital. Because of the large portion of expenditures, the effective management of inventory is crucial to the performance of many organizations (including manufactures, wholesalers, retails, hospitals, universities, governments, etc). It can have serious implications for the finance, production, and marketing functions of any organization. Finance is influenced through liquidity and return on investment, production through efficiency and cost of operations, and marketing through sales and customer relations. Different types of organizations have different inventory requirements. Typical organizations such as hospitals, finance institutions, universities, and penal institutions, are organizations that provide the ultimate consumer with goods and services. Inventory is purchased in a salable form and is usable without further processing or conversion. The organizations that provide services to consumers experience only a supplies inventory problem Inventory is a necessary part of doing business and provided by most organizations in any sector of economy. Inventory exists because supply and demand are difficult to synchronize perfectly and it takes time to perform material-related operations. Inventory serves five purposes within the firm 1. It enables the firm to achieve economics of scale. 2. It balances supply and demand. 3. It enables specialization in manufacturing. 4. It provides protection from uncertainties in demand and order cycle. 5. It acts as a buffer between critical interfaces within the supply chain. Inventory can be a source of conflict among different managers in organization because different managers have different roles to play which involve the use of inventory. The conflicting roles of managers must not be

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allowed to impair the organization as a whole. To overcome this conflict, inventory management should be everybodys concern. The objective of inventory management is to have the appropriate amounts of materials in the right place, at the right time, and at low cost. Therefore, inventory decision problem can be solved by using economic criteria. One of the most important prerequisites is an understanding of the more relevant costs to inventory system. There are four types of inventory costs Item cost Item cost is the cost of buying or producing the individual inventory items. The item cost is usually expressed as a cost per unit multiplied by the quantity procured or produced. Ordering/ setup cost Ordering cost is associated with ordering a batch or a lot of items. It does not depend on the number of items ordered, but assigned to the entire batch, including transportation costs, receiving costs, and so on. When the item is produced within the firm, there are also costs associated with placing an order, called setup costs, including paperwork costs and the costs required to set up the production equipment for a run. Carrying/ holding costs This cost is associated with keeping items in inventory for a period of time. The carrying/ holding cost is typically charged as a percentage of dollar value per unit time. In practice, this cost typically range from 15% - 30% per year. The carrying/ holding cost consists of three components: Cost of capital This represents a cost of foregone opportunities for other investments, which is assigned to inventory as an opportunity cost. Cost of storage This cost includes variable space cost, insurance, and taxes.

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Costs of obsolescence, deterioration, and loss Obsolescence costs should be assigned to items that have a high risk of becoming obsolete. Perishable products should be charges with deterioration costs when the item deteriorates over time. The costs of loss include pilferage and breakage costs associated with holding items in inventory. Stock out cost Stock out cost reflects the economic consequences of running out of stock, including back ordered cost and loss sales. Organizations should ensure that they take specific actions to optimize the inventory level with the minimum total annual inventory cost and they implement the actions consistently. But, to determine which actions are the right ones for the organizations, they first carry out the detailed analysis of the inventory. The results of the analysis can be used as a basis for defining the appropriate inventory optimization measures. ABC analysis can be used as one of inventory analysis instrument. ABC analysis is a method for dividing on-hand inventory into three classifications based on annual dollar volume. ABC analysis is an inventory application of Pareto principle. The Pareto principle states that there are a critical few and trivial many. The idea is to establish inventory policies that focus resources on the few critical inventory parts and not the many trivial ones. It is not realistic to monitor inexpensive items with the same intensity as very expensive items. According to Pareto principle, inventory has been divided into the following categories Class A items may represent only about 10% of total inventory items, but they represent about 70% of the total money value. Class B items may represent about 20% of total inventory items, and they represent about 20% of the total money value. Class C items may represent about 10% of total inventory items, but they represent only about 10% of the total money value. Using the classification, each category should be handled in different way, with more attention being devoted to category A, less to B, and still less to C. In hospital inventory management, VED analysis has been commonly used together with ABC analysis. VED analysis is based on the criticality of an item. V is for vital items without which a hospital cant function, E for essential items without which a hospital can function but may affect the quality of the
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services, and D for desirable items, unavailability of which with not interfere with functioning. By combining ABC and VED analysis, the medicines can be coupled into the following group 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. 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, and the loose attention is devoted by lower level management for class III. After the inventory has been classified, the two fundamental questions posed to any inventory system are how many and when to order. There are 2 (two) inventory system can be used to answer the questions 1. Fixed order size system Fixed order interval system In fixed order size system, the same number of units (how many) is always ordered, and the time between orders (when) is not expected to vary. This system is also termed as Q-system, since the size of order (Q) is fixed for each replenishment. The stock level is reviewed with each transaction, and whenever the inventory position reaches a predetermined point, an order for a fixed number of units is placed. Thus, the defining parameters of the system are reorder point (B) and the size of the order (Q). The fixed order interval system or periodic inventory system, is based on a periodic rather than a continuous review of the inventory stock position. It is a time based inventory system in which orders are placed at equally interval, predetermined points in time, and the order quantity is dependent upon the usage between order review periods. This system is also termed as T-system, since the order interval is constant. A maximum

