ABC Analysis

• ABC analysis divides on-hand inventory into three classifications on the basis of dollar (TL) volume.

• It is based on Pareto Principle.(80-20 principle)

• The idea is to focus resources on the critical few and not on the trivial many.

ABC Analysis

• ABC analysis divides the inventory into 3 categories.

Category A Low in number High Dollar Value Items

Category B Medium in number and Medium Dollar Value items

Category C High in Number Low in Dollar Value

ABC Example

A washing machine company uses following inputs for making a machine:

Nos. of inputs Costs1 High Power Motor Rs. 10,0002 2 Separate Plastic tubs Rs. 2,000 3 4 wheels (in trolley) Rs.500for moving machineWhich of these items in inputs is category A, B and C

items?

Answer

• High Power Motor – Category A

• Plastic Tubs- Category B

• Four Wheels- Category C items

ABC Analysis

• Numerical to be done in class

Economic Order Quantity

Inventory costs consist of three costs:

- Purchasing/Ordering Costs

- Carrying Costs of Inventory

- Buying Cost( Amount Paid to buy inventory)

Purchasing/Ordering Costs

It is the cost of ordering inventory. It includes costs such as clerical costs of preparing verifying the purchase order, costs of transporting the inventory to factory etc.

Carrying Costs

The second cost of inventory is cost of storing the inventory. It includes storage, protection, risk of wastage of inventory etc.

Balancing Carrying and Ordering Costs

If the firm orders too much quantity at one time it will incur lot of carrying costs in terms of storage etc.

If firm orders too little quantity at one time it will incur lot of purchasing/ordering costs. (in terms of clerical, transportation etc .)

Thus firm needs to maintain a fine balance between ordering too much and ordering too little.

Economic Order Quantity

The optimum quantity a firm should order at one time is called economic order quantity, It is given by formula:

EOQ =(2UP/C)1/2

Where U= Annual Inventory Demand P= Purchasing ordering cost per order C= Carrying costs of inventory

Quick Check: Economic Order Quantity

A firm has annual demand of inventory 12,000 units. Ordering cost of 500 Rs per purchase order. Carrying costs of 300 Rs per unit/ per year. What is the EOQ?

a) 500 b) 400c) 300d) 200

Answer

EOQ = (2UP/C)1/2

=((2*12000*500)/300)1/2

= 200

Stock Control Levels

• Reorder Level

It is the level at which the firm should place order for inventory refill. The reorder level is: (ROL)=Maximum daily usage rate of input X

Maximum Lead time in days

(Lead Time: It is the time it takes for inventory to arrive once order is placed.)

Management AccountingBy Paresh Shah

Oxford University Press

Quick Check

A factory uses maximum 100 units input daily. The lead time is maximum 5 days for inventory to arrive. What is reorder level?

a) 200b) 300c) 400d) 500

Answer

• 500 units

Minimum Stock Level

Minimum Level

It is the minimum level of stock that can be reached in inventory. The stock should never be allowed to go below this level. Minimum Stock Level =

Reorder level - (Average rate of consumption X Average time of inventory delivery)

Quick Check

A factory uses maximum 100 units per day. The maximum lead time is 5 days. The average usage of inputs is 80 units, average lead time is 3 days. What is the minimum inventory level?

A)300

B)400

C)260

D)200

Answer

• Reorder level =100* 5= 500 units

• Minimum= 500-(80*3)

260 units

Maximum Inventory Level

The maximum level stock can reach in inventory is:

Reorder level + Reorder Quantity-(Minimum Usage X Minimum Delivery Time)

Quick Check

The maximum usage is 100 units per day and maximum lead time is 10 days. The reorder quantity is 500 units. The minimum delivery usage is 50 units per day and minimum delivery time is 5 days. Calculate maximum level?

a)2000

b)1500

c)1250

d)1000

Answer

Reorder Level = Maximum Usage X Maximum Lead Time 100X 10= 1000Maximum Stock Level = Reorder Level+

Reorder Quantity-( Minimum Usage X Minimum Lead Time)

= 1000+500-(50X5) 1250 units

Average Stock

• It is the average stock level maintained by firm. It is given by:

(Maximum Stock Level + Minimum Stock Level)/2

Total Ordering Costs

The total ordering cost is:

Ordering cost per order X Number of orders placed

Where number of orders placed in a year is:

= Annual Demand/ Quantity ordered one time

For E.g. 12000 is annual demand, quantity ordered is 400. Nos. of order is 12000/400=30 order per year

Quick Check

The ordering cost per order is Rs. 40. The firm orders 400 units at one time. The annual demand is 12000 units for the firm. What is the total ordering cost?

a) 1000b) 1200c) 1300d) 1400

Quick Check

Nos of orders per year

= Total Demand/ Order Placed one time

12000/400 = 30 order per year

Total Ordering cost

= Ordering Cost per year X Nos. of orders per year

40 X 30 = Rs1200

Total Carrying costs

Total Carrying cost=

Carrying Cost per unit per year x (Order size /2)

Quick Check

The carrying cost per unit is 20% of purchase price per unit. The cost of input is 5 Rs/unit. The order size placed at one time is 400 units. What is total carrying cost of inventory (in rupees)?

a) 300

b) 200

c) 400

d) 500

Answer

Carrying Cost = Carrying cost per unit x (Order size/2)

(20%X Rs. 5) x(400/2)

1x 200= Rs. 200

Cost of Inventory

Total Inventory cost=

Total annual demand X Cost per unit

Total Costs

Total Costs = Total Ordering cost+ Total Carrying Costs+ Total Inventory costs

Quick Check

If purchasing price per unit is Rs. 40 per units, annual demand is 12,000 units. Carrying cost is 1 Rs/unit, Total Ordering cost is 4000 Rs. What is total cost?

a) 421,000b) 525000c) 496000d) 35000

Answer

• Total Costs = (12,000 x 40)+(12000X1)+ 4000

= 480000+12000+4000

=496000

Effect of Discount on Total Costs of Inventory

Many times suppliers offers discount in prices if purchaser orders are in bulk.

In that case total inventory cost to be used for deciding the ideal order quantity to be placed at one time.

Anil gupta ,Gupta Sachdeva & co. 33