- Defining Operations Management
- Organizational Decision Levels
- Key Terminology
- Critical Processes
- Measuring Productivity Levels
- Inventory Determination
- Inventory Policy Choices
- Inventory Policy in a Fixed-Order Quantity System
- Independent Versus Dependent Demand
- ABC Inventory Classification
- Vendor Managed Inventory (VMI)
- Challenges Facing the Modern Operations Manager
- Discussion Questions
ABC Inventory Classification
An important aspect of managing inventory is to have a way to classify it based on its importance. All items in the supply chain are not of equal importance. Some are very important, such as specialized surgical equipment. Others are less important, such as latex gloves in a hospital. The first step in managing inventory is to classify inventory based on its degree of importance to manage it properly. The tool for this is ABC classification. Classifying inventory based on degree of importance allows us to give priority to important inventory items and manage those with care. It also prevents us from wasting precious resources on managing items that are of less importance.
ABC classification is based on Pareto’s Law, which states that a small percentage of items accounts for a large percentage of value. This value can be sales, profits, or other measure of importance. Roughly 10 percent to 20 percent of inventory items account for 70 percent to 80 percent of inventory value. These highly valuable items are classified as A inventory items. Moderate value items account for approximately 30 percent of inventory items and contribute to roughly 35 percent of the total. They are called B items. Finally, approximately 50 percent of the items only contribute to roughly 10 percent of total inventory value. These are called C items and are of least importance. Figure 1-9 provides an example of ABC analysis.
Figure 1-9 ABC classification of inventory
The steps to conduct an ABC analysis are as follows:
- Determine annual usage or sales for each item.
- Determine the percentage of the total usage or sales by item.
- Rank the items from highest to lowest percentage.
- Classify the items into groups.
After ranking the items from highest to lowest percentage, do not force groups to fit the preset percentages, as these are rough estimates. Rather, there are typically natural breaking points that will occur. The data will naturally group itself and these are groupings that should be used.
ABC analysis is extremely important for determining order policies. The most sophisticated inventory systems should be used for A items. In fact, many managers personally oversee these. By contrast, C items are typically left for automated ordering systems as they do not warrant the cost of managerial involvement.