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inventory level for each item is developed, based on usage during lead time and order interval. After a fixed period of time has passed, the stock position of the item is determined. An order is placed to replenish the stock with the sufficient size to bring the present stock level up to the maximum inventory level. Therefore, the defining parameters of the system are fixed review period (T) and the maximum inventory level (E).

METHODS OF INVENTORY CONTROL

Important methods of inventory control include ABC analysis VED analysis Periodic revision of classification

ABC Analysis
The ABC analysis is a business term used to define an inventory categorization technique often used in materials management. It is also known as Selective Inventory Control. Policies based on ABC analysis:

A ITEMS: Very tight control and accurate records. B ITEMS: Less tightly controlled and good records. C ITEMS: Simplest controls possible and minimal records.

The ABC analysis provides a mechanism for identifying items that will have a significant impact on overall inventory cost, while also providing a mechanism for identifying different categories of stock that will require different management and controls. 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.

'A' items are very important for an organization. Because of the high value of these A items, frequent value analysis is required. In addition to that, an organization needs to choose an appropriate order pattern (e.g.Just-in-time) to avoid excess capacity.

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'B' items are important, but of course less important, than A items and more important than C items. Therefore B items are intergroup items. 'C' items are marginally important.

ABC analysis categories:

There are no fixed threshold for each class, different proportion can be applied based on objective and criteria. 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 number of items. Example 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: 1. "A" approximately 10% of items or 66.6% of value 2. "B" approximately 20% of items or 23.3% of value 3. "C" approximately 70% of items or 10.1% of value

Procedure for ABC analysis:

List all the materials used in the company. Work out their annual consumption value. Arrange all of the items in the descending order of their annual consumption value. Add all consumption costs and get the total annual inventory cost. Write the cumulative consumption value and find the percentage of this cumulated consumption value to total inventory value. Draw a line at 70% and 90%

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All the items which fall under 70% are A class items , items that falls between 70% and 90% are B class items and other, which are between 90% and 100% are C class items The following steps are involved in implementing the ABC analysis: Classify the items of inventories, determining the expected use in units and the price per unit for each item. Determine the total value of each item by multiplying the expected units by its units price. Rank the items in accordance with the total value, giving first rank to the item with highest total value and so on. Compute the ratios (percentage) of number of units of each item to total units of all items and the ratio of total value of each item to total value of all items. Combine items on the basis of their relative value to form three categories: -A, B and C. ABC Analysis in ERP package Major ERP(Enterprise Resource Planning) packages (SAP, Oracle, Microsoft, etc.) have built in function of ABC analysis. User can execute ABC analysis based on user defined criteria and system and apply ABC code to items (parts). Example of the Application of Weighed Operation based on ABC class:
Actual distribution of ABC class in the electronics manufacturing company with 4051 active

parts.

