One should note that the ABC classification depends not only on the value per unit, but also on the number of units consumed over the year. Because, in this classification, we are dealing with the annual consumption value. Therefore, if the value of an item were to increase or if the amount of annual consumption of the item were to increase, the ‘annual consumption value’ of the item would increase. Therefore, the classification of an item may change from say class B to class A, or from class C to class B. The point is that the ABC classification is not done once and for all time; the classification needs to be monitored periodically and may changes need to be incorporated accordingly. ABC classifications of the previous year will not necessarily hold good for this year or the coming year.
A proper ABC analysis will lead to better control over materials and consequent reduction in costs associated with inventories.
In addition to the intrinsic or market value of materials which is invested in the materials, there is sometimes a ‘nuisance’ value to the materials. What we discussed in earlier paragraphs was the cost of materials due to their presence, whereas the nuisance value is the cost associated with materials due to their absence. Certain materials are important by their absence and not necessarily by their presence. If they are not available, they hold up production and, therefore, there are high costs of shut down or slowdown of production. By themselves these materials may not be priced high in the market. The investment in these materials may be small but for lack of any of them, the production process may come to a grinding halt. These are critical items which are required in adequate quantity.
This gives us a clue to another kind of classification of materials which has to deal with the critical nature of the items, i.e. whether they are ‘vital’ to the production process, or ‘essential’ or just ‘desirable’. Vital (V) items have extreme criticality, desirable (D) items are not critical but essential (E) items are somewhere in between. In addition to the conventional ABC analysis, this VED Analysis is of great importance. Such VED ranking can be done on the basis of the shortage costs of materials which can be either quantified or qualitatively expressed.
Combination of ABC and VED Analysis:
Since the conventional ABC analysis and VED analysis are both important, it is preferable to combine both these classifications and arrive at a joint classification of materials.
As shown we may classify materials into 9 categories for management control purposes. The classification is for giving guidelines or helping management to have better control over the materials. It should tell us – What the inventory policy should be? How much of which class of materials should be held in inventory: What should be the service levels and consequent safety stocks for the different classes of inventory?
Purpose of classification:
The V class of items by their extreme critical nature needs to be held to be held in a large quantity in the inventory. The stock out cost associated with such materials is very high and therefore the service levels will be very high for this class of materials. The service levels for the subsequent E and D class materials will be lower and lowest respectively. The D class items are easily available in the market. They do not hold up production and may be substituted as well. Therefore, we can manage with small inventories of these items without drastic consequences on the running of the production line. Coming to the conventional ABC: The A class items incorporate a large turnover value in them. Naturally, the management attention must be focused on these items. This is possible as they are few in number. Therefore, ‘A’ class items are always under the scrutiny of the management. They are always monitored and followed up with respect to their stock levels, their availability in the market, their substitutes if any, etc. Since these are directly and constantly under the vision of the management, they can be kept in smaller quantities in inventory. Class C items contribute very little to the total annual consumption value and, therefore, even if they are kept in large quantity in the inventory, it really does not significantly add to the inventory related cost. It is better that they be purchased or procured in large quantities, say once in a year and thus cut down on the number of transactions and management follow up. Therefore, the service levels of C class items will be high. B class items fall somewhere in between in terms of the service levels.
The service levels of inventory, therefore, increase from D to V and from A to C. This suggests that the maximum service level will be for the CV class items and the lowest service level will be for the A D class items.