ABC Analysis and stock levels

Mr. Rahul Anand

• ABC analysis is a type of analysis of material dividing in three groups called A-group items, B-Group items and C-group items For the purpose of exercising control over materials. Manufacturing concerns find it useful to divide materials into three categories.

• An analysis of the annual consumption of materials of any organisation would indicate that a handful to top high value items (less than 10 per cent of the total number) will account for a substantial portion of about 70 per cent of total consumption value

• Remember: 70% of total number of items account for only about 10% of consumption value - "C"-group items.

Between these two extremes will fall those items the percentage number of which is more or less equal to their consumption value.

Remember: 20% of total number of items account for only about 20% consumption value - "B" group items.

Items in the top category are treated as "A" items, items in the bottom category are called as "C" category items and the items that lie between the top and the bottom are called "B" category items. Such an analysis of materials is known as ABC analysis or Proportional parts value analysis.

• Classification of items into A, B and C categories• The logic behind this kind of analysis is that the

management should study each item of stock in terms of its usage, lead time, technical or other problems and its relative money value in the total investment in inventories.

Critical items i.e., high value items deserve very close attention and low value items need to be devoted minimum expense and effort in the task of controlling inventories.

• The Material Manager by concentrating on "A" class items is able to control inventories and show visible results in a short span of time. By controlling "A" items and doing a proper inventory analysis, obsolete stocks are automatically pinpointed.

ABC analysis also helps in reducing the clerical costs and results in better planning and improved inventory turnover. ABC analysis has to be resorted to because equal attention to A, B and C items will not be worthwhile and would be very expensive.

ABC categorization: Steps• The following steps will explain to you the classification of items into A, B and C

categories.

1. Find out the unit cost and 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.

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.

Application of Weighed Purchasing conditionUniform condition Weighed condition

Items Conditions Items Conditions

All items 4000Re-order point=2 week supplyDelivery frequency=weekly

A-class items　 200

Re-order point=1 week supplyDelivery frequency=weekly

B-class items 400Re-order point=2 week supplyDelivery frequency=bi-weekly

C-class items 3400

Re-order point=3 week supplyDelivery frequency=every 4 weeks

Comparison of "Equal" and "Weighed" Purchase (4 weeks span)

ABC class No of items

% of total value

Equal purchase Weighed purchasenoteNo of delivery

in 4 weeksaverage supply

levelNo of delivery

in 4 weeksaverage

supply level

A 200 75% 800 2.5 weeks 800 1.5 weeksa

same delivery frequency, safety stock reduced from 2.5 to 1.5 weeksa, require tighter control with more man・hours.

B 400 15% 1600 2.5 weeks 800 2.5 weeks

increased safety stock level by 20%, delivery frequency reduced to half. Less man・hour required.

C 3400 10% 13600 2.5 weeks 3400 3.5 weeks

increased safety stock from 2.5 to 3.5 week supply, delivery frequency is one quarter. Drastically reduced man・ hour requirement.

Total 4000 100% 16000 2.5 weeks 5000 1.925 weeks

average inventory value reduced by 23%, delivery frequency reduced by 69%. Overall reduction of man・hour requirement

Stock Levels Maintenance of proper stock of each item of

materials is one of the main functions of stores department. Large quantity of material in store lead to huge investments, deterioration in quality, large space requirement etc. Less stock also leads to higher costs, frequent purchases and loss of production etc. Therefore, it is important to maintain stock level.

One of the best way to maintain stock is to determine the minimum and maximum stock levels as per the necessity and maintain it regularly.

Store keepers usually use scientific technique of material management to ensure optimum quantity of material in store and make purchases accordingly. In order to do that following levels are fixed in advance:

• Maximum Stock Level• Minimum Stock level• Re-ordering level• Danger level

• Reordering Level

Re-ordering level is a level at which the storekeeper will initiate the steps to purchase fresh supplies. This level is called re-ordering level or ordering level.

