Inventory Classification - ABC Classification, Advantages & Disadvantages

Inventory is a necessary evil in any organization engaged in production, sale or trading of products. Inventory is held in various forms including Raw Materials, Semi Finished Goods, Finished Goods and Spares.

Every unit of inventory has an economic value and is considered an asset of the organization irrespective of where the inventory is located or in which form it is available. Even scrap has residual economic value attached to it.

Depending upon the nature of business, the inventory holding patterns may vary. While in some cases the inventory may be very high in value, in some other cases inventory may be very high in volumes and number of SKU. Inventory may be help physically at the manufacturing locations or in a third party warehouse location.

Inventory Controllers are engaged in managing Inventory. Inventory management involves several critical areas. Primary focus of inventory controllers is to maintain
optimum inventory levels and determine order/replenishment schedules and quantities. They try to balance inventory all the time and maintain optimum levels to avoid excess inventory or lower inventory, which can cause damage to the business.

ABC Classification

Inventory in any organization can run in thousands of part numbers or classifications and millions of part numbers in quantity. Therefore inventory is required to be classified with some logic to be able to manage the same.

In most of the organizations inventory is categorized according to ABC Classification Method, which is based on pareto principle. Here the inventory is classified based on the value of the units. The principle applied here is based on 80/20 principles. Accordingly the classification can be as under:

A Category Items Comprise 20% of SKU & Contribute to 80% of $ spend.
B Category Items Comprise 30% of SKU & Contribute to 15% of $ spend.
C Category Items Comprise 50% of SKU & Contribute to 5% of $ spend.

The above is only an illustration and the actual numbers as well as percentages can vary.

Example: Table of Inventory Listing by Dollar Usage Percentage.

Item Annual Usage in No. Units Unit Cost-$ Usage in Dollars Percentage of Total Dollar Usage
1 5,000 1.50 7,500 2.9%
2 1,500 8.00 12,000 4.7%
3 10,000 10.50 105,000 41.2%
4 6,000 2.00 12,000 4.7%
5 7,500 0.50 3,750 1.5%
6 6,000 13.60 81,000 32.0%
7 5,000 0.75 3,750 1.5%
8 4,500 1.25 5,625 2.2%
9 7,000 2.50 17,500 6.9%
10 3,000 2.00 6,000 2.4%
Total     $254,725 100.0%

Advantages of ABC Classification

  • This kind of categorization of inventory helps one manage the entire volume and assign relative priority to the right category. For Example A Class items are the high value items. Hence one is able to monitor the inventory of this category closely to ensure the inventory level is maintained at optimum levels for any excess inventory can have huge adverse impact in terms of overall value.
  • A Category Items: Helps one identify these stocks as high value items and ensure tight control in terms of process control, physical security as well as audit frequency.
  • It helps the managers and inventory planners to maintain accurate records and draw management’s attention to the issue on hand to facilitate instant decision-making.
  • B Category Items: These can be given second priority with lesser frequency of review and less tightly controls with adequate documentation, audit controls in place.
  • C Category Items: Can be managed with basic and simple records. Inventory quantities can be larger with very few periodic reviews.

Example: Take the case of a Computer Manufacturing Plant; the various items of inventory can be broadly classified as under:

SKU Description Classification of Inventory Remarks
Processor Chips A Class Kept under High Value Storage/Asset Tracking / Access Control required
Memory Chips A Class Kept under High Value Storage/Asset Tracking / Access Control required
Hard Disk / Storage Media A Class Kept under High Value Storage/Asset Tracking / Access Control required
Software License A Class Kept under High Value Storage/Asset Tracking / Access Control required
Disk Drives A Class Normal Storage / Access Control Required
Cabinet / Case B Class Normal Procedures
Battery Pack B Class Normal Procedures
Monitor A Class Normal Storage / Access Control Required
Keyboard B Class Normal Procedures
Training Manuals C Class Minimal Procedures
Mouse B Class Normal Procedures
Stickers C Class Minimal Procedures
Screws & Nuts C Class Minimal Procedures
Power Cord C Class Minimal Procedures
Starter Assembly Pack-Instructions C Class Minimal Procedures

Disadvantages

  • Inventory Classification does not reflect the frequency of movement of SKU and hence can mislead controllers.
  • B & C Categories can often get neglected and pile in huge stocks or susceptible to loss, pilferage, slackness in record control etc.



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