abc inventories and systems approach to management

8/9/2019 ABC Inventories and Systems Approach to Management

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ABC INVENTORIES AND SYSTEMS APPROACH TO

MANAGEMENT

1. What is an Inventory?

Inventory or stock refers to the goods and materials that a business holds for the ultimate

purpose of manufacture sale or resale (or repair).

2. Why do we need inventory management?

a. Time- The time lags present in the supply chain, from supplier to user at every stage,

requires that you maintain certain amounts of inventory to use in this leadtime. Hoever,

in practice, inventory is to be maintained for consumption during !variations in lead time!.

"ead time itself can be addressed by ordering that many days in advance.

b. Uncertainty - Inventories are maintained as buffers to meet uncertainties in demand,supply and movements of goods.

c. Economies of scale- Ideal condition of #one unit at a time at a place here a user needs

it, hen he needs it# principle tends to incur lots of costs in terms of logistics. $o bulk

buying, movement and storing brings in economies of scale, thus inventory.

d. Appreciation in Vale- In some situations, some stock gains the required value hen it

is kept for some time to allo it reach the desired standard for consumption, or

production. %or e&ample' beer in the breing industry.

!ost manfactring organi"ations sally divide their #goods for sale# inventory into$

a materials - materials and components scheduled for use in making a product.

ork in process, I* - materials and components that have begun their transformation to

finished goods.

%inished goods - goods ready for sale to customers.

+oods for resale - returned goods that are salable.

$tocks in Transit.

onsignment $tocks.


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%. Why is inventory management essential?

Inventory management is essential to ensure that the company doesnt run out stock on

the go and doesnt fall short of the necessities. There are various methods of inventory

management like / categori0ation, "I%1, %I%1 etc. In this report e focus mainly on

/ analysis and ill later study hat other inventory analysis methods have to offer.

&. What is A'( analysis method?

The A'( classification processis an analysis of a range of ob2ects, such as finished

products ,items lying in inventory or customers into three categories. It!s a system of

categori0ation, ith similarities to *areto analysis, and the method usually categori0es

inventory into three classes ith each class having a different management control

associated 3

- outstandingly important

/ - of average importance

- relatively unimportant as a basis for a control scheme.

4ach category can and sometimes should be handled in a different ay, ith more

attention being devoted to category , less to /, and still less to .

*opularly knon as the #56786# rule / concept is applied to inventory management as

a rule-of-thumb. It says that about 569 of the upee value, consumption ise, of an

inventory remains in about 869 of the items. Thus the/ analysis method helps insetting up trends of revieing the inventory, better management of funds etc. %or

e&ample the company that follos / analysis method is likely to revie more the

class of items than that of other items due to s high demand. ccordingly it ill set

its revieing goals i.e for e&ample ill be revieed once every to days. / every

once a eek, every once a month and so on.

). Advantages of A'( analysis3

a. *rodct (ost Estimation

The ma2or advantage of / is the ability to estimate the cost of individual products and

services precisely. / is based on the belief that activities cause costs and therefore a

link should be established beteen activities and cost. The cost drivers are the link

beteen the activities and the cost. hats a cost driver: %or e&ample in a ustomer

service, cost drivers are ;umber of service calls attended, number of staff membersin

service department, etc. Its any factor that creates the cost. *roduct cost estimation under


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/ is more accurate and reliable because it focuses on this linkage beteen costs and

activities.

b. Improves Business Processes

n / system allocates indirect costs based on a products cost driver.s costs are

allocated per product, a picture starts to emerge of hich business processes are

performing ell and hich ones need to be improved. / can be used to identify non-

valued added activities and can help to concentrate our resources on efficient and

profitable activities.The use of / can also add value to the continuous improvement of

business processes.

c. !ore Efficient (ycle (onts

cycle count is the process of counting only certain items on scheduled dates.


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flipside comprises of various disadvantages of this method hich are important to consider,

hich are listed as follos.

i. A'( analysis is simplistic in certain aspects.

a. This oversimplification arises from the fact that / analysis mainly focuses upon

the dollar value of units and the price of units, as analy0ed using the "I%1 and %I%1methods.-. s a result, less attention is paid to lo-cost / > items hich may be very

important to the company in spite of their lo price. This in turn can lead to ashortage in the aforementioned items due to more attention being paid to their priceand less to their actual importance.

c. %or e&ample, a business based in carpentry might require a large number of nails andscres, hich are relatively e&pensive as compared to the ooden components butnonetheless vital to the manufacture of furniture. Thus, less attention is paid to theprocurement of these supplies, hich can affect the company negatively.

ii. A'( analysis is overly complicated in other aspects

a. / analysis relies on various ?control parameters@ hich are used to establish andmanage classes of items, e.g. target service levels, cost earmarked for manufacturing,etc.

