Inventory Investment vs Customer Service

APPLYING THE ABC PRINCIPLE IN PRACTICE
BY
BRIAN WILLCOX
OF
ACTION MRPII

The Pareto, or ABC principle as it is more commonly known, is a simple but very important tool that can help us control our inventories. The "ABC" principle is concerned with the distribution of items by value. The definition states that "for any given group, a small number of items in the group will account for the bulk of the total value. This concept is called the ABC classification when applied to inventories."

In any respectable inventory or MRPII software package will be the facility to establish an "ABC". It is then up to the user to decide what he wants to do with it when he has got it. First we will look at the calculation to establish the "ABC" and then how it can be used to advantage.

To calculate an ABC

First we establish the annual spend per item by multiplying the annual quantity by the standard cost.
The items are then listed in descending value sequence, and the percentage of each items value as part of the total spend is recorded and cumulated down the listing.
Each item code is numbered and cumulated down the listing. The percentage of items is also recorded and cumulated down the listing. This then allows a quick cross reference between the number or percentage of items against the cumulative annual spend.

Typically this will then show that about 5% of the items incur about 75% of the total annual spend. These are the top few items and are referred to as the “A items”.
The next 20% of the items incur about 20% of the spend and are referred to as “B items”.
Finally the remainder, about 75% of the items incur about 5% of the annual spend, and are referred to as “C items”.

When calculating an ABC, as a practice, purchased and in-house manufactured items should be kept separate and a separate done for each. The reason for this is that when you get into the manufactured main assemblies, they will completely outweigh all the lower level purchased items and the ABC will then not really be applicable to the items.
Another approach is to use the raw material and piece part store items for one "ABC" and the finished good store for a second "ABC".

Uses of ABC

The principle followed is that the bulk of the money is tied up with the A items thus they should have the bulk of the attention. It must be realised that with MRP, each item is planned in the same way but the batching rules would be different and possibly the method of issue.
Different companies use the ABC for different purposes. For example :-

A different periods usage would be purchased for each category. i.e. A items 4 weeks but C items 26 weeks. With any of the packages today, they provide for an ordering rule "period order quantity" which means that you order to cover a period's requirement. The ABC is a simple but very effective way of categorising the items to apply the ordering rules to.
Another approach is to physically divide the piece part store into three sections so each category of items could be stored and controlled separately. This allows special attention to be given to the A's, and you may even chose the best storemen to work with them.
When considering a finished goods store, it is possible to give the A items special attention as they are the biggest part of the sales value.

The ABC can also be used to estimate what the average value of inventory should be.

The steps are very simple and goes back to basic principles :-
The average stock holding is half the replenishment order quantity plus safety stock.
The 'ABC' category determines the periods usage ordered at one time.
For example :
If the annual spend of all A's is R24,000,000 and the ordering rule for A's is every 20 days, then the average stock holding can be calculated -

Average Total Order value is 24,000,000 = 2,000,000 per 20 day cycle
12

As the average order is half consumed then the average cycle stock is 2,000,000 x 50% = R1,000,000. Therefore the average stock holding for A items should be about R1,000,000 plus whatever safety stock is held.

This same logic can be used for the B and C items as well.

Remember, this is only an average, and if you get to within 85% of this target, you can say your inventory is under control.

The ABC is a simple but effective way of controlling items and one which many companies find invaluable. If you are not using it yet in some way or another it is time you asked yourself why.