The ABC inventory planning method is simple, yet allow us to manage the inventory more smartly.
The basic idea is to divide the inventory items into groups that will have different inventory policies. Each group has different importance from the most important GROUP A to the least important GROUP C or D.
In this post we will learn how the ABC model works and you can download an excel example file.
If you are not familiar with saw teeth inventory model read about it first.
Why use the ABC model?
Suppose we work on an organization that has more than 1,000 items. Every purchase order that we make comes with a cost, mostly that of time. When we place an order we have to:
- create the purchase orders
- follow up on each purchase order to make sure it will arrive on time
- handle the papers of each item if it needs to go through customs
- If we have a long lead time, we will have more than one purchase order open at the same item. We will need to schedule them so that we do not have too many or too few of each item. That is a time-consuming operation.
- When the item arrives we need to do acceptance tests and log the new inventory.
So if we have fewer purchase orders and each purchase order has more material, then we will need to take the 5 steps above in less time.
But inventory costs money, needs warehouse floor that costs money, and increases the cost of insurance.
So if we have a 1,000 or 10,000 items that we need to manage, it is impossible to treat each item the same. So we use Pareto. In most cases 20% of the items will be close to 80% of the cost of all items. That is the motivation for using the ABC model.
What is ABC model?
Let’s divide all our items into 3 groups: A,B and C (and I also add a group D).
Group A contains the most expensive items or ones that require a lot of warehouse space. These will be the items that we will carefully monitor. We will follow each of them daily or weekly (depends on the sensitivity of your organization). About 10%-20% of the items will be in this group.
Group C contains the cheapest and simple items that don’t need much followup, only to make sure that they will always be available to production. This group will have 50%-70% of items.
Group B contains the remaining items between group A and group C.
Group D is a subgroup of group C. Some items have very low value and we can hold a year’s worth of inventory at almost no cost.
Example:
Suppose we work in a pharmaceutical company.
Group A will contain the active ingredients of the formula. The active ingredient is usually the most expensive part of the product and has a shorter shelf life. That is why we will want to monitor those items and schedule their arrival to a plan production that will use them. We will want minimal inventory for those items.
Group B will contain the other ingredients of the formula. For example the flavors in a medicinal syrup or vaseline in a cream product. Those items are cheap, but since we use them in large quantities their overall cost is not negligible. We will want to hold a few days/weeks of inventory (depends on the supply chain of your organization) of those items. We always want to have stock, but we don’t want to hold a lot of inventory.
Group C will contain the packaging materials and the pamphlets that go with every product. These items are usually very cheap and arrives from the printing house in large quantities. We might hold a 1-6 months’ inventory of those items. In fact most of the warehouse will hold those materials.
Group D is a subgroup of group C. In this group we can find stickers that we put on the outer packages, stickers for pallets, plastic cups, and other things. In this group we will have very cheap items that do not consume a lot of warehouse space. We will hold inventory for 6-12 months, so we will need to deal with each item not more than once or twice a year. In this group we can also have slightly more expensive items that we consume very rarely during the year, so the overall annual cost is very low.
How to classify an item into a group?
I attach an excel file that does the classification almost automatically. You just need to define the annual cost that each group starts with. Here is an example:
All we need to fill up are the parameters that are in blue. The rest automatically calculates itself.
Click on the excel file icon to download the example file. You can also learn from the screen shots how the algorithm works.
Classify items into groups algorithm:
1. Calculate the yearly /monthly cost of all items. Take the current price of the item and multiply it by the number of items used (in production) at that period of time. Don’t use the quantity in the purchase order. Use only the quantities from the work orders.
2. Sort the items from the highest cost to the lowest cost.
3. Classify each item to a group according to the figures decided before (see the summary table above). Items with the annual cost of 400,000$ and more in the example above will be called group A.
4. Use the summarize table function to make sure you get a reasonable output.
Excel example summary:
We have 116 items. 19 of them belong to group A, but they are 73% of the total cost. Groups C and D have more than 50% of the items, but only 2.6% of the cost!
Now let’s define our inventory policies (using inventory days) for each group and calculate the average cost of the inventory. Notice that groups C and D have a lot of items but low cost. That is why we can afford to have a bigger inventory of those items.
Summery
The ABC inventory planning model allows us to focus our planning efforts on items that have an effect on the cost of inventory. We will usually deal with groups A and B. We will deal with groups C and D only a few times a year, although they contain most of the items.
What next?
In real life the ABC model works only for simple items, which is good for most organizations. However, if you have items with more constraints than cost, you will need a more complex model. Other constraints can be: lead time deviation, item volume, replacement items, and so on. For that complex organization I will write another post that you will be able to read on this website (You will get a notification if you sign up for the mailing list).
As always if you have any questions or comments please send them to
theplanningmaster@gmail.com
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