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Distribution of ABC class ABC class Number of items Total amount required A B C Total 5 10 85 100 75 15 10 100

Using this distribution of ABC class and change, total number of the parts to 4000 can be obtained.

Uniform Purchase When you apply equal purchasing policy to all 4000 components, example weekly delivery and re-order point (safety stock) of 2 week supply assuming that there are no lot size constraints, the factory will have 16000 delivery in 4 weeks and average inventory will be 2.5 week supply.
Application of Weighed Purchasing condition Uniform condition Items Conditions Weighed condition Items A-class 200 All items 4000 Re-order point=2 week B-class supply 400 Delivery frequency=weekly C-class 3400 Conditions Re-order point=1 week items supply Delivery frequency=weekly Re-order point=2 week items supply Delivery frequency=bi-weekly Re-order point=3 week items supply Delivery frequency=every 4 weeks

Weighed Purchase In comparison, when weighed purchasing policy applied based on ABC class, example C class monthly (every 4 week) delivery with re-order point of 3 week supply, B class Bi-weekly delivery with re-order point of 2 weeks
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supply, A class weekly delivery with re-order point of 1 week supply, total number of delivery in 4 weeks will be (A 200x4=800)+(B 400x2=800)+(C 3400x1=3400)=5000 and average inventory will be (A 75%x1.5weeks)+(B 15%x3weeks)+(C 10%x3.5weeks)=1.925 week supply.
Comparison of "Equal" and "Weighed" Purchase (4 weeks span) Equal purchase % of No of ABC No of total delivery Average class items supply value in 4 level weeks Weighed purchase No of Average delivery supply in 4 level weeks

Note

200

75%

800

2.5 weeks

800

400

15%

1600

2.5 weeks

800

Same delivery frequency, safety stock 1.5 reduced from 2.5 to 1.5 weeks# weeks#, require tighter control with more manhours. Increased safety stock level by 20%, delivery 3 weeks frequency reduced to half. Less man-hour required. Increased safety stock from 2.5 to 3.5 week supply, delivery 3.5 weeks frequency is one quarter. Drastically reduced man-hour requirement. Average inventory value reduced by 23%, delivery frequency reduced by 69%. Overall reduction of man-hour requirement.

3400

10%

13600

2.5 weeks

3400

Total 4000 100%

16000

2.5 weeks

5000

1.925 weeks

#A

class item can be applied much tighter control like JIT daily delivery. If daily delivery with one day stock is applied, delivery frequency will be 4000 and average inventory level of A class item will be 1.5 days supply and total inventory level will be 1.025 week supply. reduction of inventory by 59%. Total delivery frequency also reduced to half from 16000 to 8200.

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Result
By applying weighed control based on ABC classification, required man-hours and inventory level are drastically reduced.

VED Analysis
In addition to the intrinsic or market value of materials, which is invested in the materials, there is sometimes a nuisance value to the materials. In ABC analysis, the annual consumption value; quantity of materials consumed and unit cost plays a vital role. Thus ABC analysis deals with the annual consumption value of the item due to their presence and not any other aspect such as the criticality of the material or the nuisance value. The nuisance Value is the cost associated with materials due to their absence. 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. In addition to the conventional ABC analysis, VED analysis also plays an important role in materials management. VED ranking may be done on the basis of the shortage costs of materials, which can be either quantified or qualitatively expressed.
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Combination 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 can be done in nine ways as shown: V A B C AV BV CV E AE BE CE D AD BD CD A B C V 90% 95% 99% E 80% 85% 90% D 70% 75% 80%

This type of classification helps the management to decide the materials policy and what the service levels are expected to see that no difficulty is faced. An item belongs to both A and V class is costlier, at the same time higher criticality, the management should see that it is available at any time the need arises and the stock levels to be controlled properly to see that inventory carrying cost are kepy under control.

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Reference: Productions & operations management P.Rama murthy Productions & operations management R. Pannerselvam Industrial Engineering and managementO.P.Khanna http://en.wikipedia.org/wiki/ABC_analysis

Rohith K R