-. These differ in level ith variations in the category of the inventory beingconsidered.

c. n increase in the number of parameters allotted per category results in an increasein the setting and managing of values. This leads to a compounding in the difficultyand comple&ity involved in establishing a reliable / categori0ation.

d. %urthermore, the levels of parameters themselves rely on a trial-and-error system,hich results in an initially arbitrary assignment and later corrections based on thesale of the given inventory item. This leads to an element of difficulty in the optimal

quanti0ation of the control parameter values, in addition to incorporating an elementof risk.iii. It reires s-stantial resorces

a. In order to ensure that the / analysis does not commit errors akin to those listedabove, an allocation of substantial resources is required to analy0e the significance ofinventory itemsAespecially class inventory itemsAto ensure that they still holdsignificance to the overall sale of products.

-. s stated above / analysis can be complicated due to the need to consider variousparameters and variables.

c. direct result of this risk and comple&ity is an increased allocation of resources suchas manpoer, time and money to conduct an analysis of the inventory items, hichincludes but is not limited to data measurement and collection.

/. (onflict of A'( analysis with 0AA*

+* is the set of authoritative accounting standards issued by several standard-setting

bodies (particularly the %inancial ccounting $tandards /oard for


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ho to aggregate and present financial information, as ell as disclose supporting

information.

$ince activity based costing (/) system generally provides more accurate product

costs than traditional costing methods, hy isn!t it used for e&ternal reports:

$ome companies do use activity based costing in their eternal reports, but most do not.

There are a number of reasons for this. %irst, e&ternal reports are less detailed than

internal reports prepared for decision making. 1n the e&ternal reports, Individual product

costs are not reported. ost of goods sold and inventory valuations are disclosed, but their

is no breakdon of these accounts by product. If some products are under-costed and

some are over-costed, the errors tend to cancel each other hen the product costs are

added together.

$econd, it is often very difficult to make changes in a company!s accounting system. The

official cost accounting system in most large companies are usually embedded in

comple& computer programs that have been modified in-house over the course of many

years. It is e&tremely difficult to make changes in such computer programs ithout

causing numerous bugs.

Third, an / costing system does not conform to generally accepted accounting

principles (+*). *roduct cost computed for e&ternal reports purposes must include all

of the manufacturing costs and only manufacturing costs' but in / system products

costs e&clude some manufacturing costs and include some non-manufacturing costs. It is

possible to ad2ust the / data at the end of the period to conform to +* but itrequires more ork.

%ourth, the auditors are likely to be uncomfortable ith allocation that are based on

intervies ith the company!s personnel. $uch ob2ective data can be easily manipulated

by management to make earnings and other key variables look more favorable.

%or all of these reasons, most companies confine their / efforts to special studies for

management, and they do not attempt to integrate activity based costing into their formal

cost accounting system.

. 3ther methods of inventory categori"ation3

a. "I%1 (last in first out)

-. %I%1 (first in first out)

c. etail inventory method


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d. verage cost method

"et us study each one of them one by one3

To illustrate the concept of "I%1 and %I%1 let us consider the folloing e&ample

hile this e&ample is for inventory costing and calculating cost of goods sold (1+$),

the concepts remain the same and can be applied to other scenarios as ell.

$uppose a business that trades in idgets makes the folloing purchases during the year3

/atch B3 Cuantity 8,666 pieces at DE per piece

/atch 83 Cuantity B,F66 idgets at DF apeice

/atch G3 Cuantity B,66 idgets at D per piece

This means a total of F,866 idgets ere purchased. 1f these, let!s assume the company

managed to sell G,666 units at a price of D each. ;o the remaining inventory of 8,866

idgets needs to be valued. hat should be the unit cost used to determine the value of

this unsold inventory: This is the question that "I%1 and %I%1 methods attempt to

anser.

Using 4I43


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are the same, standardi0ed idgets, /atch G goods are unsold for the purposes of

accounting.

Using 8I43


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d. verage cost method

verage cost method (M1) calculates the cost of ending inventory and cost ofgoods sold for a period on the basis of eighted average cost per unit of inventory.

eighted average cost per unit is calculated using the folloing formula3

verageL

Totalost of Inventory


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abc inventories and systems approach to management

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