In any medium to large industry there are thousands of items in the inventory. The items may range from a spare generating set to cans of paint or small nuts and bolts. It is neither logical nor possible to exercise tight management control over these different items varying in their value, complexity, size or necessity. It will be too much of effort for little benefit.
Selective Management Control:
The principle of Management by Exception is better sited here. Items of inventory are classified into A, B, C, or other classes for selective management control. Controls exercised selectively contribute to better management, in most cases avoiding wastage of precious management time and, more importantly avoiding the confusion resulting from excessive controls. The degree and the character if the controls to be exercised by the management should depend upon (1) the necessity of the control, (2) the relative importance of the material to be placed under control, and (3) the particular characteristics of the material.
Materials may be divided into three categories or classes for selective management control. More than three gradations in materials will not be fruitful. The division of materials into three grades, for selective management control purposes, is known in general as the ABC classification. The alphabets A, B and C stand for the three different classes.
ABC analysis is based on the relative importance of the materials. Therefore, there are various bases for ABC classification: A material’s price, its criticality, its non-availability its size Vs weight etc. For various situations, various characteristics are more or less important. That is why there are a number of ways of classifying the materials on the ABC scale.
Conventionally, however, ABC analysis refers to the annual consumption value of the items. It has been found in many industries that a small number of items account for a large proportion of the annual turnover (in money terms) of the inventory. These terms should attract the Materials Manager’s attention immediately. We call such items as Class A items. It is also observed, in most industries that a very large umber of items in the inventory account for a small fraction of the annual turnover (annual consumption value of the materials). These are many items contributing very little to the ultimate problem of managing the working capital investment. Naturally, the Materials Manager should turn his attention to these items only after he has taken care of there high annual turnover items (A class items). Such items are called Class ‘C’ items. Class ‘B’ items belong to the in-between categories; neither is their total annual consumption value high nor their total numbers high.
The phenomenon as described above occurs in almost all industries and therefore the conventional ABC classification can be applied in most of the industries.
10% of the items contribute to about 75% of the total annual consumption value of all materials in the inventory; about 70% of the items contribute to about 10% of the total annual consumption value of all materials and 20% of the materials account for about 15% the total annual consumption value of the materials. The items are classified as A, C, and B respectively.
One must understand that there is nothing sacrosanct about the percentages mentioned above; they are only illustrative. But the fact remains that a few items in inventory are more important than some others in terms of the managerial attention they deserve.
Example: Consider a company which stocks 20 items. The number of units and the consumption value of each item is given. The items are listed in decreasing order of their consumption value.
Check the Col. Nos 2 and 6 which give respectively the cumulative percentage of the items and cumulative percentage of the total annual consumption value. The first 2 items account for 70% of the annual turnover. Therefore, we may classify the first 2 items as class ‘A’ items. Item Nos 8 to 20 which constitute 65% of the items account for only about 6% of the annual consumption value. Therefore, items 8 to 20 will be classified as class ‘C’ items. The remaining items that is, from Nos 3 to 7 may be classified as class ‘B’ items.
It is seen that by exercising control over only 2 items as much as 70% of the annual turnover value would be controlled. The management effort need not be spread thin over all 20 different items. ABC analysis helps in focusing the management effort, and thereby increasing the efficiency of the effort.