Question

Briefly describe what is meant by ABC analysis. What is the purpose of this inventory technique?

Discuss the major inventory costs that are used in determining the EOQ.

Answer 1

What is ABC analysis?

1. ABC analysis is a type of inventory classification method in which inventory is divided into three categories, A, B, and C, in descending value. A has the highest value items, B is lower value than A, and C has the lowest value
2. The ABC analysis provides a mechanism for identifying items that will have a significant impact on overall inventory cost,^[1] while also providing a mechanism for identifying different categories of stock that will require different management and controls.

ABC analysis works by breaking it down in the following ways:

• A-items: 20% of all goods contribute to 70-80% of the annual consumption value of the items
• B-items: 30% of all goods contribute to 15-25% of the annual consumption value of the items
• C-items: 50% of all goods contribute only 5% of the annual consumption value of the item

What is the purpose of ABC analysis?

ABC Analysis allows inventory/purchasing managers to segregate and manage the overall inventory/suppliers into 3 major groups. This allows different inventory/supplier management techniques to be applied to different segments of the inventory/suppliers in order to increase revenue and decrease costs. In terms of a Pareto Analysis, it separated the critical few from the trivial many.

• some benefits of ABC analysis are

· Better control over high-value inventory improves availability, and reduces losses and costs.

· More efficient use of stock management resources..

· Relatively low value of B or C class holdings can allow a business to hold bigger buffer stocks to reduce stock outs.

· Fewer stock outs results in improved production efficiency.

· Fewer stock outs and improved production efficiency resulting in more reliable cycle time and, therefore, improved customer satisfaction.

Discuss the major inventory costs that are used in determining EOQ?

1. The two most main inventory management costs are ordering costs and carrying costs. Ordering costs are costs incurred on placing and receiving a new shipment of inventories. These include communication costs, transportation costs, transit insurance costs, inspection costs, accounting costs, etc. Carrying costs represent costs incurred on holding inventory in hand. These include opportunity cost of money held-up in inventories, storage costs such as warehouse rent, insurance, spoilage cost
2. Ordering costs and carrying costs are quiet opposite in nature. To minimize its inventory carrying costs, a company must place small orders. But small order size means that the company must place more orders which increases its total ordering costs. Similarly, if a company wants to cut its ordering costs, it must reduce the number of orders placed which is possible only when order size is large. But increase in order size means that average inventory balance on hand will be high which increases total carrying costs for the period.