This level usually lies between minimum and maximum stock level. This level will usually be higher than the minimum stock level to cover unexpected delay in delivery of fresh supplies or abnormal usage of materials.

• Minimum Stock Level Minimum stock level is a level of stock which must be

kept in store at all times. This is a level of an item of material below which the stock in hand is not allowed to fall. The objective of this limit is to avoid the possibility of interruption of production due to shortage of material. The following points needs to be taken into consideration while fixing the minimum stock level.

Time required for the fresh supply of material - Lead time Rate of consumption of material during the lead time. Reorder level

Maximum stock level

Maximum stock level is a quantity of material above which the stock of any item should not be allowed. To avoid blocking of working capital and making undue investments in stock, maximum stock level is to be fixed. It also helps to maintain proper quality of raw materials. Following points must be taken into consideration while fixing maximum stock level:

• Availability of storage space• Cost of carrying the inventory• Amount of working capital available• Economic ordering quantity• Possibility of change in market trend• Normal rate of consumption of material during the reordering process.• Time necessary for fresh delivery of materials.• Possibility of loss due to deterioration/evaporation etc.• Price fluctuation.• Insurance costs if any

• Danger Level

Danger level is a level below the minimum level. This is a level at which urgent action must be taken to procure new stock otherwise the stock may exhaust and could affect the production. This level is calculated by taking into account the time required to get the materials by the shortest possible means.

Materials as a profit center

• In the earlier years, Materials Management was treated as a Cost Centre, since Purchasing Department was spending money on materials while Stores was holding huge inventory of materials, blocking money and space.

• However, with the process of liberalization and opening up of global economy, there has been a drastic change in the business environment, resulting in manufacturing organizations exposed to intense competition in the market place.

• Indian manufacturers have been working out various strategies to face the above challenges and to cut down manufacturing costs to remain competitive.

• Progressive Management have since recognized that Materials Management can provide opportunities to reduce manufacturing costs and can be treated as a Profit Centre.

• On an average, half the Sales income is spent on Materials. Suppose a firm is spending 50% of its volume on materials and the profits are 10% of sales volume. A 2% reduction in materials cost will boost the profits to 11% of sales or the profits will be increased by 10%.

• To achieve the same increase in profit through sales efforts, a 10% increase in sales volume will be necessary. In other words, compared to sales volume, material cost has five times the average on profits.

• Organizations earn or loose large sums depending on how effective is their Materials Management.

• The cost savings which are possible in Purchasing are as follows:

a) By obtaining materials at lower prices through:

•Development of new sources

•Price negotiations with vendors- Using modern techniques like cost-price analysis to determine the right or

reasonable price for the materials

b) By managing taxes payable

c) By reducing the cost of packaging

d) By optimizing the transportation costs

e) By ensuring the right quality of materials

g) By import substitution

Profitability

Till the last decade, the equation in business could be stated as

Selling Price = Manufacturing Cost + Profit

In view of the current competitive pressures in the market, the equation has changed to:

Selling Price - Manufacturing Cost = Profit

In the current situation, the Selling Price is determined by the market forces and as such, Profit can be ensured only by reducing the Manufacturing Cost. In most of the organizations, materials cost contribute to 60% of manufacturing cost and as such there is a significant importance to Materials Management.

Materials Cost is divided into two segments:

a) Unit price of the Materials 

b) Consumption for Production

The Purchase Department can control the prices by effective Negotiations. However, the question is, whether Materials Management can control the total cost, including the Consumption? Yes, it is possible, by controlling the issue from the Stores, based on the norms for Production. Now let us see how Materials Management can improve the PROFITABILITY of an organization –

It may be seen from the above table, that just by reducing the material cost by 10%, the Profit has increased by 85%.

Sales 100.0 100.0

Materials 70.0 63.0

Inventory 20.0 10.0

Interest @ 15% 3.0 1.5

Other expenses 17.0 17.0

Manf. Costs 90.0 81.5

PBT 10.0 18.5

% on Sales 10.0 18.5

% Increase   85.0